21 04 2015

Is this the turning point for fossil energy (1)?

We have heard a lot of nonsense about oil the last couple of months. First we were told that the fall in the oil price would continue to 20 dollars per barrel or even lower – from 100 dollars less than a year ago. Secondly that the fall in the oil price would not affect the US shale oil and gas miracle – US technology and prowess would outsmart the low cost producers as Saudi Arabia. Then, when the number of active oil rigs in operation in the US fell to half, we heard that there was not any connection any more between drilling and production. Of course it now turns out that it is all just that: nonsense.

Perhaps it is worth starting remembering some basics of non-renewable resources. It is common to say that prices are a result of supply and demand, which is as much as not saying anything. Prices are in the medium to long run determined by the cost of production. Full stop. As non-renewable resources get more difficult to access, price tends to increase, unless there are sudden discoveries of new easy to access deposits, or unless there are technological leaps, which make existing deposits cheaper to exploit. So the non-renewable resources (oil, gas, minerals etc.) are not going to be depleted – they are just going to get more expensive to exploit.

The second basic fact worth remembering is that when prices go down, the highest cost producers are the ones to suffer first. They will then have to decide whether to stay on – hoping that the price fall is temporary – or stop production, temporarily or for good. When talking about oil and gas, we know who the high costs producers are: basically we are talking about very deep sea deposits, deposits in Arctic areas, shale oil and tar sands. So these producers are the first to suffer. This is not rocket science.

The third basic fact is that for already drilled wells, the decisive factor is the marginal cost of maintaining the production, as the cost of drilling the well is by now history – what is called “sunk costs”. If the marginal costs of maintaining the production are lower than the price, then the well will obviously be kept in production, even if – looking in the rear mirror – the investment should never have been made.

Then come the more difficult parts: We don't know the actual production costs, as these costs are business secrets. The common belief has been that the Canadian tar sands need a price of 80-100 USD to be profitable, and that the most of the shale oil needs a price of around 70 USD. As the oil price has dropped below 70 USD and production apparently continued increasing, some have deducted that then the production price must be much lower. This is a fallacy, it may simply mean that the marginal costs of the deposits already in production are lower than the price, even at 40-50 USD per barrel. What we should look for are new investments. And there the message is unequivocal: investments have dropped, even as production continued to increase, as newly drilled wells are put into production.

In the US, one of the indicators looked at are the number of active rigs. They are used to drilling new wells, and to keeping old wells productive. From October 2014 to April 2015, the number of rigs has dropped from around 1600 to 734, and it continues falling, even if at a more moderate pace. As mentioned, some “experts” have claimed that this doesn't matter, as the rigs now are much more productive than before. Take at look at the following chart from Bloomberg and make up your mind:


The blue line is the number of oil rigs, and the orange one is production. Would you expect the orange line to continue upwards, while the blue one plummets? Some people claim they do, and to some extent they have been supported by the US agency monitoring the sector (EIA), which has continued to predict record production in 2015 and even 2016. Then the latest EIA report came out a week ago: yes, production is now falling, although not very much yet. Of course. What did they expect? That pigs fly?

So the coming years, there will be a stabilisation of prices and production, depending on whether demand continues increasing. Part of the overcapacity will be squeezed out, but as we don't know the actual production costs, it is impossible to say, what the long run trend of the price will be. In the medium term it will definitely not be 20 USD per barrel, but it might be 50-70 USD, with wild fluctuations responding to periodic over and under supply of the market.

Lower oil prices looks as a boon to consumers: cheaper heating, cheaper electricity, cheaper gasoline... Environmentally we know that most of the fossil fuels should stay underground. Paradoxically, the lower prices mean they may actually stay there, as it will be too expensive to take them. However, if competing energy sources are not coming along, the oil price will necessarily go up again. And then the market forces will pull them out of the ground and they will end in the atmosphere as greenhouse gas.

We should of course expect that our politicians would save the planet by denying the oil companies the permits to drill. But there are no signs of that happening. Happily, help may be coming from a completely different source: bountiful cheap non-fossil energy. We will look at that in a second article.

To read the next article, click here: Is this the turning point for fossil energy (2)?


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Thorbjorn Waagstein

Thorbjørn Waagstein, Economist, PhD, since 1999 working as international Development Consultant in Latin America, Africa and Asia.

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