According to economic theory, in a perfectly competitive market the price of a good will equal the marginal cost of production. The marginal cost of production is the cost of producing an extra unit of output. The theory states that if it costs $10 to produce an additional unit, while the selling price is $20, firms will rush to produce that extra unit since they can make money on it. This additional supply will drive the price down and this trend will continue until the market price is brought down to the marginal cost of production.
In the oil & gas industry this rule has definitely applied.
The main reason why the crude oil price began to rise following the turn of the century, eventually reaching $100/B in 2008, was not that the world was running out of crude oil (Peak Oil). It was running out of conventional crude oil.
Conventional crude oil production appears to have peaked sometime during 2006. From that moment onward the oil companies had to tap into resources which were more difficult to access and, hence, more costly to produce, in order to meet growing demand from the BRIC countries – especially China. In other words, the marginal barrel had become substantially more expensive. If the world wanted this additional crude oil it would have to pay for it, and so prices rose.
Of course, in 2014 the crude oil price fell again, down to the $40/B - $60/B range.
This was due to fact that when the crude oil price was high, the oil & gas industry was the most interesting business proposition for investors. From 2009 through 2013 the oil & gas industry raised about $850 billion in new capital, a massive 27 percent of all new capital raised globally during this period. This money oil & gas companies poured into development of unconventional sources of oil, such as ultra-deepwater, oilsands and tight oil (shale), which had become economically viable due to the high oil price. Total capital investment by the industry rose 50 percent compared to 2008 and consequently production increased. Tight oil in the United States alone added 3.5 million barrels of production per day to global supply.
Global economic growth, on the other hand, did not keep pace, meaning that crude oil supply grew faster than crude oil demand. When during 2014 the IMF then began warning about a coming era of mediocre growth, it became clear that the crude oil market would be in a prolonged state of oversupply and the price collapsed.
This is only a temporary suspension of the rule of marginal cost pricing, however. Right now the market is adapting to the new reality. The low crude oil price has caused a sharp decline in oil & gas capital investment already, and this is expected to continue throughout 2016. Eventually this will cause supply to drop to the level of demand. Once the rebalancing is complete, the rule of marginal cost pricing will again drive the crude oil price.
What crude oil price will this lead to in the short-, medium- and long-term?
Short-Term (less than 10 years out)
Between 2011 and 2013 the cost of the marginal barrel increased from $89/B to $114/B. But, the current low price environment has put a lot of pressure on the operators of unconventional resources to reduce their costs, which has brought the cost of the marginal barrel down substantially. For example, due to innovations (improvements in drilling, reduced water usage, reduced sand usage, refracking, reservoir modeling improvements) tight oil production in the United States is on way to a 65% cost reduction. The average break-even price for US independent producers is now estimated to be around $42/B, with a low of just $24/B for some parts of the Bakken Shale. That is why many American shale companies say they can now be as successful at $65 a barrel as they had been at $100 a barrel.
Their remains a lot of tight oil in the United States that the fracking technologies can be applied upon. These technologies could also be exported relatively easy to other parts of the world with tight oil reservoirs, such as Russia, Argentina, and the United Arab Emirates.
Therefore, barring a major unforeseen uptick in global economic growth, tight oil will be able to meet the increase in demand over the next 10 years. Since this oil can now be produced at a cost in the 40/B - $60/B range, this effectively means the crude oil price will remain in this range.
Medium-Term (between 10 to 20 years out)
Two trends will have a major impact on the crude oil price in the medium term.
The first is the trend of continuous innovation in fracking technologies. The players in the fracking industry will not stop innovating now that they have reduced production costs. Due to competition the cost of the marginal production technologies will continue to go down, lowering the cost of the marginal barrel of crude oil, as the number of recoverable barrels will continue to go up.
The second trend that will drive the crude oil price in the medium term is the transportation sectors' gradual move away from petroleum. Currently, more than 60% of crude oil produced is used for transportation. However, Tesla is leading the popularization of electric vehicles. In fact, Tesla could be said to be revolutionizing the car industry, as Volkswagen recently announced it would pivot to electric vehicles. Renault-Nissan's CEO Carlos Ghosn explained this move when he said: “A decade ago many people thought electric cars would never make it. The transformation in thinking about electric cars is (now) complete. EVs are on their way to becoming a mainstream choice”. Toyota responded to this trend by announcing it will target a 90% reduction in the emissions of its vehicles through utilizing hybrid and fuel cell technologies.
These changes in the car industry will limit the growth in crude oil demand and thereby extend the period during which the current marginal production technologies can be used to meet crude oil demand.
Long-Term (more than 20 years out)
The global energy industry is on the eve of major disruption. All three obstacles that have so far prevented renewables from really taking on oil, natural gas and coal are currently in the process of being overcome by technological innovation.
Continued research into solar power coupled with industrial scale production of solar panels has lead to the cost of solar power for electricity generation dropping much faster than anticipated earlier. Apparently, in parts of the United States utility-scale solar power generation capacity can now be delivered at a price below that of natural gas based power generation plants and a similar milestone is expected to be achieved in Europe within another 10 years. This means that in the not too distant future, on a cost basis renewables will be able to fully compete with hydrocarbon energy sources.
The intermittency of solar and wind energy and their limited mobility have been further obstacles to renewables powering the global economy. Energy storage is close to overcoming these issues, however. Battery innovations over the last 20 years have lead to an increase in capacity and a decrease in cost. Mass production of the batteries at Tesla's gigafactory will move energy storage technology further forward. Tesla hopes this will enable it to capture the home and grid energy storage market, that eventually could be worth as much as $50 billion. But a number of other companies with venture capital backing are furthering alternative battery technologies to beat Tesla to it.
Lastly, the global focus on reducing emissions and the Millenials' preference for renewable energy, which mean that through switching to renewables companies can establish for themselves a competitive advantage, will ensure a continuation of this technological progress. Over time this trend will weaken the link between energy demand and crude oil demand, meaning less and less of the growth in the energy market will translate into growth in crude oil demand, until eventually the link breaks entirely and overall crude oil demand starts to go down.
In the long run, therefore, demand will prevent the crude oil price from rising.
Andreas de Vries is a Strategy Consultant in the Oil & Gas industry, supporting companies to formulate strategies for success and translate them into concrete action and practical results.