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Oil Price Over $100, in a Blink
Posted on Jan. 20, 2009

By Michael J. Economides
http://www.energytribune.com/articles.cfm?aid=1238
The Cassandras are out in force these days. Some are true believers. Others are masochistic oil men. They claim that the recent price of oil -- at almost $150 -- was a “spike” fomented by speculators. And now that the oil price is down, it will never go over $100 again, it may even go down to $10 or it will stay at $30, forever.

Some of these analysts have written for this publication. How US-based speculators, as blamed by a recent TV show, can cause the wild ride towards $150 oil, is mystifying. This was supposed to happen while world oil consumption was more than four times that of the US. Big, bad oil is no longer blamed for the price hike?

The analysts are right on one thing. There was never really a rational reason for $150 oil. Headlines ruled and speculators did ride them. But oil at $40 is also irrational, fed by headlines about the economic crisis.

There are three main reasons why oil cannot stay at $40 or even $70.

First, is the physics of flow in porous rock reservoirs. (I have often wondered how many of the analysts think that oil is found in underground rivers and lakes of oil.) Most economists simply do not understand that oil is a depleting resource and that one does not need to do anything for supply to go below demand. Decline rates for world oil production are now at 6.7 percent and will grow to 8.6 percent by 2030. If only 15 percent of wells that should be drilled are not drilled, then supply will be reduced by 1 percent, even assuming a flat demand. Just one percent of over- or under- supply can move the price of oil by 50 percent.

Second, is the equilibrium or, more appropriate, the break-even price of oil. This is the required price for new wells to be drilled and for oil companies to invest, especially in new areas. The break-even price is something we can determine using the “activation index.” That index is the amount of money required to bring to market a stabilized production rate of one barrel per day. Using that index, along with life-cycle economics based on the well’s expected longevity, observed annual decline rates and after-tax cash flows, the break-even price of oil can be calculated. For example, the activation index for West Texas is about $15,000 per barrel per day. It takes $300,000 for drilling and completion costs to deliver 20 barrels per day. Surprisingly, on some offshore projects with 1,000-barrel-per-day wells, the activation index is about the same, even though the wells may cost $15 million.

I have calculated the break-even price for many petroleum producing areas of the world and by weighing their contribution to the total production, we can calculate the world equilibrium price. A critical variable is the discount rate or the time value of money. This ranges from about 10 percent in stabilized parts of the world such as West Texas to, perhaps 50 percent in Nigeria. For places like Russia and Venezuela, the risk is such that discount rates for most serious oil companies would be 100 percent or more. For Iraq it is still in the stratosphere. Today, I calculate the world break-even price at about $70. This is, of course, the average, meaning that in some places it is $30 and somewhere else may be over $90. The bottom line is this: Oil below $70 simply cannot generate new production in great swaths of oil places and some of them are huge, like Russia and Venezuela.






The final point is my favorite geo-political aphorism: With oil at $100, Hugo Chávez and Vladimir Putin are 1,000-pound gorillas; at $40 oil, they are reduced to monkeys. They need the oil revenue to prop themselves up and, especially, to project their countries’ geopolitical clout and relevance. They are certainly not consensus-seeking democrats nor are they patrons of free markets. They will do anything, including unilateral production stoppage or other theatrics to bring oil back to the price they want.

Oil is going back to $100, and very soon.