Carlo's Think Pieces

Reflections of a Filipino in the Netherlands

Oil Price will settle at around $35/barrel

Posted by butalidnl on 13 January 2015

The price of Brent Crude has crossed $50/barrel, and it still has some way to fall. This is not a temporary short term drop in the price; it is the middle of a long-term price movement.There are huge reasons to think that the low price of oil is here to stay – at least for the next few years.

Analysts say that the Saudis are out to get the shale oil producers by keeping the oil price lower than their production costs. Sounds logical. But let’s take a look at the actual production prices.The production cost of oil shale is between $35 and $50/barrel – and this is the average production cost. But the bulk of the production cost is up front – when the well is being set up. The marginal production cost (i.e. the additional cost for prducing every additional barrel of oil) is lower – perhaps as low as $10/barrel. This means that shale oil wells that are already producing will continue producing as long as the oil price does not dip below $10/barrel. However, new wells will not be opened if the price of oil is less than $35/barrel (because investment decisions are made based on marginal production cost).

Offshore oil wells produce oil at $50/barrel. There are a lot of these wells in operation, e.g. in the Gulf south of the US. Their marginal cost of production is a mere $10/barrel, and will thus continue to produce inspite of the low price. However, it costs a lot to sink them ($40/barrel of the cost is from the exploration and development of wells). A price below $50/barrel will mean that new offshore wells will not be developed.

Oil from oil sands costs from $50 to $80/barrel to produce, and most of this is in everyday production cost. This means that this kind of oil will probably be frozen (figuratively and literally), if the price remains below $50/barrel. And there are other marginal producers, e.g. US small-scale drillers (e.g. producing less than 10 barrels/day) which may close down because production has stopped being profitable.

A price below $50/barrel means that offshore and shale oil will thus continue production in existing wells and even sink new wells. Specific economics will determine which wells will be sunk, and which will be deferred. As the price goes further below $50/barrel, fewer new wells will be started, and then not enough will go online to replace older wells that get depleted.

At the same time, oil continues to come from ‘traditional’ sources. Neither OPEC nor the other oil-producing countries are willing to reduce their production. Some are actually increasing production, e.g. Russia and Iraq; while some OPEC countries may also increase theirs e.g. Venezuela and Nigeria.

In the short term, the oil price will continue to drop because there is a lot more oil produced than is needed. The price will go even lower than $30/barrel. It will settle somewhere around $35/barrel.Below this point, it would not be profitable to open new shale oil wells.
In the next 3 to 5 years, the price will range between $30 and $40. After this, economic growth will push up the demand for oil to the point that the price will gradually rise again.

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