No, Virginia, Marginal Costs Don’t Set The Oil Price Floor

No, Virginia, Marginal Costs Don’t Set The Oil Price Floor

Oil platform off the Caspian sea coast near Baku, AzerbaijanGetty

“Asked by the BBC if oil could go back “well-above” $100 a barrel, Mr Margerie said “Yes,” adding: “The problem is when, the problem is to anticipate this, not to send [a] message to scare people but to send a message … ‘it’s important to invest now’. He said prices of $60-$70 a barrel was not enough to protect our long-term investment.”  The Telegraph, UK, 9/21/2009

Visiting an oil service firm in the late 1980s, my prediction that oil prices would not rise during the 1990s was met with alarm from an executive who exclaimed, “We can’t survive without higher prices!” Sadly, he proved correct, the company is no longer extant, but he was hardly alone in thinking prices would move to enable his firm to prosper.

A persistent myth in many industries is that costs set prices. When the oil price was over $100 a barrel, comments like the one from the late Total CEO Christophe Margerie, quoted above, were quite common. Unfortunately, oil prices obey the wishes of industry executives no more than the tide obeyed King Canute.

The basis for the myth is found in microeconomics, where the cost of the marginal product sets the market price. If prices go above that level, production increases and brings prices back down; the same works in reverse when prices fall below the long-run marginal cost. This is generally true over lengthy periods, but as in so many cases, reality is sometimes more complex.

The first problem is that oil prices are not related to the cost of the marginal barrel, in part because OPEC influences prices and in part because the marginal barrel is hard to define. Is it deepwater production in the Gulf of Mexico, or conventional oil in the Saudi desert? In a free market (which is a conceptual idea, never real) the marginal barrels would come from various OPEC countries, where conventional wells produce thousands of barrels a day, compared to, say, 10 b/d in East Texas.

The second problem is that costs tend to respond to prices in the short and medium run. When costs rose after 2003, some said, “The easy oil is gone,” or that the industry was being forced to move into more costly environments, driving costs up. In fact, the industry experienced factor cost inflation as higher levels of activity sent unit costs soaring, just as happened in the late 1970s. The figure below shows how when oil prices rose in 1979, operating and equipment costs in the U.S. oil industry also increased, only to moderate or come down when prices also did so. The same appears to have happened after 2003, although sadly the government stopped collecting data after 2003.

US oilfield costs (1976=100) and real oil priceThe author fromEIA data.

But the cost of the marginal barrel is also subject to a certain amount of choice, depending on prices. When prices are high, companies make high-cost investments, reversing the behavior with lower prices. The figure below shows a standard, often misinterpreted, supply curve. This is a snapshot of costs at a particular point in time and does not indicate their direction:  costs are organized lowest to highest, left to right, they do not grow from point A to point D over time or proceed to rise beyond point D in the future. Instead, a variety of factors put pressure on each segment of the curve:  depletion drives costs up, technology drives costs down. Empirically, mineral costs tend to see technology improvements roughly offsetting depletion effects, so that the costs tend to be flat over the long term (relative to inflation).

Illustrative Supply CurveThe author

Further, if oil prices fall below point D, that doesn’t mean they are unsustainable. Point D often represents projects that only went forward because high prices made them viable; when prices fall to C, developments costing more than that are abandoned, making C the new marginal cost—but no more the floor price than point D. A company that invests in projects that cost D cannot sit back and wait for prices to return when they drop below that point; rather, they will accumulate losses.

The fact that the right-hand, highest-cost barrel is not the true long-run marginal cost of oil production is demonstrated by the manner in which most new production comes from the middle of the supply curve, not the right-hand side. Iraq, Russian and Saudi supply additions have been responsible for much of the increase in the supply curve over the past ten years, adding about 5 mb/d of medium-cost supply to global production, emphasizing the fallacy of thinking that costs proceed over time from A to D and higher.

More important, cyclical effects cause costs to rise and fall, usually in rough correlation with oil prices. When the oil price was over $100 a barrel and upstream investment (and activity) rose to new heights, inflation pushed costs up more than any depletion effect. Estimates have put the inflation rate at 200-300% during the period of $100+ prices, due entirely to heightened activity levels, not a move towards more expensive oil. That effectively moves the complete supply curve upwards, but not permanently. (Supply curves created in 2003, before the price rise, showed global costs at about half what later curves estimate.)

Ultimately, it is necessary for companies to avoid investing in high-cost projects with the hope that those costs will somehow form a floor price that protects them from losses. This is especially true for smaller operators who don’t have the deep pockets necessary to ride out 2-3 years of exceptionally low prices, but all companies should be wary of thinking that prices will follow a track that is beneficial to them and their operations.


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