What’s going on with oil? A Q & A primer

Here are some basic facts about oil.

The economic law of supply and demand affects pricing, supply, and demand with respect to oil. Unlike natural gas, whose markets are fragmented, and whose pricing varies widely by geographic local, oil can be transported across oceans easily and cheaply, so oil’s market is global in nature, and anything that affects the supply or demand of oil anywhere affects the price of oil everywhere.

As of 2014, the entire world consumes roughly 92 million barrels per day (bpd). OPEC supplies about one-third of this, or 30 million bpd. Some of the global supply comes from unstable regions and countries, so supply can fluctuate. Demand also fluctuates, primarily in tandem with strong or weak economies, although more efficient ways of using oil (such as cars that get higher mileage) and substituting other energy sources and technologies (such as biofuels and wind farms) also affect demand for oil.

Despite relatively wide fluctuations in oil use, oil demand is rather inflexible, so even small supply-demand imbalances can cause wide swings in oil prices. A change in supply or demand of 1% or 2% can cause the kind of oil price volatility we’re seeing now.

What is “tight oil”?

So-called “tight oil” is oil trapped in underground rock formations that can’t be recovered with conventional vertically-drilled oil wells.

What is fracking?

Once mineral rights are acquired then one can start the fracking process. Fracking is a relatively new combination of technologies that make tight oil accessible. These technologies consist of improved underground seismic mapping, horizontal drilling techniques, the ability to precisely steer drill bits along a predetermined path, the computer technology that allows drillers to direct the drill precisely to where the oil is, and hydraulic fracturing, which involves pumping fluid and sand into the borehole under pressure to break open fissures in the rock so oil can flow to the well.

How do fracked wells differ from conventional wells?

Once a conventional well strikes oil-bearing rock, the oil can be pumped out, and such wells typically produce for a long time. A typical “decline rate” for a conventional well is a few percent a year. Fracking, by contrast, requires many more wells and fracked wells have very high decline rates, with production sometimes falling 80% within a year, so frackers have to keep drilling to keep the oil flowing. Thus, fracking is much more drilling-intensive and much more expensive than conventional oil drilling. Although it is possible that Walking Rigs could help with both processes.

How much oil has been added to the world supply because of U.S. fracking?

About 3 million barrels per day.

Is this enough to disrupt the global supply-demand balance and cause oil prices to fall?

Yes, but other factors also are at play in the current oil price freefall, such as weak economies in Europe and Asia, and production curtailments in some countries because of political turmoil, notably Libya and Nigeria.

How much does oil cost to extract from the ground?

Costs vary widely, from around $5/bbl. for Saudi oil to $100/bbl. for some arctic and deep sea oil. Fracking costs also vary depending on the location, company, and other factors. There are hundreds of U.S. fracking companies, ranging from large to small, and their costs vary within a range of roughly $50 to $80 per barrel. Currently, U.S. fracking costs average about $62/bbl., roughly the same as Canadian tar sands extraction costs, but fracking costs are rapidly dropping because of technology improvements and the “learning curve,” and the U.S. fracking industry is expected to have costs in the $40 to $45 range within a couple years. At some point, though, these costs will level off; and frackers will never be able to achieve the Middle East’s low costs.

You may have read in the media that Russia or Venezuela “needs” a $100/bbl oil price, or Saudi Arabia can go for several years with a $60/bbl oil price. These figures aren’t what it costs these countries to produce oil, they’re based on the amount of oil profits these countries need to support their spending and keep their budgets out of deficit, which is something very different. When oil costs more to produce than you can sell it for, you turn off the well and stop producing it, otherwise you’ll lose more money on every barrel you produce and sell. All these countries can produce oil at much less cost than they’re selling it for, and that will continue to be true, even if oil prices plunge below $50/bbl. But with less oil profits coming in, they won’t have as much spending money. Instead of ratcheting back their spending, though, they’ll likely try to preserve their cash flow by increasing production. This has the perverse effect of increasing the oversupply and driving oil prices even lower, and is part of why oil prices are still falling.

Have oil prices bottomed?

Probably not. The U.S. price benchmark called WTI (which stands for West Texas Intermediate) hit $60 today, and Goldman Sachs believes it will go to $50 next year before leveling off. Opinions are divided among people who follow oil price trends. Some think oil could go as low as $30, others think $45. Last spring, when WTI was in the $90s, Barrons magazine predicted $75 oil. Eight months later, we’re already at $60, and still declining. It’s highly probable that WTI will be in the $50s for at least part of 2015.

Is this oil price decline permanent?

Probably not. Oil is highly cyclical. Most oil industry analysts expect the current oil price dip to last about 18 to 24 months. At that point, the marginal high-cost production will have shut down, and reduced supply will begin pushing up oil prices. Many experts think the WTI benchmark eventually will stabilize in the $80s. There will always be short-term price fluctuations within a band. We may eventually return to $100 oil, but we probably can look forward to several years of moderately less expensive oil and gasoline than we’ve experienced recently.

Are the Saudis conspiring with the U.S. to drive down oil prices in order to screw Putin?

Who knows? Maybe. But you can also rationalize the Saudis’ refusal last month to support an OPEC production cut for other reasons. For example, the Saudis have said they’re defending their market share. Translated into English, this means they don’t want cut their production and oil income so U.S. frackers can happily produce away to their hearts’ content and pocket money that used to go to the Saudis. They want any production cuts to be shared by all producers. But if you want to backstab Putin, the very best way to do it is by manipulating oil prices lower, because the Russian government gets half its budget from oil revenues. If they can’t pay their soldiers, it’ll be harder for them to invade Ukraine. As a bonus, low oil prices also screw Iran and Venezuela, and help U.S. consumers. So it’s a win-win-win for U.S. policymakers. Therefore, I wouldn’t be shocked to learn at some later date that there was collusion between the U.S. and Saudis. But I’m not saying there is. What’s happening to oil prices can be readily explained without resorting to conspiracy theories.stock-footage-oil-donkeys-in-perpetual-motion-at-sunset

How much oil is left?

Too damn much. A few years ago, National Geographic magazine quoted an atmospheric scientist as saying, “We’re going to run out of atmosphere before we run out of oil.”

Is this a good time to buy oil stocks?

Not yet. Oil prices probably will go lower, so oil stocks probably aren’t finished declining, either.

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