How can the market price of oil fall so far so fast?

If the oil market is reasonably efficient, then the price of a barrel of oil should reflect something like the cost of production of the highest-cost barrel of oil needed to just satisfy demand. In other words, the market price of oil should reflect the marginal cost of production.

The price of oil on the world market was about $110 per barrel in June 2014 and now sits just under $50 per barrel. Can it be possible that the marginal cost of producing oil was $110 per barrel in June 2014 and is only $50 per barrel in January 2015?

Yes.

Here is how: in the first half of June 2014 oil consumption was very high relative to the then-existing world oil production capability. In addition, existing oil production capability is always declining as producing fields deplete. The marginal cost of a barrel of oil under such tight market conditions has to cover the capital cost of developing new resources as well as the operating costs.

Toward the end of 2014 additions to world oil production capability exceeded growth in consumption, meaning additions to production capability were no longer necessary, meaning the marginal cost of producing the last barrel of oil no longer needed to cover that capital cost. Sure, some oil company somewhere had to make the capital investment necessary to develop the resource, but most of those costs are sunk and competition in the market means they cannot make some consumer cover those costs. The market price under today’s looser market conditions only needs to cover the operating costs of production.

Given the large sunk cost component of investment in developing oil production capability, it is quite possible that the oil market was efficient at $110 per barrel and remains operating efficiently today with prices under $50 per barrel.

NOTE: Related data on world oil production and consumption is available in the U.S. Department of Energy’s Short Term Energy Outlook. Commentary prompting this explainer comes from the UC-Berkeley Energy Institute at Haas blog.

Should governments raise the cost of water used in fracking?

Michael Giberson

In dry Texas, water use has been one of the bigger of the policy complaints tossed into the policy whirlwind surrounding hydraulic fracturing. A number of water quantity related bills are currently circulating in the Texas legislature and the Texas Railroad Commission (which regulated oil and gas drilling in the state) has considered a number of water related issues. At least a few of the bills aim at limiting disposal options for wastewater or promoting the use of wastewater recycling.  In effect, most of the bills would raise the cost of freshwater used in oil and gas drilling.

A general theme is much of Texas is still suffering the lingering effects of a drought, so we need to conserve freshwater. But if this is true, why focus so much attention on such a small slice of water use? Less than one percent of water in the state goes into oil and gas drilling. Recycling may be able to squeeze that one percent down a little, or at least keep usage under one percent as the number of wells drilled increases, at an estimated 50 percent increase in water costs.

Policies that selectively increase resource costs for some users and not others are almost certainly creating inefficiencies. Perhaps, to use an obvious example, irrigation could be reduced by 1.5 percent. Or maybe more cities should detect and repair leaks in their municipal supply systems. Or maybe more homeowners should xeroscape their yards. Or powerplants could buy water reclaimed and recycled from oil and gas drilling instead of requiring drillers to reuse it. I don’t know what the most efficient allocation of water uses is going to be, but I’m also sure that policymakers don’t know either.

So why not pursue policies that creates the wide-range of incentives and information needed to promote many low-cost conservation adjustments instead of policies that impose much higher costs on one particular kind of water use?

NOTE: The above prompted in part by Kate Galbraith’s article, “In Texas, Recycling Oilfield Water Has Far to Go,” part of a series on water and fracking in The Texas Tribune.

Promoting cooperation instead of conflict on public lands

Michael Giberson

A few days ago Shawn Regan and I had an op-ed that appeared in the Denver Post‘s Idea Log online section, “Promoting cooperation instead of conflict on public lands.” We begin:

Energy and the environment are often at odds. As America’s energy production reaches record levels, controversies over the environmental impacts of energy development dominate the headlines. More often than not, the result is costly litigation and lengthy political battles.

The debate is particularly intense on Colorado’s public lands. In the past five years, nine of every 10 acres proposed for oil and gas leasing in the state have been formally challenged. Plans to sell leases in the North Fork Valley and the Dinosaur area of Western Colorado provoked waves of protest this month. In response, the Bureau of Land Management deferred the sale of the controversial leases.

Although some conservationists celebrated the delay, many remain wary. During his State of the Union address last week, President Obama proposed to accelerate oil and gas permitting on federal lands. It’s clear that battles over energy development and environmental protection are not going away any time soon.

Recent agreements between energy developers and environmental groups suggest that it doesn’t have to be this way. Competing groups are increasingly working together to avoid costly litigation and reach compromises over energy and environmental values.

We continue with a few examples from Utah, Wyoming, and Colorado. We take these examples as indicating interest in alternatives to litigation and conflict, but the ad hoc nature of these actions are less than ideal ways of implementing policy. Shawn and I are working on a project to provide a more consistent policy foundation for such efforts.

Shawn Regan is an economist with the Property and Environment Research Center in Bozeman, MT, where this op-ed has been reproduced.

The most profitable oil field in the world

Michael Giberson

The Eagle Ford shale in South Texas is the most profitable oil field in the world says Michael Yeager of BHP Billiton Petroleum.

“Eagle Ford wells cost $7 million to $10 million, but Yeager said they pay back within half a year.”

More at the link.

Before getting too excited about the IEA’s forecast of US oil production leadership…

Michael Giberson

Earlier this week the International Energy Agency released their annual World Energy Outlook, and new is a forecast that the United States would surpass Russian and Saudi Arabia to once-again become the world’s largest oil producer, sometime around 2020. The news set off a wave of happy press, i.e. the Wall Street Journalmore WSJ, Fox Business, Oil and Gas JournalReuters, and this odd warning from OPEC that said the report could lead to higher prices. Mark Mills offers a slightly tempered view of the IEA report at Forbes

Many of the news reports, if you get beyond the headline and first few paragraphs, do provide a bit of context. The projection depends on a host of factors, not the least of which is the price of oil over the next few years. If oil prices drop much below $60 bbl., the U.S. oil boom will slow much more quickly than Saudi or Russian output. U.S. regulatory changes, the pace of pipeline construction, and numerous other factors will also affect how quickly U.S. production can grow.

More generally, such long term forecasting exercises are regularly wrong. Indeed, the news here is exactly the change in the forecast, i.e., the IEA view that their earlier forecasts were wrong. The obvious question is “why we should believe the new view?” Of course changing views when the facts change is a most reasonable thing to do, but we ought not believe that the facts can’t change again.

I recommend we all go read Vaclav Smil on the “Perils of Long-Range Energy Forecasting” (Technological Forecasting and Social Change, 65:3, 2000).

Natural gas “expectations were rewritten in the last decade”

Michael Giberson

A brief mention, for those of you keeping track of Giberson media appearances at home, of a brief appearance in a brief story on natural gas supply issues on last Friday’s Marketplace radio news program.

As the story says, natural gas industry expectations were rewritten in the last decade. (But of course you already know all about that.)

My congressman invites me to Submit & Join*

Michael Giberson

In the inbox this afternoon, an emailed letter from my Congressman, Randy Neugebauer, who queries me (and I guess thousands of my neighbors as well) in this manner:

Neugebauer, "Dear Friend" letter, February 27, 2011.

Notice the congressman’s question, “do you believe we should be maximizing the development of our domestic oil and gas resources?” and the button labeled “Submit & Join*”

The  *, which is in the original, links to this explanation: “*By submitting your answer, you are subscribing to the weekly e-newsletter I send out every Monday.

There was no opportunity to “Submit but not Join,” apparently meaning if I don’t want to subscribe to the weekly newsletters then he isn’t interested in my opinion. (Do I want to be spammed about Congressional pork? No, not really.)

But my real problem with this opportunity to communicate with my member of Congress on energy is that I’m not sure I understand the question: “Do you believe we should be maximizing the development of our domestic oil and gas resources?”

  1. Does “maximizing the development” mean producing as much oil and gas as possible? If so, then I’d vote “No.” I’d rather maximize the value of resources than maximize  development. Many fields are unprofitable to develop, because mostly depleted or just not very promising. Let’s not maximize the development of these fields – that’d be wasteful.
  2. Also, though I’m not the sort of person that get’s too worked up by, for example, the fragmenting habitat of the dunes sagebrush lizard, there are other things of value beyond development of oil and gas resources. “Maximizing the development of our domestic oil and gas resources” without consideration of the trade-offs involved would be wrong.
  3. More generally, I wonder just what he means by “our domestic oil and gas resources”? Since Mr. Neugebauer and I are not joint owners in any oil and gas resources (foreign or domestic), who’s resources are “we” talking about? The best answer may be those oil and gas resources that are under federal government ownership, and here again I’d favor maximizing the overall value of the resources, not maximizing the development of them per se.
  4. If, on the other hand, by “our domestic oil and gas resources,” he means to encompass privately owned oil and gas resources in addition to federally-owned property, then I’d say it is nothing I should be voting on. Private resource owners should free to maximize their value, or maximize their development, or turn their properties into duck ponds if that is what suits them (assuming they hold surface rights as well). We have no more business voting on what a private resource owner does with his property than we have voting on which church, if any, the congressman attends.

I’m pretty generally in favor of oil and gas resource (and related) development: ANWR? Open it up! Keystone XL? Permit it! Fracking? Yes, please! I’m pretty sure I’m supposed to say “Yes” to the Congressman’s question, but each time I try to read it carefully I end up saying “No.”

ASIDE: By the way, you might think it not necessary to specify that privately owned oil and gas resources are not some sort of common property of the state, but on the other hand: Bill O’Reilly and Lou Dobbs. (Not recommended viewing, by the way, because economic illiteracy is no laughing matter.)