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?
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.