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.

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One thought on “How can the market price of oil fall so far so fast?

  1. There has been an anomaly in the pricing of fossil fuels for the past 6 years. Here are the EIA charts of two very important prices of fossil fuels used in the USA:

    Henry Hub Natural Gas Spot Price (Dollars per Million Btu)

    WTI Spot Price FOB Cushing, OK (Dollars per Barrel)

    Natural Gas and Crude Oil are not substitutes except at the most general level. And they have different modes of transportation and processing. But, if they are being priced differently to their energy content it could be remunerative to make the investments necessary to make the substitution.

    E.G. internal combustion engines can use either petroleum products or NG in their operation with some changes in the fuel systems. Over the past few years, fleet operators have found it advantageous to install NG tanks and fueling machinery to power bus fleets.

    NG is sold by energy content, but petroleum is sold by volume. There are about 6 Million BTUs in a barrel of petroleum so NG should sell for 1/6th of the price of Petroleum.

    After 2009, the prices of NG and petroleum diverged dramatically. NG hung around $4/MBTU while Petroleum shot over $100/bbl. The Pet/NG ratio was thus over 4. Over the past few weeks as petroleum prices have come down, so have NG prices, but the ratio has dropped to 2.7.

    If I had to guess, NG probably will get back to $4, and petroleum will drop to around $25.

    I have not made any investments on that basis, and I am not a professional energy analyst.

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