Why is there an oil price?

Why is the oil price well-behaved? I mean why is it settling in a range around $50 a barrel instead of being stuck at a few dollars per barrel, the marginal cost of the cheapest producers? Or for that matter why isn’t it much higher, at several hundred or thousands of dollars? These questions are not as trivial as they appear.

I know that different producers face different costs of extraction and shipment, with Saudi Arabia bing the cheapest and US fracking the most costly. If producers also face scaling limits on production, that would create a sloping supply curve. But do they? What’s stopping Saudi Arabia from pumping the oil out of the ground much faster and meeting the entire world demand until its oil fields run out? It could then charge a price just below the amortised extraction cost of the next cheapest producer.

Is there a technical or geological limit on how fast you can drain an oil field? Faster extraction of course requires more rigs, but the capital requirement is moot. If one rig is profitable at a given oil price so are 100 rigs, assuming the oil field and the market last longer than the capital amortization period.

A fully competitive market with zero foresight, in other words concerned only with present returns and assuming oil reserves and world demand lasting indefinitely, would suggest an oil price close to the lower bound. That we’re not seeing that suggests producers are factoring some aspect of future or total expected returns into their supply decisions. In other words they set the NPV of future returns above zero. Hold that thought.

What’s at the other extreme? What if some really far-sighted people, say Norwegians, value future returns on par with the present? Then they should say “Hang on, this oil belongs not just to us but to our children and our children’s children. All future generations need to be compensated for losing their finite resource, so we’re keeping it in the ground until it’s the last oil in the World and prices are many times higher than thy are now”.

If a producer can wait, assuming oil stock is finite but world demand persists indefinitely, you’d expect them to sit on the oil until production collapses, there are acute shortages, and they can extract punitive prices. That’s the way to maximize total returns if you set the NPV multiplier of future income at 1, that is you value the future as much as the present. Nobody does that, not even the Norwegians.

So what determines the price of oil? Is it the intersection of a textbook competitive supply and demand curve, where supply means marginal production cost and capital amortization? Is Saudi Arabia simply trying to drive US shale (fracking) out of the business? That’s the theory that prevails in the business press. Or is there something more subtle going on?

If producers are basing their supply decisions not just on spot supply and demand but on some sort of future returns calculation, they have three factors to balance:

An NPV curve (Net Present Value) or how they value money today vs. money in the future. This is subjective. War or fear of losing power may make the current leadership of an oil producer unusually short-termist. Oh look, ISIL, Yemen, the Saudi king just died…

Finite stock considerations, in other words recognizing that the stock of oil that each producer has is not infinite. Neither is the world total. Peak oil looked like an overriding concern a few years ago, but with the exploitation of shale and other expensive reservoirs the concern has abated. Oil is still not infinite though, and it’s finite within one or two human lifetimes meaning that producers should care.

The uncertainly of future demand. Sure, demand fluctuates but it’s rising indefinitely or at last not falling, is it? Well that assumption may be dramatically wrong. Oil demand may well drop abruptly because of climate limitations, or because of a technology shift to a superior form of energy such as solar. If you’re an oil producer with foresight you might want to get your money now before that happens.

I find these price-influencing factors at least as plausible as the naive assumption that there’s a price war going on against shale. If they apply, low prices may persist much longer than analysts are expecting, or may revert quickly. Prices may also move much lower or much higher than the cutoff point for shale which appears to be near current levels. We’ll see. But if a lot of volatility happens, and price turns out not to be driven by shale costs, don’t be surprised.

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