Since we sent out our last update detailed update on, Oil a good deal has changed. Most notably, the price of WTI (West Texas Intermediate) is now trading at just over $56 per barrel. I made the following point in our last update on October 18th, 2008:
“On the production side, while I totally buy the long term supply constraint argument, in the short term and this is very simplistic, if OPEC has to cut production to maintain price than scarcity value should not be priced into Oil anymore (I think that was part of the argument that people were making when Oil was on its way to $140 i.e. there is a premium above marginal cost for scarcity), thus Oil should trend towards its marginal cost . . .$60 / $65?”
Since I wrote about the dangers of narrative fallacies this weekend, I’m not going to pretend that I called the decline in oil we’ve seen over the last few weeks, but I did want to highlight the point above because it is very important in understating the context of how Oil has traded.
Oil has traded down despite what are, ostensibly, bullish data points. Specifically, OPEC announced a 1.5MM barrel per day emergency production cut a week after my post on October 24th. Obviously this has done little to support the price of Oil as the commodity is down roughly another 10% since then. What this tells me is that the concept of Peak Oil, at least in the short term, is finally getting priced out of the commodity. And that, on the margin, suggests to me that the Oil bottoming may be beginning. Remember, bottoms are processes, not points.
On the demand side, despite consumer weakness, there is no doubt that the dramatic declines in gasoline prices we have seen in the U.S. and around the world will have, on the margin, a positive impact on demand. At a sub $2.40 per gallon price, gasoline is down by more than $1.70 from its July “Peak Oil” peak. Eventually this will have a positive impact on y-o-y demand comparisons, even if it is a quarter or two away.
The other key point I made above is that the marginal cost of production for Oil, according to many oil economists, is in the $60 per barrel range. Obviously this is a vast simplification and is subject to grades of oil and services costs, but, once again, on the margin this price level is important. At this price, many projects become less economic and at sustained prices below $60 per barrel we will see some mothballing of exploration and development projects. The excerpt below from an article in the Houston Chronicle today highlights these points:
“Oil prices closed below $60 a barrel, a level widely considered to be near the break-even point for multibillion-dollar deep-water projects that have been a key driver of Houston’s energy economy in recent years. If prices go lower still, oil companies could be forced to re-evaluate and possibly postpone deep-water projects, just as they have already done with less-costly land and shallow-water drilling plans, analysts said. At $50, they probably start canceling projects or slowing projects up,” said Eric Smith, associate director of the Tulane Energy Institute in New Orleans.”
We are not ready to call a bottom just yet, but after a ~20% decline since our last update and a 1.5 barrel production cut from OPEC, we are certainly getting interested.
Daryl G. Jones