What's the right way to think about the long-term price of oil?
This question consumes the industry -- and markets -- no matter what prices are on any given day. Back in 2000, when mega-mergers formed giants like Exxon Mobil Corp., it was typical to plug roughly $20 a barrel into valuation models. Only a few years ago, we were being told that "$100 a barrel is becoming the new $20". One crash later, no oil major's slide deck is complete without a pledge to fund itself at $55 or less.
Take a look at the oil futures curve just prior to the crash and in several more recent periods and you can see that, for all the movement in daily prices, longer term prices seem pretty anchored around that level:
Another New Normal
Long-term oil futures have collapsed by almost half and are anchored around $55 a barrel
Why that level? The likeliest explanation is that it appears to be the trigger point for U.S. shale producers to boost drilling and fracking, raising supply relatively quickly and thereby keeping a lid on prices. Meanwhile, the rest of the industry has had to squeeze costs to remain competitive with these Texas upstarts. The previous spell of cost inflation behind that "$100 is the new $20" comment now works the other way.
And because shale's productivity owes more to inputs of capital, technology and innovation -- like manufacturing, in other words -- than traditional advantages of political access to territory, it represents a sea change in oil's economics (see this and this), upending the old paradigm centered on OPEC.
But oil is a weird market.
Presenting BP Plc's latest edition of its annual Statistical Review of World Energy earlier this week, the oil major's chief economist, Spencer Dale, raised an interesting point about the role of oil-exporting nations in an age of relative oil abundance:
If you are a very large oil producer, you can run very significant fiscal deficits for two, three, four, five years, and that is perfectly fine for you to do that ... You cannot run very large fiscal deficits forever. And therefore, in the longer run, I think we need to think not only about what the cost of extracting oil out of the ground is, you also have to think about the nature of the economies of those major oil producers. And for them, I do not see many of those major oil producers with economies which work anywhere near $50, let alone below $50.
In an interview in New York the next day, he elaborated:
One's natural instinct as an economist is to say: Well, I know how to price anything in the long run. I work out what the cost of producing it is; I put a return on capital in it; that gives me a markup: That's the long-run price.
In oil's case, however, those big exporting countries present a problem because, as Dale says, most of them require oil prices far above $50 to make their economies work over the long term (see this). Even Saudi Arabia, which was smart enough to sock away billions in the boom years, can't withstand prices at this level for long.
About a decade ago, at the height of the peak oil frenzy, this need on the part of OPEC countries was used by some to justify ever-higher price expectations. Under this thinking, OPEC had most of the oil reserves, and its members' one-trick economies needed $100-plus prices to function; ergo, oil had to be priced at that level.
I mean, come on. That's like me going to my boss and saying, "I need to be paid millions because, you know, I've got a certain lifestyle to maintain." They'd find another, cheaper journalist or make do with none at all. Oil consumers did the same thing.
The point isn't that OPEC's needs set prices in that way. It's more that, with its members still supplying about 40 percent of the world's oil, their economic weaknesses represent a risk to seeing prices as being in inexorable decline from here. Consider, if U.S. oil companies aren't economic, they can try to cut costs and, even if unsuccessful, the worst that happens is a trip to bankruptcy court. In an oil-dependent economy, governments must embark on radical and potentially destabilizing reform -- see Saudi Arabia -- or can, as in Venezuela's case, flirt with outright collapse.
This inherent fragility around a large part of global oil supply raises the risk of a supply shock down the road, which could send prices higher again, just as in the 1970s and at several points over the past decade.
While it is tempting to cheer on the unraveling of OPEC's members, that would be short-sighted. If the past couple of decades have shown us anything, it is that failed states, quite apart from the moral dimension of their suffering, have ways of exporting the consequences.
Nevertheless, the risk of such shocks is rising. The twist this time, as opposed to previous shocks, is that if they occur, the resulting windfall for oil producers still standing would come at a big and lasting cost.
Besides the peculiarities of oil-export economies, the other reason the cost-plus-return model of long-term prices may no longer work is that oil will increasingly have to compete for customers. Its core market -- transportation -- is now under threat at the margin from technologies like electric and autonomous vehicles and societal pressures around pollution and climate change. A jump in oil prices due to fears of scarcity arising from a failed state, with all the attendant security fears and distressing video footage, would have a predictable effect: spurring efforts to move away from an unreliable product.
Over time, the role of drilling costs or Middle Eastern state budgets in determining oil's value will diminish in favor of a more straightforward concept: What is it really worth to a customer with choices?
This column does not necessarily reflect the opinion of Bloomberg LP and its owners.