The Martenson Report - The Cruel Math of the Marginal Barrel

The Cruel Math of the Marginal Barrel

by Gregor Macdonald, contributing editor
Tuesday, May 22, 2012

Executive Summary

  • Why oil price vulnerability is growing 
  • Why the marginal cost of oil is rising higher at an accelerating rate
  • Why the marginal cost of oil for non-OPEC regions is now above $90
  • The hard math explaining why an increase an output from OPEC will no longer reduce the world price for oil
  • The new rules that will govern the price of oil from here
  • The alarming growing risk of large-scale war for oil

Part I: OPEC Has Lost the Power to Lower the Price of Oil

There’s been a lot of excitement in the past year over the rise of North American oil production and the promise of increased oil production across the whole of the Americas in the years to come. National security experts and other geo-political observers have waxed poetic at the thought of this emerging, hemispheric strength in energy supply.

What’s less discussed, however, is the negligible effect this supply swing is having on lowering the price of oil, due to the fact that, combined with OPEC production, aggregate global production remains mostly flat. 

But there’s another component to this new belief in the changing global landscape for oil: the dawning awareness that OPEC’s power has finally gone into decline. You can read the celebration of OPEC’s waning in power in practically every publication from Foreign Policy to various political blogs and op-eds. David Ignatius of the Washington Post wrapped up nearly all of the recent claims in a nice bundle in his May 4, 2012 piece, An Economic Boom Ahead?, when he quoted PFC Energy’s David West:

“This is the energy equivalent of the Berlin Wall coming down,” contends West. “Just as the trauma of the Cold War ended in Berlin, so the trauma of the 1973 oil embargo is ending now.” The geopolitical implications of this change are striking: “We will no longer rely on the Middle East, or compete with such nations as China or India for resources.”

(Source)

While it’s true that the Americas hold great promise to convert natural gas resources to higher production levels, that is not the case with oil. The celebration of a geo-political swing in energy power therefore misses a crucial point: No region -- from OPEC to Non-OPEC, from Africa to Russia -- has the single-handed ability to lower the price of oil now, because none can bring on new supply quickly enough for a long-enough sustained period of time.



And there is more to this story than meets the eye.

History of OPEC

For over 30 years, OPEC has produced less than half of the world’s oil. Indeed, as of today, OPEC produces only a little more than 40% of the world’s oil. But most of the world’s spare capacity has been held by Gulf State producers. Thus OPEC, primarily Saudi Arabia, has long been able to control the price of oil in not one, but two, directions. Historically this has meant that the concentration of oil pricing power resided with OPEC and its largest producer, Saudi Arabia.



But starting in 2005, global oil markets sensed that OPEC was only able to influence the price of oil in one direction: higher, by lowering output. OPEC’s ability to lower prices started to crack, break up, and generally fail as the first phase of oil’s repricing headed into 2008. Indeed, OPEC raised production several times in the 2004-2008 period, attempting to restrain oil prices as it moved to protect the global economy from an oil shock. However, the oil market, which was going through a fundamental transition at the time, as it reoriented itself towards insatiable, price-insensitive demand from Asia -- paid little attention.



Instead, supply disruptions at small producers and in small regions had a greater influence on oil price (pushing it higher) than OPEC's influence on attempting to push the price lower.

It’s actually not clear that OPEC has had any measurable influence on restraining oil prices for years. Summer hurricanes in the Gulf of Mexico, unrest and outages in the Niger Delta, and various strikes presented greater upward pressure on oil prices than upward OPEC supply changes.

The Mythology of OPEC

There is a trailing cultural myth, therefore, (which is nothing more than a hangover from 30 years ago), that OPEC can mount swift, price-killing upsurges of production. But as the below chart shows, OPEC production has made no progress in at all in the seven years since 2005, as oil began its price transition.



As oil rose above $50 in 2005, eventually reaching $90 in 2007, and then on to levels above $140 in 2008, OPEC production both rose and fell, but without any reliable correlation to price. In the aftermath of 2008, OPEC production has correlated better with the recovery in oil prices. But again, the rise in OPEC production has only come back towards the previous highs from last decade. Here is a recent news story rather breathlessly discussing the most recent OPEC production levels this year:

Acting to mitigate market nervousness amid Iran supply fears, OPEC on Thursday said it was pumping more oil than the market needs—at levels not seen since summer 2008—and expressed a cautiously optimistic note on demand. The cautious optimism, combined with a production boost sufficient to cover all of Iran's oil exports, is likely to further stabilize oil markets, where volatility by some measures has already smoothed in recent weeks. In its latest monthly market report, the Organization of Petroleum Exporting Countries said its crude production was 32.42 million barrels a day in March, up 317,000 barrels a day from the previous month.

Yes, but there’s a neglected point to make: these production levels are not special. Not meaningful. And are not newsworthy in any sense. Production at/above 32 million barrels a day? That level has been reached at least 4-5 times since 2005, with at best weak correlation to price changes.

Let's take a closer look at the global share of oil supply, divided in two between non-OPEC and OPEC production.

Non-OPEC vs. OPEC Oil Production 

There are several possible conclusions to draw from the above chart, which shows that non-OPEC provided nearly 58% of global crude oil supply in 2011, and OPEC provided 42%.

  1. Non-OPEC is the domain of private oil companies, and has managed to increase its market share over the past 30 years through competition and through the use of technology.
  2. OPEC’s market share has stagnated, possibly due to the predominance of state-run oil companies and the interference of political structures.
  3. Non-OPEC has the pricing power, due to its larger market share.
  4. Or perhaps OPEC still retains the pricing power, due to its greater quantity of spare capacity.

There’s an element of truth in each of these observations. 

Many also believe that both OPEC and non-OPEC could be producing a lot more oil. In the case of OPEC, many harbor the view that state-run producers and governments are sitting on massive, hidden spare capacity and retaining it as a cartel to manipulate oil prices higher. In the case of non-OPEC, many believe that environmentalists, regulations, and other limits placed by democratically-elected governments are suppressing a wall of supply that could come to market easily if only the oil is ‘set free.’



These views, however, are not only extreme but shaky. They are typical of the kind of grand claims that fit people’s worries and suspicions, rather than fitting any empirical data. The fact is that OPEC spare capacity has been under pressure for some time despite persistent belief to the contrary, with estimates running below 3 mbpd, or even below 2 mbpd. (For recent commentary on OPEC spare capacity, see A Model of Oil Prices by Chris Nelder). The case for hidden, held-back oil capacity in OPEC is weak, especially as domestic populations in the Gulf have dramatically increased the consumption of their own oil.



Meanwhile, non-OPEC large producers like Russia have significantly increased production this past decade. And regions like North America have been able to slow declines. Western oil companies -- which dominate non-OPEC production -- have scoured the globe looking to replace their reserves, but largely to no avail. This is why ExxonMobil and ConocoPhilips eventually gave up, capitulated, and bought natural gas assets instead. By doing so, they followed in the steps of Royal Dutch Shell, which had taken the natural gas pathway years earlier.

Therefore, a fact about non-OPEC production that was unknown even to the industry ten years ago is now very plain: There just isn’t a vast quantity of new oil that can come online easily and inexpensively outside of OPEC-controlled regions. Only Russia, the largest non-OPEC producer and now the largest single country producer in the world -- eclipsing even Saudi Arabia -- was able to significantly increase production.

A Window into Non-OPEC Supply: Russia

Two charts will tell us all we need to know about the limits facing non-OPEC crude oil production. First, let’s take a look at total non-OPEC production on an annual basis:

Just as with OPEC production, little if any progress has been made in the past seven years. This has been a complete surprise to most analysts, especially within the industry itself. Who would have thought that with a regime change in oil prices, non-OPEC could not sustainably increase production to much higher levels? Instead, non-OPEC production remains stuck around a ceiling, just like OPEC.



The Big Reveal comes, however, when we take a look at non-OPEC supply without Russia.

Without Russia, non-OPEC supply has actually lost about a million barrels a day of production in the last ten years. This speaks volumes to the quickly-rising costs of bringing on a new barrel of oil in non-OPEC regions, which we will discuss further in Part II of this report.

The Price of Oil When OPEC Is Powerless

Let’s imagine for a moment that OPEC could, if it chose to, pour an extra 3 mbpd of oil on the world market. And that by doing so, it could lower the price of WTIC oil to $90 or less. What would that accomplish? And for how long would such “lower” prices last?

In Part II, we explain that while fluctuations in economic activity can certainly raise and lower the price of oil, there are deeper structural reasons why OPEC -- even with its spare capacity -- can no longer sustainably “lower” the price of oil. Moreover, we will discuss how, paradoxically, any surge of supply from OPEC which did persuasively lower the price of oil could wind up having the opposite effect on price eventually thereafter.

Surprising? Yes, but not strange or unlikely, for reasons we will explain. Finally, we conclude that oil’s floor price -- outside of volatile 30-90 day periods -- is higher than ever before. This will make for a large surprise, should another acute phase of the financial crisis rock oil prices lower over a 2-3 month period.

Part II: The Cruel Math of the Marginal Barrel

An unpleasant megatrend that has affected global oil production the past decade has been the quickly escalating cost of production. However, prices have finally risen high enough to stabilize declines in regions like North America.

This actually makes for a new and emerging vulnerability: the risk that prices fall at some point through levels that remove the new oil supply.

Given that world oil production has been trapped below 74 mbpd since 2005, and that the cost of the marginal barrel keeps rising, this vulnerability is growing.



Let’s first take a look at North American crude oil production:

As we can see, the combined production of Canada-US-Mexico has been in decline for a long time. But this decline stabilized just recently, as prices were finally sustained at high enough levels to bring on some new supply.

While Mexico’s production has not increased at all, but merely stabilized at low levels, US production has recovered by a half million barrels a day (compared to a five-year trailing average) and Canada’s production has finally started to push forward, recently hitting the 3 mbpd mark.

Despite what you read in the newspapers however, these new production advances in the US -- and also especially in Canada -- are not rapid. It has taken years of investment to create this new supply. And it has taken the promise of, and the reality of, higher prices to inch supply higher, now back above 11 mbpd. 

The Cruel Math of the Marginal Barrel

Thus, we come to the emerging problem in global oil: The cost to bring on the marginal barrel of supply keeps rising, ever higher and ever faster.



For readers who are not fluent with the terminology, it’s very important to understand. So just briefly, the cost of a marginal unit -- whether that is a product or a natural resource -- refers to the cost to bring on the next single unit via production.

As most of us grew up in the modern era, we are used to thinking of the marginal cost as something that eventually falls. This is why in recent reports I have addressed the fascination with technology and especially the digital world of production. Indeed, in these areas, marginal costs do often fall, and, of course, in the world of the Internet, the marginal cost of the next unit of service often falls rapidly towards zero. This may help some readers to understand better why venture capital has a new and vitalized allergy to investing in anything that takes place in the physical world. Zynga, LinkedIn, Facebook, Farmville, and other such entities can offer the marginal unit of service, at some point, for nearly zero cost. Those are the kinds of powerful dynamics that exert a magnetic effect on investor capital.

Alternately, Silicon Valley fingers have been burnt, badly, trying to invest in greentech, for example. And there’s no surprise in that. After all, greentech takes place in the domain of the physical world, where costs are high. And this serves as a lesson: In the world of bits, marginal costs have the potential to fall. But in the world of physical production, despite the best efforts of automation and efficiency gains, the cost of the marginal unit can either fall much less rapidly -- or worse, not fall at all. And the economics of profit-maximizing ventures go especially awry when the cost of the marginal unit rises.



Now, while it’s true that the next barrel of oil from an individual oil well can indeed cost “less”, depending on how you run the accounting, the cost of the marginal barrel on a global or regional basis refers to the cost to bring on a new barrel of production from a new field or well. Over the years, many of us in the oil-analysis community have watched the cost of this marginal barrel rise.

But here’s the thing: We watched it rise in jagged, unequal fashion across various non-OPEC regions. I remember when the $40 cost of the marginal barrel in the Alberta Tar Sands struck everyone as very high, back when Canadian Oil Sands Trust was adding capacity to its existing operations prior to 2005. And as the years went by, there was a lot of disagreement as to how much a new barrel of supply cost in The North Sea, in ultra-deepwater of the coast of Brazil, in the next set of Alberta Tar Sand projects, and now in shale plays like the Bakken, in North Dakota.



Some analysts feel that you must therefore make a laundry list of the various marginal costs to bring on a new barrel in each separate region. So for example, US offshore might need $60-$70 dollar oil and Canada, which is weighted towards the tar sands, might need $70-$90 dollar oil. The ODAC newsletter from September 2011 listed a number of these estimates of marginal costs in table form.

However, I have always felt that in a world of very tight oil supply, even if “some producer, somewhere” can bring on a new barrel of oil at, say, $50 dollars a barrel, it matters whether other producers need much higher oil prices to bring on the marginal barrel. This is why I was delighted, and thankful, to see the recent piece of research from Bernstein on this very important issue.

In Non-OPEC, the Marginal Barrel Has Soared Above $90

Writing in FT Alphaville, fellow energy journalist Kate Mackenzie noted that Bernstein’s most recent data showed that “The marginal cost of the 50 largest oil and gas producers globally increased to US$92/bbl in 2011.”

That would be about $5-7 above the figure that I've been using over the past 12-18 months, and which I cited in my co-authored Harvard Business Review piece last fall. So this is not a huge surprise to me. But it’s bracing, nevertheless. I mean, think about it. With WTIC oil trading around $100-$110 a barrel this year, and especially given the recent weakness in oil, we are already very close to the marginal level. And that has huge implications.



I have made up a simple chart to show the new estimate of marginal costs in non-OPEC vs. OPEC. I have used the update number as mentioned in the Bernstein research, and my other research (ongoing) shows that the figure is roughly $50 for OPEC. After all, even Saudi Arabia in recent developments at fields like Khurais has had to build out very expensive infrastructure to bring on its own, marginal barrel of supply:

Now, having pondered the previous discussion on the cost of the marginal barrel in Non-OPEC, let’s revisit my question that I posed at the end of Part I: 

Let’s imagine for a moment that OPEC could, if it chose to, pour an extra 3 mbpd of oil on the world market. And that by doing so, it could lower the price of WTIC oil to $90 or less. What would that accomplish? And for how long would such “lower” prices last?

As the question marinates in your mind, let me leap ahead to a kind of paradox that now faces the world oil markets and the world price of oil: If OPEC is indeed holding enough oil off the market to keep prices elevated, this is paradoxically restraining oil prices from going even higher. Why? Because by keeping oil prices above $100, high-cost marginal barrels in non-OPEC are given the green light to be developed.

OPEC and Non-OPEC Create a New Zero Sum of Oil Supply

The model that we can use, therefore, is roughly as follows: The barrel of extra supply from OPEC, which would effectively drop world oil prices below the cost of the marginal barrel in non-OPEC, will simply be negated by an equal reduction of non-OPEC production.



As Bernstein correctly deduced:

While OPEC plays a key role in influencing price through production quotas, in the long run we believe that it is the marginal cost of non-OPEC production which sets the oil price. As global demand has surged over the past decade the marginal cost of production and oil prices have increased, as the industry has ventured to increasingly higher cost (smaller, deeper fields) and more marginal regions (deep water, high arctic) to produce the incremental barrel of oil.

(Source)

By George, I think they’ve got it! (Forgive me, but with so much terrible research and flag-waving in the oil industry space, it’s a relief to hear an outfit actually speak the truth).

This is why oil prices this year, restrained by turmoil in economies, have had trouble rising -- but have also had trouble falling. The oil market correctly understands that the price floor on oil is much, much higher now.

That does not mean oil can’t go below $90 for short periods of time during acute phases of the ongoing financial crisis. But think about it: How many trading days late last summer, into autumn, during the nasty phase of the European debt crisis, did oil trade below $90? Maybe 40+ trading days. That’s just two calendar months. And during that time, oil only traded below the $80 level for 5-10 trading days:

We can reasonably conclude that the global oil market, which is always able to buy and store oil for future delivery, knows something that most still don’t understand: If we see oil prices below $90 for any length of time, then, the undeveloped barrel in non-OPEC will not likely appear on the scene. In other words, you can simply buy oil for storage below $90 because it's cheaper than trying to find that same barrel and develop it yourself.

The Oil Limit Hardens Further, Introducing New Rules

I keep thinking the oil limit can’t harden any further. And then it does. Here are some new rules:

  • $100 dollar oil is now closer to a low than a high.
  • Only the most massive dislocations in financial markets will be able to take oil prices to very low levels for short periods of time -- possibly as low as $60-$70. But only for about 90 calendar days.
  • Buy oil and gas producing companies during stock market declines, especially during periods when oil falls below $90.
  • Players in the oil markets, including the large producers like Shell, Total, BP and Exxon, will use their trading divisions to gather up and store oil at prices below $90, because it's cheaper than developing those barrels.
  • The public has still not figured this out.
  • The recognition phase of oil's increasing price floor has still lays ahead.

Per my recent piece, The Race for BTUs, and also per the view of Erik Townsend, the impact of the recognition phase has the potential to become rather powerful and widespread.

Conclusion: Hot War for Oil?

The longform writer and blogger FOFOA (Friend of a Friend of Another), who produces thoughtful essays on gold, recently used the key concepts in my piece Get Ready for Hot Inflation, to explain further his own view: that hyperinflation will come as though a light-switch is being thrown.

He takes issue, a little, with my concern for strong inflation and my lack of concern with hyperinflation. However, we agree that hyperinflation, at its core, is a behavioral event. FOFOA sees that risk as ever-present. Instead, I see that risk as needing time to develop. My view: The economy will need strong, conventional inflation first, before it can tip into hyperinflation. 

At its root, this recent discussion about inflation is applicable to oil. Because we all need to be watchful now as to when the social-psychological tipping point arrives. To be frank, I think it's nearly impossible to anticipate the flashpoint of such a shift. Surely it's a sign that North American energy independence is clearly a new meme, widely embraced in the media, which people discuss now in passionate terms -- almost with tears in their eyes.

Here is the Anadarko CEO James Hackett, in an email to Steve Levine who runs the excellent Oil and Glory Blog at Foreign Policy:

It is a huge issue for me emotionally and as a patriot that we have a chance for the first time in my 30-year-plus career to actually become close to technically independent of foreign sources of oil. You think about that for a country that has had an energy policy that only consists of aircraft carriers in the Middle East for over 30 years of my life, and the opportunity to change that metric, and the leverage it affords American policy, the lives it saves, the balance of payments implications, making us less susceptible to people who don't like us. Letting free enterprise flourish in a way it wasn't a few years ago. We are on the cusp of this, and there are people in the country who, I don't know if they care like I do about those things. Well I will be darned if I let them keep me from educating my fellow citizens about why this is so cool. And if it takes us to our dying breaths and spending a lot of personal time on this, we gotta get this message across.

Perhaps the recognition phase of oil scarcity will be put off even longer, should the global financial crisis move into another acute phase, sending oil prices -- as well as production volume -- lower.

But when you have CEOs of oil companies mangling reality and saying such things as "we are close to technically independent of foreign sources of oil," then it's a sign that certain emotional pull is being exerted in opposition to a painful truth.

I don't know which will be more terrifying for the Western industrial economies, recognizing that non-OPEC production hangs in the balance of maintaining oil prices above $90, or that OPEC would simply knock some of this supply off-line, were they to overproduce and actually get prices below $90 for any length of time.

Overall, if we add to our anticipation the fact that global governments are maintaining an ongoing Reflationary Put to the global economy, then all economic weakness and associated deflationary fears will be met with more liquidity (money-printing). This strongly suggests that a period of oil-scarcity panic, hoarding, and even the use of oil as a unit of savings or a way to store wealth will arise well before we get to any "collapse" that descends into a true deflationary spiral.

The conclusion is inescapable: A hot war for oil, one that is explicitly about oil, will be an emerging risk in the next three years.

~ Gregor Macdonald


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