Oil Is Too Cheap

No, not for the reason these guys think:

Venezuela will back repeated cuts in OPEC oil production until prices stabilize, Oil Minister Rafael Ramirez says, and Russia is proposing closer cooperation with the oil cartel.

Ramirez said Wednesday that his country will back a proposed 1 million barrel per day cut when OPEC meets Saturday in Cairo. If that doesn’t halt the price slide, “We will keep cutting until the market stabilizes,” he said during a visit by Russian President Dmitry Medvedev.

Oil prices fell below $54 a barrel Thursday as dismal U.S. economic data and rising crude inventories outweighed the possibility of production cuts by OPEC and non-member Russia.

Russia, the largest oil producer outside OPEC, produces around 11 percent of the world’s oil and it could be eager to seek new customers to shore up its suffering economy. OPEC output is estimated at about 31.5 million barrels a day — about 40 percent of daily world demand.

Venezuela’s President Hugo Chavez has said OPEC should work to keep global oil prices in a “band between $80 and $100.”

I normally explain price moves using conventional terms of supply and demand. In this case, though, the rules are somewhat different*. There is certainly some demand destruction that has reduced the price of crude oil, but I hardly think it’s a large enough change to move from $147/barrel to $50/barrel oil. At this point, the price of oil seems artificially low, considering the fact that fundamental supply and demand forces haven’t changed.

Yet the response from OPEC, Venezuela, and the big oil companies is the same as if the price decline was natural — they reduce production. This is not only true of the state-owned oil companies, but areas such as Canadian tar sands and some of the more difficult offshore fields have stopped production or shelved new exploration projects. This only makes sense, of course, as the marginal cost of production of many of these projects is well over $50/barrel, and they don’t want to lose money.

This causes a major problem for two reasons, assuming that the fundamentals haven’t changed:

  • It takes supply offline in the short-term, and due to the nature of drilling, shutting down existing fields may reduce the ability to pump oil from those fields in the future. I.e. if a field is pumping 500,000 bbl/day before being shut down, it may only reopen with the capacity to produce 460,000 bbl/day. Thus, taking oil offline in the short term reduces potential oil recovery in the long term.
  • Reduction of exploration projects reduces oil supply in the future. While this may only push out exploration projects 2-3 years, current IEA projections of decline suggest that we should be searching for oil right now — and fast.

What does this mean for future oil prices? They’re going to go up, and they may be going up faster than before. This isn’t a return to the norm, this is the swinging of a seesaw. We’re at a low point right now, but an 800-lb gorilla just got on the other side.

Of course, to hear that oil prices are too cheap is not a common theme these days, as here in California gas has dropped under the $2/gallon mark. From a personal level, of course, I’m enjoying the reprieve. But now may simply be the best time to jump out and buy yourself a gas-saving auto, because these prices will not last.

* The new paradigm can still be related in terms of supply and demand, but it’s the supply of money that has shrunk. The deleveraging process has sucked money out of a number of markets, and while the monetary base hasn’t shrunk (in fact it is growing quickly), the velocity of money is far lower. In a fractional reserve world, that has a deflationary effect. Demand is still strong for gasoline, but there is a far smaller supply of dollars on a commodities trading floor to pay for it — all this at a time when the costs of production are still paid in old dollars. Supply and demand still applies, but it requires a different vantage point to understand the change.