A few weeks ago, I suggested that the oil market was stable and range-bound, and therefore not a good proxy for economic health (in our blog post, “Stop Looking at Oil”). Moreover, we have argued for years that the market clearing price of oil was going to drift along the curves of supply and demand only as far as the marginal costs of hydrofracking would allow it to. As a reminder, the marginal cost of oil production for hydrofracking drilling operations is between $40 and $80 per barrel.
Over the past few days, we got an opportunity to test this supposition out with a real-world shock to the system. As you may know, there were coordinated drone strikes on Saudi Arabia’s oil facilities. These attacks knocked out half of the country’s production capacity – approximately 5.7 million barrels of oil per day. This is the largest supply shock in history, greater than the Iranian revolution of 1979, greater than the Iraqi invasion of Kuwait in 1990, and greater than Hurricane Katrina in 2005.
So… Would oil spike to hundreds of dollars a barrel because of supply concerns? Will this lead to shortfalls like the 1970’s embargo crisis? It sure doesn’t look like it. Oil futures are trading at $62 per barrel, right in the middle of the assumed range, and well below the recent April peak of $74 per barrel. Of course, the oil facility damage is having an impact, but it’s primarily of interest to industry watchers and market enthusiasts. A 10% increase in the price of oil, while noticeable, isn’t a world-changing event.
If anything, the shocking news to the Saudi Arabians isn’t the immediate loss of production and revenue. The real shock is that the world can easily absorb losing 6 million barrels a day, due to violence, and barely bat an eye. Oil producing cartels and governments are being given a useable case study, demonstrating the limits of their leverage.