The Price Ceiling on Oil By: Gabriel PotterMBA, AIFA® 2014.12.31

Did you read our latest article on the Energy sector?  We are still thinking about this sector and we expect to continue watching it closely next year as the story develops.

So, the first notion is that low oil prices is bad for OPEC nations.

In our article, we suggested that a key oil producer – Saudi Arabia - can maintain a high supply of oil without great cost to itself.  We pointed out that many OPEC countries need the price of oil to be higher than $80 or even $100 per barrel to balance their national budgets, but that isn’t the primary number worth considering.  Pumping oil from the desert sands is still pretty cheap; the marginal cost of pumping a barrel of oil is about $20 in Saudi Arabia, so it’s still worth it.  Saudi Arabia isn’t selling oil at a loss in an attempt to maintain market share.

Back to the main problem for OPEC:  what will end cheap oil?  We know that their budgets won’t balance with oil prices being relatively cheap.  Even if it is still profitable for OPEC countries to pump and sell their oil.  In contrast to OPEC nations, the newcomers to this market - north American wells - have higher “break-even” points, mostly from $40 to $80 per barrel.  In other words, Saudi Arabia could keep oil at $55 (where it is now) and they’re still making money.  For the moment, most fracking wells continue to pump and sell what they can, but the incentive for drilling new wells is diminished.  So, consider low prices today as a disincentive for future supply.  Given these complications, Saudi Arabia can maintain a high-supply, cheap oil environment and limit competition in the future.

So… the second, more sophisticated, notion is that low prices prevent future competition and maintains OPECs strength. Market pundits have been considering this deeper level of analysis and wondering if this isn’t a very canny play by OPEC after all.

My notion?  This is still a bad situation for OPEC to be in.  Yes, they can limit their competition and maintain market share.  However, they’ll never have the power they used to have because there is always the threat of high prices encouraging competitors into the market. In other words, given a little bit of lead time for north American frackers, there is an existential ceiling on the price of oil that never used to exist for OPEC.  Worse, as hydrofracking technology or alternative energy sources improve, the price for using these sophisticated techniques gets cheaper for producers.  In other words, that hovering price-ceiling on oil should creep downward over time. 

Gabriel Potter

Gabriel is a Senior Investment Research Associate at Westminster Consulting, where he is responsible for designing strategic asset allocations and conducts proprietary market research.

An avid writer, Gabriel manages the firm’s blog and has been published in the Journal of Compensation and Benefits,...

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