Artificially Overpriced Oil

oilwellOil has been artificially overpriced for quite some time. The recent plunge in oil prices represent a correction of highly distortive market forces. Unfortunately, the correction is unlikely to last – in no small part due to the effects caused by lower oil prices themselves.

Oil has been artificially overpriced for quite some time.

Eighteen months ago, oil was trading for over $100 a barrel. At that point, it had been above $80 a barrel for nearly five years. For the five years prior to that it had mostly stayed over $60 a barrel. All of these price points are far higher than a simple business analysis tells us they should be in an ideal market.

A little bit of napkin math makes this clear.

The US Energy Information Administration figures for oil consumption are out of date, but only by a little bit. They list 93 million barrels a day of global consumption. Let’s round that up to 100 billion barrels a day, both for easier math (we’re doing estimates here, we don’t have to be perfect) and to account for the numbers being a few years out of date. The US Energy Information Administration estimates total annual consumption for 2011 (chosen to match most closely with the Wikipedia consumption stats) at 88.5 million barrels a day. [Note: Wikipedia doesn’t provide a good measure of this or I’d use their numbers for consistency.]

Let’s grant that both of these are estimates and likely not quite perfect, but they’re probably close. What we see is that global production doesn’t quite meet global demand. But… it could.

Let’s look at the breakdowns of oil production. The US leads the pack with nearly 14 million barrels per day, followed by Saudi Arabia at 11.6 million barrels per day. We’re going to skip a bit down the list, but not too far, and note a few others. Iran and Iraq, both sitting right around 3.4 million barrels per day, occupy places 6 and 7 on the list. Venezuela, at roughly 2.7 million barrels per day, is number 12.

Every country that I’ve named has producing oil at rates far below their capacity for years (probably several other nations as well, but let’s stick with what I can speak on reliably).

Iraq’s oil production has been hampered for two and a half decades by geopolitical realities: sanctions, then the first Gulf War, then another decade of sanctions, then the 2003 invasion, then years of internal civil war. Iraqi oil production has finally surpassed their peak production prior to the 2003 invasion. But does anybody think their production couldn’t be 10-20% higher – or more – if they hadn’t had their infrastructure ravaged by decades of sanctions and war?

Iran is in a similar boat, only it might be more drastic. [Iraqi production might be as drastically low a Iran’s, but we can’t prove it the way we can with Iran.] Iranian oil production is nearly half what it was at its peak – in the late 70s! That’s right – Iran’s production tanked after the 1979 Islamic Revolution. But that’s not because they don’t want to produce it or because they lack the means. It’s because international sanctions prevent them from selling it. [Sidebar: this is why the “war for cheap oil” argument never made sense; if we wanted cheap oil, all we had to do was lift sanctions on Iran.]

It’s unclear exactly what sanctions are being lifted on Iran as part of the deal that went into full effect this weak, but it’s at least allowing them to sell more oil than they have been. But we know from historical data that they could feasibly double production if they chose to.

Venezuela’s production is off its peak because socialist dictator Hugo Chavez, spectacularly mismanaged their oil industry. They’re down nearly 30% from their peak.

Saudi Arabia has the opposite issue. It’s been underproducing oil for years – by conscious choice, in order to keep prices high. Note that in the last few years they’ve substantially raised their oil production – specifically to manipulate the price of oil and to try to claim market share from competitors. Note however that Saudi Arabia hasn’t made major new investments in oil production in decades. They haven’t wanted prices to go down. Until now they do for some reason [more on that tomorrow].

Then we get to the US – the world’s largest producer of oil. We use a lot of oil, but we produce a hell of a lot of it, too. But we could be producing more – much more. We have oil reserves all over the country that aren’t being tapped. But it’s not for international reasons or price manipulation. Here, it’s all about environmental regulation. [Note that for the purposes of this post, I’m not arguing for or against this; merely stating that it is reality.]

Now, let’s look at that. Iran alone could be putting out another 3 million barrels per day in an ideal world. Iraq could probably be putting out half a million to a million more. Venezuela could be putting out a million more. The US… let’s guesstimate that they could be putting out a million more (I’d be willing to bet that we could go much higher than that).

That’s a grand total of around 6 million barrels per day – or nearly six percent of total oil production – that is simply missing.

Now, we know from modern economics that the effects of changes in supply or demand on a market’s price are non-linear. A small change in supply or demand causes a small change in price, but a big change in supply or demand results in a huge change in price. In a commodity market like oil, six percent is a huge change in supply.

In an efficiently operating commodities market, the average price should be price just a bit higher than the marginal price. In other words, it should be right around (but probably a tad higher than) the highest cost to produce. Right now that’s fracking oil in the US, which costs around $40 per barrel to produce. So in a fully undistorted market, we should be seeing oil prices hovering below $45 per barrel.

However, that’s not the whole story. Because in a market with 6% higher supply, fracking might not make sense anymore. Saudi oil costs around $20 per barrel to extract, and much of the middle east is the same. So the undistorted market price might be somewhere closer to $25 a barrel. It’s hard to say exactly where it should be without… letting the markets figure it out.

What we’re seeing in the market today represents a price much closer to where oil actually should be (although the current prices might be a tad low, and in need of upward adjustment now; it’s hard to say). This is a direct result of Saudi Arabia ramping up their production.

Unfortunately, today’s low prices will probably not last. Oil is likely to become once again artificially overpriced. But that’s a topic for a later post.

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