August 20, 2015


A Funny Thing Happened on the Way to $80 Oil (A. Gary Shilling, 8/20/15, Bloomberg View)

Me? I'm sticking with my forecast of $10 to $20 a barrel. The logic behind that February projection still seems valid. Cartels exist to keep prices above equilibrium. But that encourages cheating, as cartel members want more than their allotted share and outsiders sell more to take advantage of the artificially elevated price. So the job of the cartel leader -- in OPEC's case, Saudi Arabia -- is to cut its production to accommodate the cheaters and prevent a price collapse. The Saudis had been doing that for decades, and as a result, OPEC production over the last 10 years has been flat, with all the growth instead enjoyed by non-OPEC producers, including U.S. frackers and Canadian oil-sands companies.

The Saudis got tired of seeing their market share shift to others, so they and the other financially strong Persian Gulf producers decided to play a high-level game of chicken. They figured, in that Nov. 27 OPEC meeting, that they could withstand low oil prices longer than the cheaters. So they effectively abandoned quotas. OPEC production last month was 31.5 million barrels a day, the highest since May 2012 and up 1.5 million barrels a day from the previous ceiling. The Saudis themselves are producing a record 10.35 million barrels a day.

In this war, the chicken-out price isn't what's needed to meet budget requirements, which ranges between $40 a barrel in Kuwait and $125 a barrel in Venezuela. It isn't the cost of drilling, pipeline laying and other overhead expenses, either. No, it's the marginal cost of getting the oil out of the ground once the wells are drilled, the pipelines laid and the overhead covered. It's the price at which cash flow for an additional barrel drops to zero. In Texas's Permian Basin and in the Persian Gulf, the marginal cost is $10 to $20 a barrel, and even lower for some Saudi oil fields.

As long as prices exceed marginal cost, more (not less) production is encouraged to make up for lost revenue.

Posted by at August 20, 2015 4:23 PM

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