Current Oil Prices Offer Lesson in Supply and Demand, Rice Business Prof Breaks It Down

by on February 8th, 2018

As the New York Times reported recently, oil prices briefly passed $70 a barrel more than once last week—the first time since December 2014. Chances are good you’re feeling those increases at the pump or as you try to keep your house warm if you live in any of the parts of the United States currently experiencing extremely cold temperatures. While prices are fluctuating slightly due to the Keystone pipeline shutdown and an explosion at Libya’s state-run National Oil Corporation, what the new price really means for the market is harmony. At least that’s how Bill Arnold, a professor in the practice of energy management at Rice University’s Jones Graduate School of Business, sees it.

According to Arnold, the new oil price reflects an intersection of supply and demand. He’s witnessed oil demand gaining strength at the same pace as the global economy, but with oil prices at only about half their peak in 2014. So, how has the world reached this equilibrium? Arnold credits smart decisions by large oil producers.

In an article originally published on The Hill, he said: “OPEC countries, led by Saudi Arabia and other large producers like Russia, have been more decisive and effective in controlling production. This is not to say that every large producer has cut back; however, the net effect has strengthened prices—but not to the point of killing off rising demand.”

But that’s just one piece of the story. Arnold suggests that there are five other factors that have helped to harmonize oil supply and demand:

  1. The decreasing imbalance between supply and demand
  2. Levels of investment
  3. Normal operational decrease in production
  4. Short-cycle nature of oil production in the U.S.
  5. Oil inventory

For example, Arnold looked at the market in 2014. Early in the year, oil was at its peak price. Then, supply outpaced demand by just under 2 percent. This was enough to tank oil prices from their peak all the way down to around $20 per barrel. “This reflects the commodity nature of oil, the price of which will gravitate to the cost for the producer who supplies the last barrel to balance the market,” wrote Arnold. “Higher-cost producers will be driven out over time, although this may not be linear.”

The truth of the matter is that commodity prices are highly volatile and variable in both directions. Too much supply drives prices down while too little supply can drive prices to astronomical levels. So, what does this mean for the current market? We could be in for even more of an increase.

Over the last three years, as prices have remained low, oil companies have cut back on their staff and decreased their investments. While this won’t have a big impact on oil prices in the short term, in three to five years it could lower production levels, meaning demand will outpace supply and prices will creep back up.

As Arnold explained it, “oil fields outside of OPEC on average decline by about 5 percent each year. That takes more than 2 million barrels per day out of global production. Companies are constantly on a treadmill to replace those reserves. Without new investment, that puts upward pressure on prices.”

But there is some good news. The “shale revolution,” which offers a much shorter cycle for oil production, should help keep prices down.

According to the traditional view of oil production, it takes three to five years for the results of investments in oil manufacturing to come to fruition. This is still the case for deepwater or Arctic sources of oil. However, in Texas, the manufacturing process is much quicker. Oil production can be turned off or ratcheted up in a matter of weeks, which means supply and demand can be easily matched.

And because of quick oil production in Texas, OPEC now has unprecedented competition. “What this means is that absent a surge in demand or a dramatic shortfall in supply, say from a crisis in Venezuela, prices are likely to cap at West Texas costs of production that cover invested capital, probably in the $55-$60 range,” wrote Arnold.

Other factors supporting balance between supply and demand include lower costs and improved sustainability due to new technology and processes, as well as the vast inventory of oil. Over the last few years, production of oil has outstripped demand causing a surge in oil inventory, which puts a cap on future prices of oil until only new supply is left.

“Bringing all these factors together suggest that while oil prices may be ‘lower for longer,’ an equilibrium has settled in. Whether this will continue is not a foregone conclusion, as OPEC struggles with dissent among its members and there is no shortage of political instability around the world,” wrote Arnold. “Over time, competition from natural gas and renewables cloud oil’s price horizon.”

To read the full article, head over to the Rice Business Wisdom site.

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