The Trillion-Dollar Question: Are Low Oil Prices Here to Stay?

"Any number of headlines could drive prices back above $100 a barrel very quickly, even more rapidly than they have fallen." 

Beyond such tangible gains, prospective new sources have also factored into future supply assessments and, accordingly, into prices. Playing a large role in this part of the story is a major South Atlantic find made by Brazil’s Petrobras oil company. This Lula field, as it is called, has the potential to add the equivalent of 6.5 billion barrels to known global oil and gas reserves, 13 billion barrels when combined with other new Brazilian fields. When fully developed, these sources should pump the equivalent of 4 million barrels of oil a day onto would markets, a 5.2 percent addition to current global flows. More recently, Australia has announced a shale find that its engineers estimate could increase known global reserves 12 percent. The find is too new yet to yield estimates of production flows. Preliminary Exxon drilling in Russia’s arctic had reported good prospects, though such activity has all but stopped because of the economic sanctions imposed on Russia. Potentials have also gained from the possibility that new conventional extraction technologies will spread from North America to other parts of the world. Russia, engineers estimate, could increase production by 50 percent in this way, even in the absence of any new finds.

Nor will the price declines reduce new North American flows anytime soon. The concern on this front stems from the perception that fracking and tar sands extraction cost more than pumping from conventional wells. To be sure, if prices stay low for an extended time, pumping from these sources might well slow at the margins. But the fact is that tar sands and shale production is not as fragile as some suggest. Production costs can indeed sometimes run high. In some parts of a fracking field, it could cost $90 a barrel to lift oil. But other spots in the same field might cost only $20 to lift the oil. The crucial point is that developers contract for whole fields and for relatively long times. They will, as a consequence, continue to work them entirely for the foreseeable future. On average, engineers suggest, tar sands and shale are largely profitable, as long as oil remains above $50 a barrel, and prices would have to remain below that level for quite some time to have a significant impact on production flows.

Anxieties Rise and Then Fall

This basic supply-demand picture suggests about $60 a barrel as a fundamental market-clearing price— the level that equates fundamental supply and basic demand for oil and gas, all else equal. Such a condition has, however prevailed for some time. Though it has made room for the sudden price drop of the last few months, it certainly cannot account for it. After all, these underlying supply-demand conditions prevailed last spring when prices topped $100 a barrel. An explanation of that seemingly high anomaly and the more-recent, sudden price drop requires a consideration of the third, more-volatile pricing influence—the largely geopolitically based anxieties over supply and demand.

These looked very different only six months ago, when oil prices were uncomfortably high. Russia then had just moved on the Crimea and eastern Ukraine. Many voiced concerns about what the Kremlin would do with oil shipments in response to Ukrainian resistance and Western economic sanctions. At the same time, ISIS’ military advances in Iraq and Syria were at flood stage. Concerns prevailed about what would happen in the then-considered-likely event that ISIS gained control over much or all of Iraq’s oil. Initial ambiguities about Washington’s response to ISIS added to the general anxieties. At the same time, doubts about the course of negotiations over Iran’s nuclear program raised fears that tensions in the Persian Gulf would intensify. Though production gains in the United States, Canada and elsewhere had given long-term hope that global supply would diversify away from these less-than-reliable regions, the unmistakable fact was—and remains—that the Persian Gulf and Russia account for almost 44 percent of global oil and gas output. That fact and this mélange of anxieties understandably prompted markets to bid a considerable risk premium into the price of oil, more than $40 a barrel above the $60 basic supply-demand benchmark at its peak.

The intervening months, however, have seen much of this anxiety dissipate. Washington’s position on ISIS is clearer than it was. These radical jihadists have suffered military reverses, quelling former fears about them gaining control of Iraq’s oil. What is more, it has become clear in the interim that ISIS happily sells what oil it has, raising confidence that the oil would find its way to market, even if ISIS captured all of Iraq’s oil. Also, since prices peaked, Iran and the West have cordially agreed to differ on a nuclear deal, easing oil supply, if not nuclear proliferation, anxieties. And it has become increasingly apparent that Russia is too oil dependent to use it as a weapon, at least not as readily as many feared last spring. The risk premium, accordingly, has collapsed.

Technical Influences and Likelihoods