The future of oil prices

By Chris Nelder | June 13, 2012, 3:00 AM PDT

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Over the past several months, I have detailed the implications of the gradual shift from conventional to unconventional oil production, particularly its upward pressure on the cost of oil production. As it has been a little over three months since I presented my model for oil prices, this week I’d like to review what we know about unconventional oil, and offer an outlook on oil prices for the coming years.

The unconventional non-solution

First, we know that tight oil production, like that in the Bakken Formation of North Dakota,is a treadmill. The constant drumbeat of highly-placed editorials about incipient U.S. energy independence is strictly political fodder, with no sound basis in data. Yes, in theory, it’s possible that we could double the output from the Canadian tar sands and the deepwater Gulf of Mexico, quintuple the number of wells that have been sunk in the Bakken so far, and pull off some biofuel miracles. But local resistance to that drilling program will be fierce in some areas, and its cost will eventually prove prohibitive. And it won’t end there; to maintain that level of output, we’ll have to keep drilling like hell, with increasing risks to the environment and public tranquility.

In reality, despite the technological achievements that have enabled production from these difficult resources, the world is losing the race against the depletion of mature conventional oil fields. And the pace of that depletion is accelerating: it’s now an estimated 5 to 6 percent per year for OPEC, and 8 to 9 percent for non-OPEC. Unconventional oil cannot compensate for a drag of that magnitude for very long.

Further, even if the U.S. were to follow the path to so-called energy independence, it would likely cut the lifespan of our remaining oil in half, leaving us to struggle for decades afterward with greatly diminished domestic production at the very time when global oil exports are declining fastest and becoming intolerably expensive.

We also know that the shift to unconventional oil has moved up the floor of oil prices to around $85 a barrel, which I estimated to be the marginal average cost of profitable production worldwide. A report from Bernstein Research, covered in May by the ever-capable Kate Mackenzie for the Financial Times, suggested that the real floor was even higher at around $92 a barrel in 2011, on its way to $100 a barrel this year. This fits with the stated objective of OPEC members to defend a $100 price target.

But there is also a ceiling around $125 a barrel for the global Brent benchmark (roughly equivalent to $105 for the U.S. benchmark, West Texas Intermediate). This is why world oil prices have been bouncing around the “narrow ledge” between that floor and ceiling since the beginning of 2011, as shown in the following chart.


Source: EIA

In short, unconventional oil doesn’t scale; it’s expensive, and getting more expensive every year; and its risks are increasing.

Finally, we know that we’re losing the race for vehicle efficiency, and probably will lose it forever. Emerging markets, particularly in Asia, have been outbidding the U.S. and Europe for oil since 2005, exerting a constant upward pressure on oil prices even as demand from the developed world continues to decline. Our response to this has not been a materially significant shift to greater vehicle efficiency, but rather a gradual shift from personal to public transportation, shrinking economic activity, and the “nearshoring” of manufacturing.

All of these factors augur higher oil prices as we move into the future.

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