Friday, January 1, 2016

Macro: From Peak Oil to Trough Oil?

How low we can go from here

Well here are two completely opposite perspective - to $20 (surplus argument) or to above $100 (geopolitical argument). The first one is standard, the second is kinda fat-tail argument (it can happen, but it is less like a probability and more like an uncertainty. Difficult to trade on). Then of course you have the click-bait articles like this and a long term official version of $80. Opinions apart, let's try to get a perspective from the available data. Here is a chart that juxtaposes the current built up inventory vs the marginal supply curve against price.

The inventory is indeed large (left chart). OECD inventory is 60+ days of consumption against IEA recommendation of 30 days stockpile. OECD estimates are mostly reasonable (but sometimes you doubt them). On top there is a much larger than usual oil "At Sea". The rest are running not a particularly high inventory (but at the same time those numbers are very wild estimates).

Chart 2 is my approximate total marginal production curve, see below sources. It basically says at a given price of oil, how much of world oil production achieves breakeven. It shows a very large supply drop around USD 20, and ramp up above USD 50 (red line is 2014 demand at approximately 92.5 mbpd). Of course this can change temporarily based on producer's reaction. But a physicist would say from the curve itself, that oil is at a stable equilibrium and going nowhere. All trades technical here, nothing macro yet. But build longs below USD 30. The supply drop is too sharp to wait for (or ever reach) USD 20.

Also the there is a fundamental difference between shale production and the low cost OPEC production (apart from the cost of production of course!). In case of shale, the variable cost is relatively much larger. Unlike conventional oil field, the cost of exploration and operation set up is relatively much lower. This makes shale production kind of "on the tap". This, and the fact the production curve looks like the way it is, and the built-up of inventory together make the case for a macro-driven sustainable price rise from here any time soon quite unlikely.

Note the last chart is based on production cost, and excludes building in exploration cost, so probably the range is on the higher side. Balancing this impact on oil price, is the ever-increasing cost effectiveness of alternative energy sources. Now add to this your own opinion about global demand for the medium term, and draw your own equilibrium oil price.

Happy new year.

Source: see here, here, here and here, for example

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