Oil Market Remarks by Spencer as Taken from Comments

Lifted from comments from this post, Angry Bear Spencer England further explains oil and markets:

Oil production is an unusual business in that virtually all of the cost of getting crude to the refiner is fixed costs while variable cost or current spending is insignificant.

Economic theory, at least what you will learn if you take some economics courses besides intro, shows that as long as a producers are covering their variable cost, even if they are losing money, it pays to continue production. Thus, what you hear from so many economists and analysts that lower prices will lead to lower output and so balance supply and demand is not quite true. Consequently, lower oil prices will only leads to oil firms not undertaking new drilling. So only with a long lag will lower prices lead to lower output.

Currently, the marginal supply of oil is oil from fracking. At $70 to $80 dollar oil about half of the current supply of fracked oil is unprofitable to bring to market. But oil from wells already drilled will continue to flow.

But next year oil drilling will collapse and with a short lag that will lead to a sharp drop in US oil production. Traditional oil, or non-fracked oil has been falling about 5% annually already. Moreover, fracked oil wells have a relatively short life span — on average maybe about three years. To offset these natural rates of decline in US oil output new fracking has to grow sufficiently to offset these two factors. So in 2015 when new drilling for fracked wells fall sharply most people will be surprised to finally see US oil output drop sharply.

Interestingly, the optimal pricing strategy for an oligopolist like Saudi Arabia is to set the price just below the price that will allow major new sources of oil come to market. Over the years Saudi has not done a very good job of following this strategy, but it sure looks like that is what they are trying to do now.

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