January 27th, 2011 
Category: 
The price for a barrel of oil has been steadily rising and forecasts are calling for triple digit prices in 2011. I am sure many amongst you are back to complaining about paying more for gas at the pump. I don’t blame you especially that higher gas prices are looming on the horizon. As much as I don’t want to see oil above $100 any time soon, I also don’t want to see oil fall below $70. Oil prices need to remain strong because slipping below $70 has long term implications. Do you wish you can fill up your car again at $40 oil? I hope you will reconsider once you get exposed to the long term implications
Here is what our production currently looks like.
Every Oil well in production has a natural annual decline rate. Generally speaking, oil production will tend to enter natural decline once around 50% of oil on the reservoir has been produced. This happens as fluids are produced from a sub-surface reservoir, pressure of the remaining fluids decreases.
The largest and oldest oil fields with low production costs are declining or soon will be. Producers have to seek new sources for crude in order to satisfy rising demand and replace natural declines. The problem with that is the rising cost of exploration and production whether from new conventional fields or from difficult unconventional ones such as oil sands or deep water.
The Cost of Oil
“It is pretty clear that there is not much chance of finding any significant quantity of new cheap oil. Any new or unconventional oil is going to be expensive.” Ron Oxburgh, ex-Chairman of Shell, 2008.
For mature projects in Saudi Arabia, Russia, Norway and the UK the cost for producing oil can be less than $20 a barrel. However, the cost of new oil is in a different range of pricing. Within the world’s remaining growth regions, analysts from Deutsche Bank reported in 2009 that the average oil price necessary to achieve a 15% rate of return is now $68/bbl in Angola, $62/bbl in the US Gulf of Mexico, $60/bbl in deepwater Nigeria, and around $60/bbl in Brazil.
Even those with low production costs can be dependent on a certain price level for oil to meet budgetary needs. Other established oilfields like those in the North Sea have breakeven costs of around $50 per barrel. The numbers are confirmed by the figure below presented at Canada’s oil sands conference in Washington in June 2010: the cost of new oil ranges between $50 and as high as $80 per barrel in some cases.
Dangers of low pricing
The search for oil has always been costly and involved risk taking, but the challenges facing explorers have intensified as wells have moved further offshore, into deeper reservoirs and to places with much higher political and physical risks.
Why would a company invest billions of dollars to develop a new oilfield if prices slip below 70$? If the price of crude does not justify the investment, the project will be canceled or postponed into the future. This could result in a supply crunch as current economic woes dissipate and demand growth accelerates.
One thing is for sure in the near future, we won’t be running out of oil but the resulting supply crunch will increase oil prices dramatically and it will be those with spare capacity such as Saudi Arabia who will fill the gap reaping some very profitable rewards. I just hate to know that more of my money would be ending up in the coffers of countries with questionable regimes/ideologies. I would use ethical dirty oil (oil sands) anytime over conventional cheap oil from these countries.
Final thoughts
High oil prices do not have to be in triple digit territory because that will create demand destruction as the world is pushed into another recession. High oil prices are what we’re seeing right now, a range that will keep us well supplied into the future as companies find it worthy to invest in exploring and developing new fields. In the end, it’s a win-win situation because alternative energies become more attractive and hopefully get pushed on the fast track of development and into mass deployment.
What is your view on high oil prices?
My DIY stock portfolio is overweight in Canadian oil producers for a reason. I believe Oil consumption is on the path of growth for the next decade and I intend to take every advantage possible of it:
Mich,
This is a great article explaining the benefits of the high cost of oil. I’m still not sure whether oil is going to linger around $87 a barrel or push higher. Recent reports in America suggest that we have enough oil and there’s no need for prices to increase, but officials abroad have voiced their feeling on the reality of having oil around $110 a barrel. I agree with you that triple digit numbers are not good, but for us investors, its not bad. Just hedge the high gas prices with investments in oil companies.
If triple digit oil becomes the norm, I agree, “alternative energies become more attractive” and will get pushed into the fast lane.
Hi Mich,
I agree that it’s like impossible now to bring down the oil price but the best we can do is to find or develop an alternative for oil.
@Jeff, You’re right that for us investors, triple digit oil prices will put a big smile on our faces. However, the party would last longer if we avoid triple digit prices and maintain strong prices in the area we’re at right now.
@MyOwnAdvisor, Definitely! Triple digit prices will be the catalyst for alternative energies making its way faster to us.
@Shailender, that is correct. Since oil demand remains strong, the only alternative for now is research into renewable alternative energies.
The high price of oil is also a monetary phenomena; so for example, as compared to gold, oil doesn’t change much in price. Thus, nominally, oil goes up in price in the long run. But that is an indication of the devaluation of the currency. This is a factor that must be taken into consideration before concluding that triple digit oil will spark alternative energies. It may not because the devalued currencies will just simply force up the cost of all forms of energy in tandem. Alternative fuels will probably become a viable alternative only when hydrocarbon energy is largely exhausted globally–and that may never happen.
@PWD,
You bring in a good point regarding the monetary aspect. If prices are not fueled by genuine global demand growth, then the scenario may not apply as prices are simply reflecting a devaluing currency. Thanks for your input P!
Thanks Mich. This monetary problem is also why I’m not jumping for joy over my portfolio. It’s up fabulously to be sure, but inflation in the cost of living is right around the corner too.
Thanks for the post! It’s very enlightening to see the state of oil production.
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After the BP incident and stricter regulations, higher oil prices are inevitable. Bad for the consumer, good for the investor!
@MoneyCone, Let’s just hope there recovery keeps its traction!
I’m bothered by the first chart. The assumption that we will get increasingly amounts of production out of “fields yet to be found” is stretchy.
By the way, great post! I agree that excessively high oil prices destroy demand, but i also concur w/ PW Dunn that devaluing currencies play a large factor.
@101, the “fields to be found” represents the potential profits one can make by investing in this sector, it’s huge!
I agree with the others and I think it’s both a question of devaluing currencies and demand. With money created and sustained flowing into commodities, it means higher prices for the rest of us.
You’re right that high oil prices will encourage exploration, production, and investment into alternatives. Unfortunately, that comes at the cost not only of higher pump prices, but higher prices for everything.
There’s very little that we consume that doesn’t have oil as a signficant factor in its cost, if only to transport it from factory to our home via FexEx.
And even people who stay home in the tropics and don’t buy anything new have to eat. Fertilizer requires energy, so higher oil prices mean higher food prices.
This is causing suffering in the developed world, and starvation in the developing world. We can expect more unrest, violence and political instability.
@HR, the pain is necessary if you want to keep the world economies running. Until a cheaper and an abundant new source of energy replaces oil, there is no other way around it.
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“..This could result in a supply crunch as current economic woes dissipate and demand growth accelerates.”
This is exactly was it happening in Argentina today. The government capped gas prices so most exploration activity was frozen, and now there is a huge gas shortage and the government is giving better prices (“gas plus”) to new exploration activity.
@Perucho, Thank you for sharing this information. Incidentally, I was looking at a Canadian listed company with exploration activities in Argentina. Apparently Argentina is importing high priced gas from Bolivia selling it locally at subsidized prices. Domestic prices will definitely be going up. I will probably be initiating a position once my DD is complete.
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