Monday, August 12, 2013

The New Baseline - Why Oil Prices Won't Go Down

After a decade that saw
oil prices skyrocket, only to come suddenly crashing back down, it’s easy to wonder where the market might be heading in the next few years. Despite these fears, though, every indication suggests that oil prices aren't going to drop far from their current level ever again.

The Big Drop

If you were on planet Earth over the past few years, then you've felt the pinch of the Great Recession. But people investing in oil and gas took a bigger hit than many, with oil prices dropping from more than $145 per barrel in July 2008 to just more than $30 per barrel that December.

Since then, however, prices have climbed a bit more slowly than in the lead up to the crash, hovering around $100 per barrel. Now oil investors are asking, "What might cause the next crash?"

The New Normal

It's impossible to say for certain that there won't be another big drop in oil prices, since the commodity is so intimately tied to the global economy. The world took a hit at the start of 2010 when a massive earthquake and tsunami crippled Japan.

But it's important to at least understand one idea: $100 oil should be the expectation.

There will always be ups and downs, but the lead-up to 2008 was a clear bubble, and the crash in prices simply mirrored the huge shock to the global economy. But as a recent infographic demonstrates, the oil market has seen some fundamental changes that will keep prices well above the levels we saw at the low point of the recession.

  • Developing demand - In 2007, before the worst of the run-up in prices, the globe consumed around 85 million barrels of oil per day (bpd), according to numbers from the U.S. Energy Information Administration. The U.S. alone made up nearly one-quarter of that, and Europe was another fifth. By 2012, American demand had actually fallen by more than 2 million bpd even after largely recovering from the Great Recession. European demand fell nearly as much. Yet, global consumption rose by nearly 3 million bpd, driven by growth in developing economies like China (2.7 million bpd), Saudi Arabia (844,000 bpd) and India (600,000 bpd). 
  • Rising costs - While China is certainly driving the demand end of the equation, there are pressures on the supply side as well. Many Americans have heard about how hydraulic fracturing - or fracking - has helped sparked a domestic energy boom, and wonder why that isn't leading to lower prices. The problem is that these techniques are driving production purely because of these high prices. Production costs for conventional oil deposits vary dramatically from region to region, but tend to range around $20 or $30 per barrel. For fracking, the break even point is often closer to $80 per barrel.
With conventional wells starting to slow down and more oil coming from expensive new sources, oil investments are increasingly protected by the fact that nobody in the industry can afford for prices to drop too far below $100 per barrel. That means it might take some patience to wait out economic dips, but if you're worried about oil selling for cheap, you're probably worried about nothing.

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