Oil price crash shows the challenge of breaking addiction

The price of crude oil has fallen more than 50% since summer and drivers are responding exactly as economists would predict.  Americans are driving more, the market for SUVs is roaring again and the average fuel economy of new cars sold is declining after years of increases.

CrudePrice150120

Many oil analysts predict that oil prices won’t stay this low, and the futures markets agree.  The price for oil delivered in March 2019 is 40% higher than the price for oil delivered in March 2015.  Regardless of whether oil prices regain some of their 2014 losses in the next few years, the latest petro-roller coaster illustrates the monumental challenge that still lies ahead for attempts to reduce greenhouse gas emissions by switching to EVs or biofuels.

To see why, start by recognizing that the oil crash of 2014 resulted from a collection of unforeseen changes to supply and demand.  Economies in Europe and Asia saw slower demand growth than was forecast.  The U.S. supply expansion (mainly from fracking in North Dakota and Texas) continued at a more robust pace than anticipated, while U.S. demand is dampened by years of improving fuel economy. Libya’s oil production rebounded as warring factions reached enough accord to get oil onto tankers.  And OPEC did not offset these surprises as it has done in the past (mostly just Saudi Arabia) by taking a few million barrels per day off the market.

CrudeProductionShocks150118

But the piece of this story that has gotten very little attention is how small the supply and demand surprises have been as a share of the 92 million barrel per day market.  Given past trends, the news in the last year didn’t plausibly change the supply/demand balance by more than 5 million barrels per day, and it was probably a lot less.  Yet, that was enough to drop the spot price of oil by more than 50% and push down long-run oil price expectations by more than 30%.

The reason for this outsized reaction is the simple economics of competitive markets: the price is set by the marginal cost of the last, or highest cost, barrel sold.  The marginal barrel is less costly to produce these days than 6 months ago, but most of the crude oil supplied is even less expensive.  The recent oil price drop shows that a small increase in crude supply and/or a small drop in demand brings a much cheaper barrel of oil to the margin, and that sets the price.

The 2014 crash gave us a small glimpse of what reducing world crude demand would do to oil markets.  There is a lot of conventional crude oil that is unpumped and an enormous supply of oil from shale and tar sands that is becoming cheaper to produce each year.  The annual energy forecasts from the U.S. Energy Information Administration, International Energy Agency, BP, Exxon and others see consumption of liquid hydrocarbons increasing or flat for many decades.

CrudeDemandOutlookBPSource: BP Energy Outlook, 2014

If switching to alternative fuels took even 20% out of world oil demand – less than a third of the oil used for transportation — the price would surely crash further and for much longer than we have seen in the last year.

What would oil prices would look like if world demand fell to 70 million barrels a day by 2025?  Anything above $40/barrel doesn’t seem very plausible, and below $30/barrel seems much more likely, possibly well below.  Even at $30/barrel, the oil-cost component of gasoline is about $0.75/gallon.  With transportation, refining, and retailing costs plus taxes (at today’s level), the U.S. price of gas would barely clear $1.50.

Alternative transportation technologies are indeed making real progress.  Energy storage is improving and making electric vehicles credible, if still very expensive.  Biofuels are improving and I read stories that some can compete at $3/gallon, though scalability is still an unresolved question.  I hear frequently from some of my former students who are deeply involved in these exciting ventures.

An alternative fuel vehicle that is cost competitive (including amortized capital costs over the life of the vehicle) with $3/gallon gasoline has a shot at being a successful small or medium scale business.  But to get to a technology that drives oil out of the transportation market for 21st century, that drastically reduces carbon emissions from vehicles, and that does it worldwide without imposing much higher gas taxes – which even relatively-wealthy Americans resist strongly — $3/gallon is still way too high.  The cost of alternative fuel transportation would have to get to half of that or less.

I’m thrilled by the rapid advances we’ve seen recently in alternative energy.  But when it comes to powering transportation, I don’t agree with the advocates who say the mission is nearly accomplished.

Scaling up alternative energy will greatly disrupt the conventional energy markets.  That disruption will cause oil prices to plummet and ratchet up the challenge to alternative transportation. The economics of oil markets mean that the two major roles for government in the fight against climate change – pricing greenhouse gases and supporting research on alternatives – will remain critical for decades to come.

I’m still tweeting energy news articles and new research papers @BorensteinS 

About Severin Borenstein

Severin Borenstein is E.T. Grether Professor of Business Administration and Public Policy at the Haas School of Business. He has published extensively on the oil and gasoline industries, electricity markets and pricing greenhouse gases. His current research projects include the economics of renewable energy, economic policies for reducing greenhouse gases, and alternative models of retail electricity pricing. In 2012-13, he served on the Emissions Market Assessment Committee that advised the California Air Resources Board on the operation of California’s Cap and Trade market for greenhouse gases. Currently, he chairs the California Energy Commission's Petroleum Market Advisory Committee and is a member of the Bay Area Air Quality Management District's Advisory Council.
This entry was posted in Uncategorized and tagged , . Bookmark the permalink.

13 Responses to Oil price crash shows the challenge of breaking addiction

  1. Nils Ohlson says:

    In other words, the demand-elasticity of fossil-fuel prices functions as a sort of “buffer” tending to drag fossil-fuel consumption back up as prices fall. This needs to be countered by technology-driven price reductions for alternative energy, to keep it competitive. At present we can’t count on our policy-makers to impose oil and coal taxes nor to raise solar tax incentives, because Congress is a wholly-owned subsidiary of Big Oil and Big Coal. A challenge indeed!

    • Joe Far says:

      Is Nils saying that we cannot count on politicians to take money from the tax payers so give to electric car and solar energy fat cats. Thank goodness for that!

  2. Joel Levin says:

    If the drop in prices leads to a significant increase in fuel consumption in California, I wonder if that will cause the supply of carbon allowances to tighten up noticeably. I would assume that the models that predict an oversupply of allowances don’t account for such low fuel prices.

  3. Pingback: How can the market price of oil fall so far so fast? | Knowledge Problem

  4. Frank Blaskovich says:

    I am curious about your statement that recent oil production marginal costs are declining. (“The marginal barrel is less costly to produce these days than 6 months ago..”) If anything, I would expect total operational (exploration, development and production) costs to continually increase even though technology improvements tend to slow those trends. Cheap, easy oil always gets produced first and more expensive oil is delayed as long as possible. I am not aware that recent oil development (e.g., US shale oil) is any exception to that long term, general rule.

    • Baltusrol says:

      The concept of marginal cost refers to the cost of producing the last (or next) unit. Long term operational and exploration costs do not directly influence marginal cost. Marginal cost is a component of the added costs that result from extracting the marginal barrel of oil, as opposed to keeping it in the ground. Severin is essentially indicating that the extraction process has become more efficient.

      • Frank Blaskovich says:

        I see what you mean and thank you for clarifying the statement. It makes sense to me that, once a well is producing, the next barrel of oil will be easier and cheaper to produce than the previous one. Therefore, the marginal cost will decline. However, as the production rate declines, won’t the operating cost per barrel eventually tend to increase again as work needs to be done to keep the well producing? Eventually, decisions will need to be made to install artificial lift, waterflood or inject gas, frack or acidize, etc.? Improvements in technology will make the decision to continue producing easier, but I see this improvement process as similar to the punctuated equilibrium idea from evolution theory. Improvements over the short term are generally very slow and almost imperceptible. Then, there is a burst of innovation followed by another slow improvement period. Technology improvement is probably also affected by the price of oil. Low prices seem likely to slow investments required to fuel the innovation process. For me, this idea is somewhat supported by a recent report that the major oilfield service companies that drive much of the innovation have significantly reduced their staffs over the last few months to evidently reduce their costs. In any case, that’s my simple mental model of the situation in this very complex system. The only thing likely to happen is that most, if not all, predictions of future behavior will be wrong.

    • mcubedecon says:

      Essentially cost reductions through technological improvements have been outstripping cost increases due to more difficult access. Shale oil became feasible because technology drove costs, and continues to do so. RFF put out a paper a few years ago that gave some detail on this effect.

      • Frank Blaskovich says:

        I agree that shale oil production would not have been possible without innovations like horizontal drilling, multi-laterals and multiple fracks in these complicated, relatively expensive wells. That being said, it’s still hard for me to believe that marginal or operating costs will continue to decline with time. In my opinion, the other reason we didn’t produce this oil earlier is that there were always better, cheaper opportunities elsewhere. I would greatly appreciate any link you can provide to the RFF paper you mentioned.

  5. bikeopeli says:

    Energy use is also a function of speed and distance. More SB375-envisioned cities with Neighborhood EV permitted access would also take a bite out of demand.

  6. The fall in crude price is certain to have an adverse effect on advances in the energy efficiency of the transportation sector. A new oil market framework is likely to evolve as a result of the price drop resulting in volatility in the price of oil and in periodic shortfall and excess of oil supply capacity impacting consistent progress toward energy efficiency over the medium and the long term.

    Over the past fifty years: significant importance has been accorded shortfall of crude oil on the international economy, critical spare capacity was assigned to one or two key oil producers to maintain oil demand supply balance and to prevent spikes in the price of oil, and significant relevance to meeting demand was accorded OPEC. Over the past 10 years, several factors combined to change this outlook. Except for the oil producing countries, the developed countries has exhibited lower energy intensity per GDP dollar causing oil to be less of critical strategic value to the international economy. The need for Saudi Arabia to provide a residual capacity of 2.5 MMbpd lessened with increases of non-OPEC oil producers. OPEC’s role as a key market player settled around 30% or about of world oil supply as additional crude supplies came through: 1) conventional oil production, 2) oil sands of mainly Canada, and 3) fracking. This has been accompanied with significant technology advances with major implications to cost of production: horizontal drilling, integration of power production with field development and crude extraction, and streamlining of oil and gas production and operations. Technology’s immediate effect has been to significantly reduce cost of field development and oil production impacting both the short and long run marginal costs. The net effect of technology advances along with rise in cost of maintaining aging fields in the oil producing countries is convergence of production costs of conventional oil production and non-conventional namely oil sands and fracking significantly reducing the comparative advantage oil producing countries have with regard to production cost.

    As demand for oil declined due to a weaker economy worldwide, reduced supply, did not follow the drop in oil price indicating lower short run marginal production cost than previously estimated. But also it reflects the need of non-conventional investments to generate revenue and pay debts despite prices being close to cost. As further decrease in demand results in further drop in price, relatively minor reduction in supply can be expected. However, at a price of $ 31, supply can drop by 1 MMbpd eliminating half the glut in the world oil market today. The capacity removed will come from oil market non-conventional oil production with the higher short run marginal cost.

    The situation is the opposite with regard to the effect of price collapse on capital investments and the role of long run marginal costs. New non-conventional oil sources, already in production, competing with Saudi Arabia out of Canada and the US are likely to be producing at a short run marginal cost of $ 28 – 50 per barrel. At the same time, new projects may require $ 60 – 80 per barrel to attract the necessary venture capital and meet the capital cost required. The result particularly since last September has been cutbacks of no less than 10% in capital budgets of both conventional as well as non-conventional oil whether in the US or elsewhere. Thus while the same dynamics will continue to spur oil production in the US and Canada and marginal increases from the same sources as long as price is in excess of their marginal cost, the same dynamics are curtailing new oil capital investments significantly.

    Moving forward, non-conventional oil will continue to encroach on conventional oil market share. The oil price will continue to be determined by the market with a decreasing role for OPEC and with the price being determined by the highest marginal cost. OPEC and particularly Saudi Arabia will have a reduced role to play as a reserve capacity provider. The cost of field development as well as production for both conventional and nonconventional oil producers will converge. The same circumstances will create the grounds for cycles of over and under capacity and hence the grounds for oil price volatility posing a serious challenge to furthering energy efficiency efforts. The same will however create the grounds for public policies to capitalize on the evolving oil market.

  7. mcubedecon says:

    I don’t have immediate access to the RFF paper and don’t have time to dig it up, but you can find it on their website under their working papers. Google will help find it.

    I agree the trend of oil extraction costs is complex and may tend to be upwards, but I was making the point that it doesn’t move in a universal direction and one can’t make general statements about trends. Many in the industry couldn’t foresee the decline in production costs starting in the 1980s. By the way the same thing is happening in solar PV costs. In 2008 almost no one foresaw the rapid cost declines that occurred.

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s