The following article by Ali Aissaoui, Senior Consultant at the Arab Petroleum Investments Corporation (APICORP), is published concurrently in APICORP’s Economic Commentary dated June 2012. The views expressed are those of the author only. Comments and feedback may be sent to aaissaoui@apicorp-arabia.com

Recent research studies conducted by international policy-advisory institutions have raised the prospect that severely constrained supply growth could drive long term oil prices much higher than previously assumed. The International Energy Agency (IEA) for instance has found that, with lingering socio-political turmoil in the Middle East and North Africa (MENA), a shortfall in investment in the upstream sector could shift output to higher cost sources resulting in real oil price peaking to $150/B within the next five years.¹ Other institutions have reported similar trends even assuming that higher oil prices would spur further technological innovation that might improve supply. This is the case of the IMF whose research staff has empirically evaluated a model of the world oil market, which encompasses both the geological view (resource constraints determining future output and prices) and the technological view (higher prices encouraging technological solutions), to forecast a permanent doubling of real oil prices to $200/B within 10 years.²

To the extent that long term prices are set by perceptions about the price level required to motivate investment and bring long term demand and supply into balance, the above expectations should have been reflected in the shape of the forward oil price curve. However, at the time of writing, the back-end of the curve – the proxy for long term price – has remained stubbornly below $100/B (Brent five-year forward and beyond). In this commentary we consider both the forward curve and the future supply curve, in order to gain the insight needed to explore whether or not the prospect of a large price swing to the upside is inevitable.

‎The Forward Curve

To better explain commodity price behavior, leading research analysts have provided a useful framework by postulating, in the words of Jeffrey Currie and his colleagues at Goldman Sachs, that “on balance, the key to commodity price movements is marginal costs and inventories.” ³ Hence, the forward curve is decomposed into a short term, cyclical component and a long term, structural component. The cyclical element is driven by fluctuations in fundamentals, as ultimately captured by inventory levels. The structural element is determined by the cost of bringing the last needed unit of the commodity output to the market. Central to the framework is that the structural element provides an anchor and a hinge around which short term prices fluctuate (Figure 1). The dynamic of commodity prices can be observed in the changing shape of the forward curve. In a tight market a premium for prompt delivery shifts the curve into backwardation. Conversely, in a soft market a discount, to offset the costs of carrying inventories forward, shifts the curve into contango.

While this framework seems conceptually intuitive and robust, the suggestion that the marginal cost is a primary determinant of long dated commodity price has been challenged when it comes to oil. For instance, Paul Horsnell, from Barclays Commodities Research, argues that “one could try to say that long term prices should be determined by marginal costs,” but “the link between costs and prices has tended to be very weak to non-existent in oil, particularly given the operation of the low cost producers at the margin of the market.” ⁴ However, as elaborated later, Dr Horsnell’s argument can be addressed by substituting for marginal cost the average unit cost of the most expensive project’s output.

Figure 1: Decomposition Of A Commodity Forward Curve

Source: Goldman Sachs Global ECS Research.

Equally worth pondering is the case made by Frédéric Lasserre – former Global Head of Commodities Research at Société Générale – who observes that the forward curve can be over-priced, ie long-dated price can be higher than marginal cost. The reason he gives is that the above characterization is incomplete and has to factor in the demand side. In this regard, Goldman Sachs research staff have highlighted that in an environment of anemic long term supply growth, long-dated price needs to rise above marginal cost in order to achieve demand destruction and bring supply and demand into balance. Mr Lasserre’s suggestion to “fine-tune the model by assuming that the marginal cost acts as a floor to the back [of the forward curve] while the price [that triggers] demand destruction acts as a cap” is particularly relevant.⁵

Figure 2: Brent Forward Curve – 2012 Trading Range

Source: Barclays Commodities Research.

Having clarified the relationship between marginal cost and long term price, the key question we now seek to address is why is it that the price expectations of the IEA and the IMF are not reflected at the back end of the forward curve (Figure 2)? To provide an answer to the question, we need to bring into the discussion the long term oil supply curve as well.

The Supply Curve

A great deal of insight into the marginal cost of production, and therefore long term price, can be derived from a long term supply curve. As shown in Figure 3, a reasonable approximation to such a curve is obtained by ranking current and potential sources of supply, from lowest to higher cost. The ‎cost in Saudi Arabia is put at $25/B. Within other MENA countries it is estimated at $35/B. The cost of non-MENA conventional oil production may be as high as ‎‎$45/B. Estimates for more expensive unconventional oil production range from $50/B for CO₂ based enhanced oil recovery (EOR) projects to $100/B for gas-to-liquids (GTL) and coal-to-liquids (CTL) projects. The conjectural supply distribution in Figure 3 implies that to balance future global demand a hypothetical total output of 100mn barrels of oil is produced each day at an assumed marginal cost of production of $100/B.

Figure 3: Juxtaposing The Forward Curve And The Supply Curve

(This figure is provided for illustration purposes only)

Source: APICORP Research.

As suggested by Frédéric Lasserre, a simple juxtaposition of the supply curve and the forward curve (Figure 3), can perfectly illustrate how long-dated price moves in tandem with the marginal cost of supply.⁶ For a given demand, we should expect constraints on low cost oil supply to shift output towards high cost oil. As a result, the price at the back end of the forward curve should adjust to stimulate investment and deploy new capacity. But as argued next, cost and therefore price would probably not need to increase to that effect.

Non-Inevitability Of Price Rise

Having illustrated how long-dated oil price may move in tandem with the marginal cost of production, our focus now is to try and infer from such a cost the direction of a long term price.

Figure 4: Costs At The Confluence Of The T-P-E Triadic

Source: APICORP Research.

Marginal cost is essentially unobservable. However, as we suggested earlier, it can fairly easily proxied by the average unit cost of the most expensive project’s output. Accordingly, and in the case of a planned greenfield upstream project, it includes the costs of finding, developing and lifting, plus fees, royalties and taxes as well as a return commensurate with investment and risk. What is much harder is to predict it. The difficulty stems from the fact that, as depicted in the triadic T-P-E of Figure 4, costs lie at the confluence of uncertain technological, political and economic factors.

First, finding and developing oil depends on technology and innovation, which should continue enabling frontier oil to be produced cost-effectively and productively. In the period from the mid-1980s to the mid-1990s, significant technological breakthroughs such as 3D seismic, horizontal drilling and subsea completion, have greatly contributed to the exploitation of new resources particularly in deep waters. In recent years, sub-surface hydraulic fracturing, combined with horizontal drilling, allowed shale hydrocarbons to be produced more economically. Furthermore, in the particular case of shale oil, new in situ conversion processes, which apply heat to release oil, have proved to be affordable under current economic conditions, though still environmentally challenging.

Next, finding and developing oil depends on politics, which is a powerful motivator of policy. In some producing countries such policies have been rather restrictive in terms of either access or taxation. In contrast, motivated by concerns about security of supply, key consuming countries’ policies have generally been more supportive. In these countries, notwithstanding stricter environmental regulations, fiscal incentives and appropriate public and private financing mechanisms have, on balance, greatly contributed to growing investment and output.

Finally, cost inflation is a major factor in project economics. The nearly tripling of the cost of energy projects, observed during the last decade or so, has been largely due to rising prices of input factors, contractors’ margins and project risk premiums. Such a trend, however, is unlikely to endure. As the industry continues to experiment with new technologies and innovates with contracting and managing large-scale projects, we should expect it to shorten the learning curve and reduce costs.

To sum up, marginal cost – or to be precise its proxy – can hardly be predicted due to the combined effect of highly uncertain factors. But uncertainty does not justify the anticipation of higher costs. On the contrary, it can lead to the opposite result. In other words, technology, politics and economics can also combine auspiciously to lower marginal cost, therefore lending support to moderate long term oil price.

Conclusions

As global oil demand increases, even if only moderately, and production from mature areas declines, finding and developing additional oil will definitely be more challenging in the future. However, the view that marginal cost, which drives long-dated price at the back of the forward curve, should increase to stimulate additional supply is not immediately plausible. Despite (or because of) all the uncertainties, the likelihood, based not on empirical data but on reasoned judgment, is that rising marginal cost, and therefore long-dated price, may not be inevitable.

1. IEA, World Energy Outlook 2011.
2. J Benes et al, ‘The Future of Oil: Geology versus Technology’, IMF, WP/12/109, May 2012.
3. J Currie et al, ‘Commodity Prices and Volatility: Old Answers to New Questions’, Goldman Sachs, Global Economics Paper No. 194, 30 March 2010.
4. P Horsnell, ‘The Dynamics of Oil Price Determination’, Oxford Energy Forum, Issue 71, November 2007.
5. E-mail exchange with the author dated 2 July 2012.
6. F Lasserre, ‘What are the key drivers for oil prices’, PPT Presentation to IFRI Energy Breakfast Roundtable, Brussels, 20 December 2007.