The new oil boom

The new oil boom

In 1999, after years of annual oil prices of around $US10 a barrel, The Economist famously argued that prices would head to $US5.

Instead, the next decade bought the most astonishing bull market in the commodity's history. Prices peaked at close to $US150 a barrel. Predictions are for the brave and the foolish.

Despite a recession in the US, stagnation in Japan, a slowdown in China and financial Armageddon in Europe, oil prices remain stubbornly above $US100 a barrel.

That implies the world's cheap oil reserves were on the verge of exhaustion and the era of cheap oil was over.

The advent of shale resources has torpedoed that argument, or at least many claim it has.

The US, still the world's second-largest consumer of oil, may soon become the world's largest oil producer as it achieves energy independence for the first time in a century.


It isn't alone. The International Energy Agency (IEA) believes that Iran, Iraq, Africa, and Brazil can all potentially increase oil supply dramatically.

Oil production, which has been falling since the '70s, is now growing again, largely due to shale oil production.

The words "peak oil", which filled the world with dread only a few years ago, are now forgotten as the world contemplates an age of plenty. Surely this dents the bull case for oil?

Not necessarily. The oil age will end not because oil runs out but because it becomes too expensive to extract.

It isn't the absolute level of oil output but the cost of production and the reliability of supply that matters. Taking those factors into account, additional supply isn't quite as assured.

Between now and 2035, almost half of new oil supply is expected to come from Iraq. Yet both regional and central governments claim ownership of the resource, to say nothing of an excess of violence, bureaucracy and graft.

The situation is even worse in Iran and Africa. Iran can at least extract oil cheaply. Offshore Africa remains one of the most expensive places in the world to produce oil.

Vast supplies of oil sands give Canada the world's largest oil reserves but production is difficult, expensive and inefficient. It's an exercise in energy arbitrage rather than a genuine technological innovation.

With the marginal cost of production estimated at between $US80-$US100 a barrel, producers of oil sands require an oil price around the current level to remain profitable. Most of Canada's oil is simply too costly and inefficient to exploit.

That leaves the US, America, the source of current jubilation, as the real threat to high oil prices. And it's a serious and current threat. In shale basins across North America, oil bulls are re-examining old predictions.

Yet more output doesn't necessarily mean lower prices. Again, it's the cost of production that matters.

Whereas traditional oil reservoirs consistently decline at about 5 per cent per year, shale reservoirs register an average decline of 40 per cent in the first year with a steadier decline thereafter.

New wells have to be drilled all the time, which has huge implications for the cost of extraction. In the Bakken formation, for example, the marginal cost of production is $US80-90 a barrel.

As the most productive wells are exhausted, drillers move to more marginal locations. The costs of rigs, skilled labour and water also rise with increased production. Add in higher capital costs and the marginal cost of production could easily reach $US100 a barrel.

That tempers the case for the new oil boom. A collapse in prices to $US50-60 a barrel is unlikely but so is a price of $US200 a barrel which, just a few years ago, was the norm.

Those prophesying the end of the oil age will probably be proved wrong. But that is not an argument for falling prices. New supply remains expensive and requires high prices in order for it to be exploited.

For investors, production costs remain paramount. It is not enough to assume that oil prices will rise.

This article contains general investment advice only (under AFSL 282288).

Gaurav Sodhi is Resources Analyst at Intelligent Investor. BusinessDay readers can enjoy a free trial offer. For more Intelligent Investor articles click here.

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