As the oil price shrugged off a looming hurricane and a cut in supply from Opec, briefly dipping below US$100 a barrel, traders on global oil markets held their breath, wondering if the price would collapse. After all, the price of a barrel stood at just $10 a decade ago, and the industry is famously cyclical. But all signs indicate that the three-digit oil price is not just an empty bubble, and that higher drilling costs and political considerations will sustain high prices for years to come.
Lost in the public debate over whether Opec should reduce production to boost prices is the reality that it is becoming significantly more expensive to bring new barrels to market, meaning a natural oil price floor is much higher than many people might think. Skilled personnel and equipment are in short supply and much of the "easy oil" has been tapped, meaning engineers must now look for reservoirs in more difficult environments, such as deep beneath the ocean or under the polar ice caps. In addition, unconventional and expensive sources of liquid fuels, including biofuels, are now relied on to meet a part of the world's increasing demand for energy.
In a research note this month, analysts at Goldman Sachs estimated that the marginal cost of oil production now hovers between $80 and $90 per barrel. The finding echoed a similar estimate reached by MFC Global Investment Management earlier this year. Opec itself estimated in its annual outlook, published in July, that the marginal cost of oil was between $70 and $90, and noted it was determined by the cost of oil extracted from unusual sources, including oil sands in Canada and liquid fuels derived from natural gas.
"Rapidly rising upstream costs point to higher break-even prices for some capital-intensive and highly costly oil investments projects," the report said. "The marginal cost of producing alternative fuels, be they oil sands or Fischer-Tropsch liquids [derived from natural gas], is probably now higher than $70 a barrel." In a free market, the price of something should, in theory, be equal to the marginal cost, or what it costs to bring the most expensive supply to market to satisfy demand. However, oil is not sold in a fully free market, since Opec and other structures exist to regulate supply and, in turn, offer some control of prices.
But last week in Vienna, Opec oil ministers could be heard frequently making the case that rising marginal costs, combined with the falling price of oil, were factoring into their decisions on production. Hussein al Shahristani, the Iraqi oil minister, told reporters before the Opec meeting that the cost of new projects in the country's war-ravaged oil industry could be covered only with a minimum oil price between $70 and $90.
Mohammad Ali Khatibi, Iran's Opec representative, voiced a similar sentiment. "International oil companies say that producing a barrel of crude in some new fields costs $80, so the oil prices cannot be lower than this, considering a reasonable profit for production," he said. Both countries are seeking to substantially increase their production of oil in coming years. This will help compensate for the declining production in countries outside Opec.
For all Opec producers, including the low-cost Gulf exporters for whom marginal costs barely register as a concern, the price floor is also determined in a large part by budgetary obligations, which have ballooned amid record prices. Investment in grand projects such as Saudi Arabia's economic cities and Venezuela's welfare programmes was spurred by high oil prices, and Opec will seek to ensure that prices remain high for those projects to be completed.
According to a report by PFC Energy, a consultancy based in Washington, Saudi Arabia will need prices to stay above $62 a barrel to balance its budget next year. Jean-Francois Seznec, a professor at Georgetown University who specialises in Gulf economics, confirmed the PFC assessment. "In my own computations, I think the minimum the Saudis need to run their budget, subsidies and state investments is about $50 to $60 per barrel FOB, that is a very minimum WTI [West Texas Intermediate Crude price] of $60 to $70 per barrel," he said.
FOB, or free on board, is an export price that does not include the cost of shipping. The Saudis fiscal needs pale in comparison to other Opec members, however. PFC said the Venezuelan budget required a minimum price of $97 next year, while Nigeria will look for prices to stay above $71. The UAE, Kuwait and Qatar have much smaller budgetary obligations compared to oil revenues, and analysts estimate they need prices to stay only in a range of $30-$50 a barrel.
But oil's price floor is not merely set by high-cost producers and Opec members' budgets, but also by political considerations in consuming nations. High oil prices are needed to sustain the drive toward developing alternative energy resources. With the oil price above $100 a barrel, industrialised nations have recommitted themselves to developing nuclear power and producing energy competitively from the sun, wind and biomass. Such developments take time and money, and a sharp fall in the oil price could eliminate the incentive to pursue such policies.
When oil hit a series of then-record highs in the 1970s, governments in the West vowed to end their dependence on imported foreign oil and poured billions of dollars of funding into renewable energy sources. When prices crashed in the 1980s, however, interest in alternatives dried up. Homeowners who had invested thousands into rooftop solar panels were stuck with the reality that they would never recoup their investment.
Today, the alternative energy industry that is perhaps most vulnerable to swings in the oil price is biofuel, which is a direct substitute for petrol and diesel and has become incorporated into the marginal cost of oil. The industry in the US, Europe and South America has boomed amid high oil prices and government subsidies designed to diversify energy sources. In March, Ali al Naimi, the Saudi oil minister, estimated that oil prices would have to remain between $70 and $80 a barrel in order to make biofuels cost-effective. He characterised the price range as the absolute price floor of the oil market.
Wallace Tyner, a professor of agricultural economics at Purdue University in Indiana, estimates that if US Congress interest in continuing expensive subsidies lags and corn prices remain high, US ethanol production will be competitive only if crude prices remain above $100 a barrel. "If oil stays above $100 per barrel, corn ethanol, under normal conditions, will be viable simply because of the energy demand for it as a substitute for gasoline," Mr Tyner wrote in an article published in a research magazine in July. "We have entered a new era in which agriculture supplies not only food, feed and fibre, but also fuel."
Mr Tyner said yesterday that if oil prices continued their slide, it could mean trouble for the industry. "If oil falls to $80, gasoline would fall as well, and that would bring down the equilibrium price of ethanol," he said. "A lower ethanol price would not support the high corn prices we see today, so there would be a real cost squeeze, and ethanol production could fall." cstanton@thenational.ae
