Tuesday, October 21, 2014

Frackestan (North Dakota) vs. Saudi Arabia

How low can oil prices go? The answer ultimately is associated with the marginal cost of production and the profits that can be derived from pumping oil. Unfortunately, the decision to produce is affected by the fact that states are producers not just profit maximizing companies. The table above shows the break-even price for budget surpluses. These countries need higher oil prices or they have to run budget deficits. They can offset the deficit by pumping more oil, keeping product high or higher in a declining market. Of course, their cost of production is low, so they can continue to produce and turn a profit. They will just have to dip into foreign currency reserves to meet expenditures. This can be sustained for some time.

The oil produced by companies will be more sensitive to price. New production will have a harder time obtaining financing which will slowly reduce supply. Financing for the producer will bind behavior. The supply side of the market will not be a good help at determining a price bottom in the short-run. 

At issue is what will the shale oil producers of North Dakota do. Let call that area Frackentan. These producers have high average and marginal costs but close to a million more barrels may come on-line in the US in the next year if we are at the average price this year. The same high cost applies to tar sands in Canada. The oil market will tighten and prices will stabilize if that production does not come on-line and if current production is slowed. 

What we know is that production decisions will be based on longer-term price expectations and not what the price does in any given week. Even if oil prices decline further, the issue is whether they will stay low for some time. This is an issue of global demand and economic growth. 

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