I don’t know where world oil prices will be when you read this, but as I write they have collapsed from a peak of $147 per barrel to $65.
Opec has just held an emergency meeting to agree on production cuts of 1.5million barrels per day in order to try to force prices back up.
I doubt if they will be successful in the short run because of the widespread fears of economic recession in many countries.
There can be little doubt that oil prices at $147 were far too high, and unsustainable, but it is very difficult to determine what the equilibrium oil price is. Many cost models have been developed, but they have proved incapable of accurate predictions in the recent past.
The long-run replacement cost must be a key factor. The world is currently consuming about 85million barrels of oil per day. The worldwide reserves:production (R:P) ratio is 42. In other words, the world could produce oil for another 40 years at the current level of output. However, there are massive geographical differences. Saudi Arabia’s R:P ratio is 70; the UK’s just 6, and the US’s 12.
I read one recent report by a well known investment bank that stated that the average cost of production was now $70 per barrel. That is ludicrous. In Saudi, for existing fields, it is still less than $10, and for most new developments less than $20. Even in the North Sea, new fields are being developed with capex less than $30.
These costs are undoubtedly increasing over time, although the cost inflation we experienced in the industry in 2006 and 2007 has abated. It seems to me reasonable to assume that the biggest oil and gas fields have already been discovered and the trend is for smaller and more expensive finds. The West of Shetland area is a good example. Nevertheless, claims of average costs of $70 per barrel are unprofessional.
Such a figure may be reasonably accurate for alternative energy sources, such as tar sands, coal-bed methane and wind power, which is why I believe that Opec, or more accurately, some members such as Saudi Arabia, may be happy with the recent roller-coaster fluctuations in prices. They do not necessarily mean that these alternative energy sources are unviable, but they certainly cast serious doubts on their basic economics.
Investors in these alternatives – both existing and potential – must be very nervous about the massive price changes, which is why I believe the Saudis and others will benefit in the long run.
There will obviously be short-term financial damage for them because of lower oil prices and revenues, but destroying investor confidence in tar sands and coal-bed methane will reap longer-term benefits.
Many energy investments are long term in nature – power stations, gas pipelines, West of Shetland fields, for example – and uncertainty about future prices and revenues will inevitably deter investment. You may invest if you can do your calculations on a stable oil price of $75 per barrel, for example, but will you do that if the 2009 price is either $147 or $65?
No, you are inevitably very cautious, particularly in the current financial climate when it may be your bank rather than you taking the decisions.
I think that, over the next year or so, we will see a lot of alternative energy projects cancelled, or at least postponed, because of the uncertainty over prices. Opec may appear to be very unhappy at the present situation, but short-term pain can result in long-term gain, to coin a phrase.
Opec is a disparate group, however. Most of the Middle Eastern member countries can cope with an oil price of $65 and can take a long-term view. Other countries, such as Nigeria and Venezuela, need the revenue and will have problems if the relatively low prices continue.
It would be good to have a period of stable oil and other commodity prices, but I fear that there are more fluctuations to come.
Tony Mackay is the MD of Mackay Consultants
