Oil Fundamentals: Supply & Demand

As with all commodities, the price of oil is determined by supply and demand. People often think that oil is “special” because we are “running out,” and do not understand how prices can fall. But like all commodities, the daily price of oil is determined by daily demand and deliverable supply. When supply is tight or demand increases, the price increases. When supply exceeds demand, the price declines.

Until five years ago, it was widely believed (much like in the 1970s), that the price would keep rising forever, until oil became too expensive to use as a fuel. But the US “Energy Renaissance” has reversed that trend.

World Supply Growth

World oil supply is growing at a rate unforeseen just five years ago. The source of this new supply is the US Energy Renaissance. New sources of oil are being developed from “tight formations”, primarily in Texas and North Dakota.

US Oil Production

US Oil Production

US Oil Production (Texas & North Dakota)

US Oil Production (Texas and North Dakota)

The long-term decline in world-wide oil production has reversed, but the oil produced from the Shale Revolution has a high price tag. The cost to develop shale oil is +/-$50/barrel—over twice the price of crude in the late 20th Century.

The idea of imminent “Peak Oil,” widely accepted early in the last decade, has been proven incorrect. See Jeff Davis’ article, “Great Expectations: Revisiting Peak Oil,” for a detailed discussion. At the end of the 20th Century it was believed that US production would continue to decline, while consumption would continue to increase as the economy grew. Although the rate of consumption per unit of economic growth was expected to decrease due to conservation, alternatives and renewables, it was believed that total demand would still continue to grow. The scenario of increasing demand coupled with decreasing supply would ultimately result in a Malthusian scenario where oil prices would continue a long-term increase with prices dictated by the market manipulation of the OPEC cartel.

World GDP vs. Petroleum Demand

World GDP Change vs Petroleum Demand Change
Source: World Bank for GDP, EIA for Petroleum Demand

 

World Petroleum Demand OECD vs. Non-OECD

World Petroleum Demand OECD vs Non-OECD
Organisation for Economic Co-operation and Development (“OECD”); Source: EIA

 

The Energy Renaissance in the United States has been phenomenally successful. The US is on its way to once again being the largest oil producer in the world. This past summer US production exceeded Saudi Arabia production.

The application of horizontal drilling to develop previously uneconomic shale reservoirs is achieving the more optimistic expectations of a few years ago. Adding to the growth in supply is the recent reversal of strategy by OPEC kingpin Saudi Arabia. Saudi Arabia is now increasing production to defend market share rather than curtailing production to manipulate the world price of crude oil. See Seth Phillips’ article, “OPEC in the Modern Era,” for an overview.

Higher crude oil prices provided the funding for technological advancement, which reversed the trend of declining supply. We now know that there is a lot more oil and natural gas to recover than we thought in the 20th Century, but this supply is only available at a higher cost. See Gary Stone’s article, “Shale Revolution,” in this issue for a detailed discussion.

Demand Growth Slowing

While supply continues to increase, the rate of growth in energy demand is slowing. Technology and conservation have slowed the rate of growth in energy consumption per unit of economic growth. Energy demand is highly correlated to economic growth. The Great Recession further curtailed energy demand growth.

But the industrialization of the emerging economies (primarily China and India) is more than offsetting conservation and efficiency in the industrialized economy. This trend is expected to continue for several more decades.

Growth in Oil Demand, 2014-2040

In recent years, supply has been growing faster than demand. The oil market has been anticipating a future price decline for the last several years. The primary reasons that prices had remained in the $90 – $100 per barrel range were supply disruption in Africa and the Middle East and sanctions on Iran and Russia.

As with any commodity, when supply is growing faster than demand, price declines. But high prices are the cure for high prices, and vice versa. The new US production has a very rapid depletion rate. The development cost is over $50 per barrel in many of these plays, so oil needs to be over $60 per barrel to provide a profit and cover operating costs and taxes.

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