I first wrote this based on cost estimates from 2014. Recent (January 2017) developments suggest the total cost for shale decreased by about $10 and may well continue to decrease. The key point here is that price will reflect shale’s production costs, whatever that may be. 

Oil is a commodity. Vehicles don’t care where the oil that fuels them was drilled. Like most commodities, price is the outcome of supply and demand.
Changes in oil prices over the last five years reflect changes in supply. To focus on the supply side economics, it is best to simply assume that demand for oil is fixed (inelastic) in the short term. That is, when the price changes by a little bit, the effect on demand is negligible. Indeed, despite prices dropping by over 50% in the last years, demand barely nudged.

Fuel production has three parts: producing (drilling) crude oil, refining, and distributing. The changing part is crude production. Historically, the cost of crude oil accounted for about 70% of the pre-tax production cost for gasoline, sometimes peaking to over 90%. With the recent drop in prices, this changed to about 50%. Refiners and distributors add their costs and margins, but these rarely change.

Crude oil production plants fall into one of three categories, with the following basic economic factors:

Oil source Fixed cost Variable Cost Total Cost Size
Traditional wells Shale oil well ~25 Low (~40) | 60-70 | 2-3 years
High cost (e.g. off-shore) wells 30-50 30-50 80-120 10+ years

All costs are in $US/barrel. The actual numbers vary, of course. The EIA provides detailed data on production and imports. State agencies provide more details, and there are very good analysts out there, such as the previously mentioned Ed Morse, and other various sources. While there is significant variability in costs between different high-cost projects, what’s important, well known and agreed across the board is that high-cost wells are much more expensive than the other two methods.
The following figure shows the US oil sources in the last 30 years
Ballparking the numbers, traditional wells, mostly from the US, OPEC and Mexico, supplied about $10 MBD, until 2012, and most of the rest was supplied by various high cost projects. Price was determined to cover (with some premium) the cost of the high-cost projects. If a relatively cheaper ($80) high-cost project came online, price could decrease. To control prices, OPEC could decrease supply, more off-shore projects would be needed and prices will increase. The following figure illustrates a possible equilibrium circa 2010 and the effect of shale.
If you are not familiar with these types of plots, imagine ordering all oil that could be supplied to the US in a line, from the least costly to the most costly. The blue solid line matches for every total quantity (on the x-axis) the most costly oil that would have to be included (that’s the price on the y-axis). The first 10 MBD, supplied by traditional wells in OPEC and North America, costs $6 – $20 to produce. If we want more, we have to use more expensive sources. If we’re willing to pay $120 a barrel, all sorts of high cost producers will be available.
The red line is the demand curve, connecting each price on the y-axis with the expected demand on the x-axis.

Price is where the two curves (supply and demand) intersect. If they cross at $100, off-shore projects that cost more that $100/barrel to produce all-in (i.e. fixed costs + variable costs + required ROI + risk premium) are losing money. If these projects are pitched, no one should invest in them. In the long run, off-shore projects will be done based on expectations regarding OPEC’s supply, other off-shore projects, etc. If OPEC produces more at the same cost of production, the blue supply curve gets pushed to the right, the price is lower and only the most efficient off-shore projects get funded.

Now imagine adding to the 2010 supply about 7 MBD of North American shale oil. The result is the dotted blue line, splitting from the solid line at roughly $60, the lowest all-in cost for shale, and slowly climbing to $70, the higher end cost for shale. Update: shale producers claimed in January their all-in costs are around $50. 
It is clear that prices will drop to somewhere in the shale all-in price range.
As long as shale producers across the world have enough capacity to serve demand, high cost producers are irrelevant. Based on current geological expectations, this is exactly what we should expect will happen in the long run, unless some other big change happens.

To summarize this part: Shale is a new oil sources that is abundant and costs less than the previous “marginal” oil source (off-shore). Without further intervention, we should expect prices to settle around the all-in cost of shale, as illustrated above.

The next parts discuss:
Why is price today lower than shale’s “all-in” cost?
Why isn’t OPEC raising prices?
What I think will happen next


One Response to “Oil 2016: $50-$60/barrel will be the new normal ?”

  1. Oil Prices 2016: Overview | Guy Arie

    […] next posts discuss: Why $65-$70 ($50-$60) a barrel should be the new normal Why is price today lower than shale’s “all-in” cost? Why isn’t OPEC raising […]

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