We Will Never See Cheap Oil Again

Doesn't $2.50 per gallon for gasoline sound just dandy? During the 2012 presidential race, a couple candidates used that number as a way of showing how increased American production would lead to lower prices and higher energy security. The problem is, though, that despite the increase in production in the U.S., cheap gas and cheap oil will more than likely remain a pipe dream. 

Let's look at why oil prices will remain high despite our best efforts.

Drilling costs just aren't what they used to be
The boom in U.S. energy has been made possible by several factors: development of advanced drilling technology, a large distribution network already in place, and a favorable regulatory framework. One element that is commonly overlooked, though, is the price of oil production. Accessing shale deposits requires not only deeper wells, but also much more energy for extraction. Today, wells are drilled for miles underground and cracked open with high pressure pumps and lots of water. Chesapeake Energy (CHKA.Q) estimates that each new well requires 5 million gallons of water. Despite the best efforts of exploration and production companies to reduce costs, these new drilling techniques have break-even wellhead prices for most U.S. shale plays at $55-$80 per barrel.

The U.S. is not the only country that needs expensive oil prices. Both Russia and Saudi Arabia, the two largest global oil producers, need high oil prices for economic sustainability. For Saudi Arabia, its $630 billion economic development program is funded on the back of its national oil company, Saudi Aramco. In order for the country to meet its budgetary obligations, it needs current production levels priced at about $90. The same can be said for Russia; its government's largest revenue source is oil royalties. For the country to balance its budget, oil export prices need to be north of  $120. For both of these countries, it is imperative that oil prices remain high enough to prop up government spending. 

Saudi Arabia, Russia, and the U.S. are the three largest oil producers in the world and are responsible for more than 35% of global production. If all three require higher oil prices to sustain production and financial stability, they will all produce oil accordingly to meet their needs.

Price is set by the most expensive markets
For many years, the U.S. has been the largest consumer of oil in the world. Despite our large import bills, we have had a modestly robust oil and gas industry that at its lowest point was still supplying 40% of demand. When compared to some of the other top oil consumers, our production looks pretty impressive.

Source: U.S. Energy Information Administration, authors calculations

The countries with little domestic production pay a much higher premium for oil, and companies located all over the world will flock to capture those markets, even ones in the U.S. At the end of 2012, Valero (VLO -0.32%), Phillips 66 (PSX -0.66%) and Marathon Petroleum (MPC -0.26%) combined to export 531,000 barrels of refined petroleum products from American refiners to premium markets around the world. Furthermore, all three of these companies have stated that they intend to significantly expand export capacity in the upcoming years.

This is a trend we will have to get used to in the U.S. Overall gasoline consumption has gone down by 16% since its peak in 2005, yet we have seen prices climb 57% since then. This is all because overseas demand has grown, and will continue to grow by one-fifth between now and 2035. As long as these premium markets around the world will pay top dollar for oil, then there is little chance that the U.S. will see any price relief.

What a Fool believes
The idea of energy independence and lower oil prices do not go hand in hand. Whether it be the high cost of our newfound resources, or the high prices others are willing to pay for them, it is highly unlikely that U.S. production will lead to a sustained drop in oil prices. Consumers who want to lower their energy costs should look toward other fuels to meet their energy needs. Clean Energy Fuels (CLNE -0.87%) boasts that a gallon equivalent of natural gas is $1.50 less than diesel, and this 40% cost reduction is causing the U.S. trucking industry to take a hard look at converting long distance fleets to natural gas.