Cheap Oil May Be Here Before You Know It

Earlier this week, my Foolish colleague Tyler Crowe penned a smart piece about how "We Will Never See Cheap Oil Again." Though I agree with many of the points Tyler makes, I disagree with his main thesis. It's certainly possible for the bottom to fall out of the oil market, and history gives us some context for understanding this.

You can't always get what you want
It's true that the U.S., Russia, and Saudi Arabia all need high oil prices. As Tyler wrote, the advancements in U.S. drilling techniques mean that the cost of producing a barrel of oil necessitates selling it for a minimum of $55 to $80 per barrel, depending on where in the States it's produced. Russia and Saudi Arabia both depend on revenue from oil production to fund their respective governments, with per-barrel prices ranging from $80 to $120, depending on whom you ask. As the top three producers in the world, the thinking goes, they will manipulate production to do what it takes to keep oil prices high.

The problem is that isn't quite how it works. Russia, for one, has always been dependent on oil prices. In fact, it was the collapse of oil prices in the late '80s that ended up being the straw that broke the USSR's back. As Tyler Priest wrote in the Journal of American History last June:

The oil price collapse also played a lead role in ending the Cold War. It undermined the economy of the Soviet Union, which had quietly become the world's largest oil pro­ducer, dependent on oil export revenues to pay for imported manufactured goods from the West and to support the economies of East European satellites. Plummeting crude prices cost the Soviet Union an alarming $20 billion per year, causing panic in the Polit­buro.

Right there you've got the world leader in oil production combined with the necessity of high oil prices, and all that comes of it is a price collapse -- a collapse caused, I might add, by a surge in world production and OPEC's inability to stick to its quota system. The price of oil was halved in one year, falling to $14 in 1986.

Needing high oil prices is one thing, but assuming that countries can cut production and prop up prices at will is quite another. The Financial Times' Nick Butler explained this from the view of Saudi Arabia's current position earlier this week:

Saudi Arabia is the only country in the world with the ability to cut production and to keep prices up. ... I expect the Saudis to pursue the tactic of making small incremental cuts in output in the hope that the market will stabilize. I doubt if this will work. Only a cut of 1.5m to 2m b/d will suffice to maintain prices and that would squeeze Saudi revenues too much. With growing domestic demand Saudi Arabia has little room for [maneuver]. As noted last week, the Saudis seem to be in process of losing control of the oil price."

Essentially, though it may appear on the surface as if Saudi Arabia has control, it is between a rock and a hard place. Cutting oil production enough to make a difference hurts too much on the bottom line. Butler goes on to examine the impact of falling prices, noting that countries dependent on revenue will feel pain, but companies that need high oil prices to sustain expensive production techniques have more time to wait this out.

The bottom line
I've often said that trying to predict oil prices is a fool's errand, but understanding who is affected by what happens when the price goes up or down, and how, is something that all oil and gas investors should know. What happens, for example, to a company like ExxonMobil (NYSE: XOM  ) that's investing $37 billion a year to find and produce all of this expensive oil? How will Valero (NYSE: VLO  ) stock perform, given that the falling price of Brent means eroding margins for refiners? All things to consider instead of making assumptions about oil prices, given they have proved to be unpredictable and impossible to control.

If the price of oil stays high, you might as well know who benefits. If you're on the lookout for some currently intriguing energy plays, check out The Motley Fool's "3 Stocks for $100 Oil." For free access to this special report, simply click here now.


Read/Post Comments (6) | Recommend This Article (8)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On April 22, 2013, at 1:35 AM, Dadw5boys wrote:

    just 6 months ago a industry wide study was published show that $30 a barrel covered the entire cost of finding, drilling , pumping and shipping. Everything above $30 was profit because there is so much oil being produced now.

  • Report this Comment On April 22, 2013, at 2:25 AM, megalo99 wrote:

    The Sun hits the Earth, every second of the day, with enough energy to feed the global demand for a year (nasa.gov), yet we want to hold onto this 19th century "technology" so that a few people at the top can sit on a pile of money that reaches the moon.

    Will New York have to look like Shanghai before people get it? It's time to evolve.

  • Report this Comment On April 22, 2013, at 4:35 AM, usa1electrician wrote:

    To borrow the words of Alstimers stricken President Reagan.....Popycock ! Who sits around and immagines all the false statements in the oil article ? Does someone really think the cost of oil production is the same in war torn Nigeria ? Versus sweet little North Dakota ? Do yall really have people that dont know that Alaskan oil production has never required electricity ? To say nothing of the 1700 PSI well head pressure ? Or the fact that the fields were paid for 3 decades ago ? Come on folks...ease up on the ficticious $50 to $80 per barrel costs. Try 50 cents to 80 cents per barrel. Get some education on a subject before you attempt to state facts.

  • Report this Comment On April 22, 2013, at 8:48 AM, 11969546 wrote:

    the price of oil HAS gone down, but here in michigan, the prices go up, THE GREED ISN'T FOREIGN, ITS DOMESTIC!

  • Report this Comment On April 22, 2013, at 10:41 AM, lilyvonshtupp wrote:

    Funny....

  • Report this Comment On April 30, 2013, at 11:51 AM, moneytaxactivist wrote:

    Do we really think that free market, vulture capitalism, unfettered by regulation, is the best system for the country?

    Maybe a touch of socialism mixed in with it would be better.

    We all know that greed and power go hand in hand. An interesting note though is that people are seldom recognized for their greed until they are in a position to exercise that greed on a massive scale.

    An investor, on the way up, is often said to be brilliant, remarkable or insightful. He/she is praised for their "Risk taking" insight. Everything is rosey until they are caught by something unexpected and suddenly crash and burn. Now, they don't get praise they are called greedy.

    That is a common excuse for failure, "He got greedy."

    I postulate that the market could not function without greedy people.

    Wait for it,

    wait for it,

    We are all greedy, otherwise, we would never risk our hard earned money and family security in the market.

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