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Economics 101 tells us that prices in a free market are set by the interaction of supply and demand. The world oil markets have gotten a graphic lesson in that truth over the last year, as the dramatic surge in US oil production has met stagnant demand. This, in turn, has pushed down spot prices by nearly half.
The recent uptick in oil prices, however, has buoyed hopes among market watchers that a strong oil price rally is in order. Unfortunately economics is working against these investors.
Gasoline demand is starting to rise as prices have reached multiyear lows. As it continues to rise, motorists around the world will begin to suck up extra all of that extra supply. That would normally lead to a strong rebound in prices.
But unlike the 2008 fall in oil prices, which was driven by a collapse in demand across the industry, the current price quandary is supply based. And the massive expansion in supply is overwhelming the newfound demand. That may make it more difficult for prices to bounce back.
Over the past few years exploration companies have unlocked extraordinary new unconventional resources like the Alberta oil sands and US shale, leading to a historic increase in supply. More impressive is the fact that even at today's low prices, there is likely to be some small production increase in 2015.
That is because many firms are looking at new efficiency improvements that should increase oil production while lowering production costs. Statoil, for example, says it has lowered its per well drilling cost by $1 million or roughly 22%, and it can now drill wells faster than ever before. The rise in efficient oil production has led to more than half of the country's rig fleet being idled with many firms now drilling multiple wells at a time rather than single ad hoc wells. These innovations have led to a 20% fall in the per barrel cost of production according to some industry executives, and more improvements are still to come.
As a result, the EIA is forecasting oil production will rise to 9.2 million barrels of oil per day for 2015 versus 8.7 mopd in 2014. That's right, an increase in oil output this year even though prices have cratered.
It should not be a surprise, in light of all this, that many industry experts are pretty grim about the future of oil prices, including recent studies announcing that it may be a decade or more before the price of oil hits $100 a barrel again. With drillers able to profitably produce at ever lower price levels, the ceiling on oil prices could remain low for quite some time. We are in a new era.
The new oil price environment will take some adjustments and it will definitely result in economic pain in some areas. At the end of the day, oil companies are starting to get used to the idea of lower prices and they are adapting to the new reality. Now investors need to do the same.