The recent surge in global oil supplies, coupled with sluggish global demand, has sent oil prices to a multi-year low and generated a gusher of thinking about oil prices. Some commentators (click HERE) suggest that the price plunge will continue until oil reaches its marginal cost, approximately $20/barrel. Others (click HERE) see oil prices rebounding in 2015 on the back of a stronger global economy. Ask five economists or investors about the future price of oil and I suspect you’ll get seven different answers…but virtually everyone will agree that understanding the cost of production is critical.
So what? The laser focus on production is missing an important underlying dynamic. To better grasp long-term oil price possibilities, we need to think about reserves, a topic that receives inappropriately little attention. Even those focused on reserves tend to analyze only where they are located and fail to incorporate that reserves are price dependent. In fact, the Society of Petroleum Engineers defines “reserves” (click HERE) as oil that is “commercially recoverable, from a given date forward, from known reservoirs and under current economic conditions, operating methods, and government regulations.” Wouldn’t current economic conditions include current oil prices?
Yet mainstream analysis fails to consider oil prices in calculating reserves. Run a quick Google search of “global oil reserves” (click HERE for current search results) and you’ll find plenty of information, graphs, and interactive maps. Not one of the hundreds of links that I clicked discussed oil reserves evaporating during the second half of 2014. Yet we know with reasonable certainty that projects exist that are no longer commercially viable at today’s prices. Given the large drop in price, billions and billions of barrels of oil reserves have disappeared.
To understand the impact of this reframed perspective, imagine how you might react if media headlines were “Global oil reserves plunge, accelerating fears of forthcoming supply pinch” instead of “Surging production sends oil price plunging.” These two statements are effectively two sides of the same coin. Time to flip the coin.