The price of the “marginal barrel” in the world of oil is critical, as it dictates the price of all oil. The marginal barrel is the one (or at least a small number of barrels) that represents the gap between supply and demand. In a market that uses c. 100 million barrels of oil per day, the delta between supply and demand is typically only about 1% or 1mmbbls/day. In normal times the price bounces around within manageable ranges as this ebbs and flows. Price has no correlation to absolute supply (see image in title).
Price shocks occur when the deficit or surplus becomes larger. For example, in 2014 the oil price crashed from over $100/bbl to about $50/bbl before continuing south through 2015 because the US shale patch was adding about 1 mmbbls/d each year from 2012 onwards. Disruptions in conventional supply (Nigeria, Venezuela and Libya) left a gap in supply that was almost perfectly matched. However, when Libya brought back on-stream 1.4 mmbbls/day the market flipped into clear over-supply and the price tanked.
Obviously the 30% collapse in daily demand seen in 1Q 2020 due to Covid is and extreme example of this but is such an outlier it is better to focus on normal dynamics.
The EIA kindly publishes detailed production data from the US. The monthly data is generally considered the most reliable. Here I am just looking at the Permian subset.
It is presented as total production – with the increment month-on-month being the net of a (big) decline in all previous production (“Legacy”) and a usually bigger increase in new production (although this recent example is of a small net decrease)
Rinse and repeat, month after month and the overall production increases.
Returning to one of my favourite subjects – those disgraceful subsidies for fossil fuels. One of the features of having teenage kids is you often hear “whatever”, or more recently “no one asked” as conversation stoppers. In the same way, having reasonable conversations about fuel subsidies is often met with the “concerned citizen” equivalent – one such appeared on a previous blog post that laboriously (I thought) tried to show that it wasn’t a simple case of “Fossil-Fuels Bad (and subsidised), Renewables good (and yes subsidised, but that’s OK)”. Despite this I got the “whatever” style comment of how “we should just stop subsidising fossil fuels”.
So here I go again. The infamous $5.2 Trillion headline has been widely debunked so will be ignored hereafter and whilst there are some places that have direct subsidies for production, in the vast majority these are “implied” subsides whereby the specific and very high petroleum taxes simply generate some rebates, and were discussed at length in the previous post.
However, there clearly are countries who subsidise the cost of (notably) petroleum products to their citizens. The headline number is often mentioned “$426bn” or “$372bn” or some such. A far cry from the debunked $5.2 Trillion, but still a big number, but you have to dig pretty hard to see who these bad actors are. The platitudinous headline is “fossil fuels subsides to consumers must stop” or in more thoughtful works, “should be swapped to subsidies for renewables”. Let’s just ignore that petroleum product molecules and renewable electrons are not always interchangeable, especially around transport.
Note in the 33 pages of this report there is no definition of these subsidies other than the above – it is just gospel that they exist and must be swapped out. When digging, I found the cited IEA reference has no mention of subsidies at all in it, the Merrill paper is better, and references price-gap analysis.
Spoiler Alert: the countries that subsidise their citizens for say gasoline are clearly globally significant, get them to change and all will be well in the world…
By conventional logic, low oil and gas prices suppress demand for low-carbon alternatives, and conversely high oil and gas prices spur substitution. There is some debate that the current low oil prices will slow the transition to low carbon energies. I argue below that we should not be worried about low fossil-fuel prices undermining the energy-transition, but rather the complete opposite. High fossil-fuel prices will be a bigger problem.
In corporate finance the concept of the Weighted Average
Cost of Capital (“WACC”) is well known. This is the total cost of how the company funds
itself through equity and debt. Simply
put, the cost of funding a corporate entity is the percentage of equity times
by the cost of equity and the percentage of debt times by the cost of that debt,
WACC = (%E*costE) + (%D*costD) where %E+%D=100%.
When thinking about the concept of embodied or embedded
energy I have adopted and adapted the idea of the WACC to better explain the
issues. In this new model I call the
Weighted Average Cost or Energy – I am trying to capture, albeit very
simplistically, the idea that making wind-farms and solar panels requires a
large energy input, and the cost of that energy input(“cRE”) is today dictated
by the cost of fossil-fuel power (“cFF”).
This statement is true given that roughly 85% of the world’s primary
energy comes from fossil fuels – so it stands to reason that this will underpin
the cost base. Thus, the WACE can be expressed:
= (85% * cFF) + (15% * cRE)
If you are constructing a renewable energy project today,
the WACE for your project will be dominated by the 85%, that is by the cost of
fossil-fuels. This has important
implications for the Energy Transition: if the cost of fossil fuels increase,
the cost of renewable energy increases also.
Immensely pleased to have been given the opportunity to speak at the Scottish Energy Forum at the historic Geological Society in London yesterday. I would like to thank the organizers, sponsors and the audience.