My last blog on LinkedIn talked about the process whereby the price of oil will eventually go back up,although how high is not clear.It made a few good points but LinkedIn did chop it up and move stuff around on it.The main points made were twofold.The cost of new oil discovered and delivered to market is more than earlier discoveries.So the average cost of oil will go up and the average price of oil will follow.Price is based on the cost plus a margin and the cost will move the price back up.The second main point is that the elasticity of demand is substantial in the long term and this increases the demand for oil more than any of the official estimates show.Old estimates show the daily production of oil at 94 to 95 million barrels per day but new and more accurate estimates show it closer to 100 millon barrels per day.This blog believes that the latter estimates are correct.Studies done by the University of Calgary show the long term elasticity of demand much greater than the short term elasticity.
The Recovery Rate
Some of the controversy has come because of the different estimates of the recovery rate from oil wells.It was conventionally thought that the recovery rate for light oil was 25 to 35%.While the recovery rate for heavy oil is about 30 to 40%.But it is clear that there are new enhanced oil recovery (EOR) methods that increase the recovery rate beyond these rates.They inject various substances into the wells that increase the pressure and recovery in the well.The problem is that these methods are costly.Producers cannot afford any substantial enhanced recovery at these prices.Substances injected into the well vary from water to water vapour to carbon dioxide.The recovery rate varies with each substance.
In 1956 M. Hubbert introduced the peak production theory.It proposed that at first in 1970 and later in 1995 that production would outstrip oil from new discoveries.So reserves would be falling not increasing.This has been changed to the year 2000 now as hydro fracturing has increased potential reserves.Once again the size of reserves depends on the recovery rate and the price of recovery.
Elasticity of Demand
The University of Calgary has done extensive studies on the elasticity of demand.That is, what is the percentage increase in demand with a percentage change in the price.It has found that there is little change in demand in the short term but there is significant change in the long term,that is ,over 4 to 6 months. The base demand is generally considered to be around 92 million now.With the decrease in the price of oil many studies have pegged the new demand at 94 to 95 million per day.But there has been a 55% reduction in the price of oil over the last six months.This is enough time for a long term change in demand.And the new studies peg demand at around 100 million barrels per day.In fact, this blog believes the new studies are correct as the long term elasticity kicks in.
Studies have shown that the slope in the demand curve to be less than .4.From 2000 to 2009 the increase in production was 900,000 barrels per day.From 2010 to 2015 production increased(according to American studies) by 1.2 million barrels per day.That is when the price of oil was $90 to $100 per barrel.Now that the price is about $45 a barrel this blog calls for an increase in production of 3 to 5 million barrels per day over 2015 to 2017.That means that the recent studies showing 100 million barrels per day of consumption are probably correct.
Summary
It is very likely that demand for oil is higher than most official estimates and growing faster than expected.If price stays in the present range of $45 to $55 a barrel per day then the slope of the supply curve will increase closer to .75 or .85.If this happens then the demand for oil may be as high as 110 million barrels per day in late 2016 or early 2017.This definitely will decrease reserves.EOR will only be important if the price is at a level that will allow covering the cost plus a profit margin.If price falls below this level then EOR will be curtailed.For sure, from now to 2017 the marginal cost of producing oil will rise and more expensive oil will replace the cheaper oil.So the average cost will rise and the average price will follow.By then oil reserves will be considerably smaller. see Workathon for analysis of resource stocks; use Workathon for consulting on resource stocks
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