Email of the day (1)
Comment of the Day

November 27 2013

Commentary by Eoin Treacy

Email of the day (1)

on "cheap" energy:

"There was a good article on Fracking in the Economist Magazine (still the best business magazine with no close second choices).  It was the 16-22 November issue. Sorry life has been to busy to bring this to your notice earlier.

"I am not taking sides in the argument of social versus business arguments for fracking. I personally not convinced Fracking is a cheap source of oil although in the short term it is providing the US with cheap gas.

"What I observe is fracking has created a collar in the oil market. If oil prices drop the frackers respond quickly and fracking stops. If oil prices rise frackers drill a lot more to meet the demand. T Boon Pickens commented recently that fracking is not in his experience cheap oil. I think we agree Mr Pickens knows the oil business in particular the economics of fracking.

"As the Economists Magazine article points out the economics of fracking is a combination of gas prices, other liquids and oil prices. I will not go into the boring arguments of the relative merits of different sources of gas. Australia has lots of gas. We always knew about coal seam gas (CSG) however the petroleum engineers used to tell us CSG was very poor quality gas with low heat qualities and of no commercial significance. Not a argument you hear today. 

"I guess the economics of fracking will improve. BHP are hoping they do. But unless they do improve even the dumb money (i.e. BHP) will get the hint and stop funding what has been so far a stupid idea.

"Hopefully see you in February at the Chart seminar."

Eoin Treacy's view

Thank you for this insightful email which brings us to the question of what exactly the term “cheap” energy means. We have described the peak oil argument, for much of the last decade, in terms of the rising cost of production. As you point out, geologists have known about coal seam methane, shale oil and gas, tight gas, methane hydrates etc for almost as long as the fossil fuel industry has existed. The commercial viability of these resources has always been dependent on the application of technology and the marginal cost of production.

Here is a long-term chart of oil prices. There have been panicky statements that the world is going to run out of oil. It would be more appropriate to say that the world will run out of oil at a certain price. Returning to the above chart, we could conclude that the marginal cost of production jumped in the 1960s and again in the early 2000s.

A great deal of the new supply now coming online either from shale formations, bitumen or offshore has a reasonably high cost of production by historical standards which can only be justified because prices are also high by historical standards. This suggests that the potential for prices to return to the pre-2002 environment are quite low. The effect of inflation on prices over a lengthy period also acts against this eventuality. 

If the long-term step sequence uptrend is to remain consistent, $40 represents the lower boundary of what could become a very lengthy range, with prices likely to trade quite a bit above that level for the foreseeable future. The other side of that argument is that the peak near $140 is unlikely to be surmounted anytime soon. .

With new sources of supply now coming online, the supply inelasticity that characterised the market from 2000 has changed. Supply and demand have begun to come back into balance on a secular basis, suggesting that the medium-term outlook is likely to involve quite a bit of ranging which can be expected to be volatile.

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