The Triangle

Issue date: 7/31/09 Section: Ed-Op

Media Credit: Reinaldo D’Santiago MCT

Oil price touched $147 for a barrel of WTI on July 11, 2008. Then the world economy was hit by the worst recession since the Great Depression. This global recession triggered a precipitous collapse in the oil price. In January 2009, it dropped to $32 a barrel and many people predicted that it would drop further to $25 a barrel and will also linger there for some time. That low price did not fit well with the oil fundamentals. It reversed itself and started to move up to reach $50 in April. It hovered around there for a short while, and some market participants thought that $50 was the fair value. But the price rejected the presumed fair level and climbed up to more than $70 a barrel. It seems now that it is resting around $70 in the middle of this global recession. There are people who still think that cheap oil will come back and stay. I believe that oil price cannot linger long below $60 a barrel.

The rationale for this assertion lies in the components of the oil price and the values they command. The first component is the marginal extraction cost. In economics, the marginal cost of the most expensive product in the market usually places the floor below the market price for that product. In the oil market, the MEC in the most expensive area categorizes the floor for the oil price. It is not the MEC for the oil in Iraq and Saudi Arabia, which costs about $3 a barrel, but the MEC for deep water off the shores of the United States that forms the price floor. The MEC for the expensive oil ranges $60 to $80 a barrel. Thus, $60 a barrel should be considered the lasting floor for the oil price even during recessions. The era of cheap has gone!

The oil price has other components, in addition to MEC. Oil is a depletable resource and the cost of depletion for the marginal barrel is added to MEC. In economics, the depletion cost is known as the marginal user cost which rises with more extraction. Oil has been depleted in many parts of the world including the North Sea, Mexico, Dubai, Angola, Vietnam, among others. The depletion rate is expected to accelerate over time as demand outpaces supply.

The oil market structure cannot be categorized by perfect competition. Thus, oil price should be higher than total marginal cost which includes both MEC and MUC. In other words, there is a monopoly or market power in the oil price. Regardless of how OPEC is characterized, whether as a cartel or a dominant firm, the oil price should be higher than the total marginal cost. Thus, market power adds to the price of oil about total marginal cost, resulting in a price that is higher than $60.

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