In the most important sense, the title to this post is incorrect. Gasoline prices do not come close to covering all the social costs of driving. They underprice pollution, especially carbon emissions. They underprice the congestion imposed on other drivers. They underprice the damage done to roads and infrastructure: gasoline taxes are no longer sufficient to fund America’s transport needs. So no, gasoline is not too damn high.
In one sense, however, it is: oil is currently worth more than the marginal cost of getting it out of the ground. Brent is currently trading around $111. The marginal cost of getting a barrel out of the ground ran about $92 in 2011. That leaves a 20% spread: some room for prices to fall (even with current demand) but not a whole lot.
How do you calculate the marginal cost of getting a barrel out of the ground? Well, there are two ways to do it. The correct and complicated way has been done by Bernstein Research. They used the annual reports produced by the 50-largest oil companies for which there are data (sans Russian and Kazakh producers) in order to calculate the marginal cost of a barrel. That is the dashed line on the below chart. As you can see, it’s been rising incredibly fast over the past decade, even as world production has more-or-less stagnated.
There is a quick-and-dirty way to replicate their methodology. I’ll walk you through it. Start with the bottom line, which is the average cost per barrel of actually getting the stuff out of the ground. That has risen from $4 to $21 over the past decade, as more and more difficult oil has come onstream. Now add in depreciation, administrative expenses and marketing costs. That’s the second line from the bottom. (It includes direct taxes and royalties on oil production.) It has risen from $7 to $36 over the past decade.
Bernstein then calculated the amount of capex (including exploration costs) that the companies would need to undertake in order to keep their reserves constant. That is the greenish dashed line labeled “Unit costs + est. capex.” There is a quick-and-dirty way to replicate their results, which is simply to use what the companies actually spent on their capital expenditures. That is the greenish solid line labeled “Unit costs − DD&A + capex.” (It subtracts depreciation before adding back in actual expenditures, in order to avoid double-counting.) The result is more-or-less the same. That number, a simple estimate of marginal cost, has skyrocketed from $11 to $51 over the past decade.
Now here’s the rub: oil companies do not actually earn the Brent price unless they are, you know, selling Brent. In 2011, Brent averaged $111, but the average realized price earned by the 50-largest oil companies was only $66 per barrel. In order to calculate the Brent price at which the companies could cover their marginal costs, you need to add that “realization spread” to the basic marginal cost calculation. That is the dark green line that more-or-less parallels the correctly-calculated marginal cost.
|
2001 |
2002 |
2003 |
2004 |
2005 |
2006 |
2007 |
2008 |
2009 |
2010 |
2011 |
|
|
Lifting costs |
$ 4 |
$ 4 |
$ 5 |
$ 6 |
$ 8 |
$ 9 |
$ 11 |
$ 17 |
$ 13 |
$ 17 |
$ 21 |
|
Unit costs |
$ 7 |
$ 9 |
$ 10 |
$ 13 |
$ 15 |
$ 18 |
$ 21 |
$ 30 |
$ 26 |
$ 30 |
$ 36 |
|
Unit costs − DD&A + capex |
$ 11 |
$ 15 |
$ 15 |
$ 19 |
$ 25 |
$ 31 |
$ 34 |
$ 45 |
$ 36 |
$ 47 |
$ 51 |
|
Above + realization spread |
$ 21 |
$ 24 |
$ 24 |
$ 28 |
$ 41 |
$ 51 |
$ 57 |
$ 82 |
$ 57 |
$ 75 |
$ 97 |
|
Marginal cost |
$ 25 |
$ 30 |
$ 36 |
$ 45 |
$ 58 |
$ 54 |
$ 64 |
$ 96 |
$ 68 |
$ 83 |
$ 92 |
|
Brent oil price |
$ 24 |
$ 25 |
$ 29 |
$ 38 |
$ 55 |
$ 65 |
$ 73 |
$ 98 |
$ 62 |
$ 80 |
$ 111 |
What does this tell us about the world oil market? Well, the peak oil people seem to have been half-right. Technology has enabled the world to maintain oil production, and the truth is average production looks set to expand. But technology has not enabled the world to maintain production without using increasingly expensive techniques. I was at a dinner the other day with two hedge fund guys, and we calculated on a napkin (using an entirely different methodology) that it was barely worthwhile to drill in the Bakken at current oil prices. Given that the world seems to have an ending thirst for oil, prices may fall, but not by that much.
What does this imply about American energy security? Well, the U.S. may, if it is willing to carry out the right policies, be able to insulated itself from future price shocks that could take oil up to $200+ per barrel. But it will not be able to bring back the days of buck-a-gallon gas. Not even three-buck-a-gallon gas. Absent some sort of radical demand shift (and raising CAFE standards ain’t that) cheap oil is gone forever.
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