One of the big "mysteries" in the oil market right now is the marginal cost of production. According to some theories that I follow, commodities should trade near their marginal cost of production in the long run. Anything can happen in the short run but the prices should be slightly above the marginal cost of production.
To figure out if a commodity is irrationally low, one can look at marginal cost of production for an idea. Prices can drop below but it will bankrupt some producers and when that happens, it will rise back up to the marginal cost. This thinking doesn't take potential increases in demand or decline in supply but it does give a very conservative estimate.
So is the current oil price below the marginal cost of production? If so, it would imply that it is undervalued and will rise for certain--although timing will be uncertain.
Well there was a hint of the cost of oil production, at least in the Canadian oil sands. I ran across an obscure story from the Globe & Mail of some Americans complaining that Canadian oil companies are dumping oil in their market. They charge that the oil is being sold below cost in America. The relevant point for our discussion is the response by the Canadian Association of Petroleum Producers, the industry lobby group, claiming that the cost of production in the oil sands does not exceed $35:
The prospect of a U.S. state investigating Canadian oil dumping raised the ire of producers in Alberta and prompted the Canadian Association of Petroleum Producers to bring out numbers showing that the current cost of producing oil sands crude does not exceed $35 a barrel, which is below current oil prices.
Assuming CAPP is correct with their numbers, it goes to show what the marginal cost of production for oil may be. One often hears that the oil sands, which is supposed to be high cost, has a cost of production of $80. Well, it clearly isn't $80 (it was around that figure a few years ago due to high input costs, labour, etc but that's not the case right now.) One could argue that $80 is required to significantly increase oil sands production but that has nothing to do with the marginal cost of production.
None of this is to say that oil won't go to $150; all it implies is that a conservative investor should value oil closer to $35 than to $80 or $150. Tags: energy