A Trend to Watch in the Oil Market

Posted by Brad McMillan, CFA, CAIA, MAI

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This entry was posted on Nov 5, 2014 12:43:00 PM

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oil marketAs expected, the midterm election resulted in the Republicans gaining control of Congress. Despite all the ink and hot air expended on it, though, the election isn’t the most important news right now. The bigger story is the slump in the oil market as Saudi Arabia cuts prices for U.S. buyers.

When you don’t have to worry about the present, it's the perfect time to start thinking about the future. With the U.S economy now well settled into a recovery, it makes sense to look a bit farther ahead to see how trends in oil prices could play out—and to get a sense of the opportunities and threats that may exist.

Oil is now a technology business

Our base assumption here is that the existing trends will continue over the next five years. As I see it, the most important trend is oil extraction as a technology business. No one's really putting it that way, but that is what has happened.

Up until about five years ago, oil extraction was pretty simple, at least from a lay perspective. Drill a hole, pump up oil. The fracking revolution has changed that. Now, one hole drives multiple wells. Productivity is improving and costs dropping. It’s no longer one hole/one well; technology now lets us do more on the same piece of land, providing scalability.

What does this remind you of? For me, it’s the semiconductor industry, where technology’s ability to get more out of a piece of computer real estate—a chip—has driven 30-plus years of advances.

What if Moore’s Law (that chip performance doubles every 18 months) could be applied to oil production? There are obvious physical limits, of course, but the benefit might just as easily come from lower costs. The natural gas market has already shown this is possible.

Don’t underestimate technological progress

One of the arguments that oil prices can’t go much lower rests on the marginal cost of production, which is higher here in the U.S. than in the Middle East. The Saudis, for example, can cut prices enough to slow down supply expansion in the U.S. and thus maintain their market share. After all, it makes no sense to continue to drill here if the price of oil is too low to cover the costs. Based on their move to cut the price of oil for U.S. customers, the Saudis seem to buy into this reasoning.

What this argument overlooks, though, is continuing technological progress. Costs in the U.S. continue to decline as we get better at oil production. The virtuous circle now in play should continue to drive costs down regardless of what the Saudis or anyone else does.

The next computer industry?

Everything I understand about the new oil technology suggests that the trend is in its early stages. Anyone who made predictions about the power of computers based on the Apple II would have been way off. We probably won’t witness that kind of technologically driven growth in the oil business, but I strongly suspect we’ll see much more growth than is currently expected.

In fact, over time, lower costs should drive more volume—in the papers today, a company announced a deal to export oil without government approval—which in turn will support more investment in technology and even lower costs. Again, the parallel with the computer industry is clear.

The world has gotten used to rising oil costs over the past several decades, and it's now accepted as some kind of natural law. Oil’s shift to a technology business may end up reversing that trajectory for some time, and the implications of the change are definitely worth thinking about.

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