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When OPEC comes off its power play, expect a return to high oil

Let's get one thing straight. Oil's nosedive doesn't prove that the "end of cheap oil" pundits are a bunch of dim-witted number-gazers whose grasp of the real world was comically wrong (as many of their detractors are now gleefully declaring). Oil is cheaper. It isn't cheap. Nor will it be.

When I first wrote about global peak-oil theory (a key argument for the "end of cheap oil" argument), when I was an oil and gas reporter for The Globe in Calgary in 2001, West Texas Intermediate crude was trading for less than $25 (U.S.) a barrel.

And that actually looked quite rich; WTI had been less than half that only a couple of years earlier. A decade ago, $45 would have been some of the most expensive crude the world had ever seen. The fact that we're now talking about $45 oil as being cheap in the extreme is, in itself, compelling evidence that the oil market's reality has transformed.

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Global oil demand has increased 11 per cent in the past decade – despite years of unprecedented high prices, one of the deepest recessions in history, continued below-trend global economic growth, and advances in conservation and alternative fuels. The rapid and ongoing expansion/ modernization/ industrialization/ urbanization of the world's major emerging economies, led by China and India, has created demand where it never previously existed.

And the process in emerging markets is far from over; new demand is going to continue to underpin oil prices for years, if not decades, to come. The International Energy Agency has predicted that global demand will increase by another nearly 7 per cent over the next five years.

Yes, there is new production, most notably the shale oil boom in the United States. But these new supplies are also, effectively, raising the floor for world oil prices – because the world's new sources of oil cost more to develop and produce than the old sources.

The price at which the world's oil producers can make money has gone up, which means that, no matter how plentiful the reserves, there's only so low the oil price can go before producers are unwilling to drill for it. This is the economics of oil production, and it will stop oil from ever getting as cheap again as it was routinely a decade ago.

Yet paradoxically, these very same economics have driven prices as low as they have now fallen. Put simply, what we are witnessing is a price war. Some of the world's richest, lowest-cost and best-established oil producers know that their higher-cost newcomer competitors aren't viable at substantially lower prices – and so they are orchestrating a price drop of their own product, confident that their cost advantage will allow them to withstand the pain longer than the competition.

These rich, low-cost producers are the members of OPEC; their stated refusal to cut production, despite oil's declines in the fall, was what really sent the price into a tailspin. The OPEC nations aren't willing to reduce their own output to help their competitors remain profitable – and with lower prices already starting to hurt the competition, they smelled an opportunity.

But we're now about as low as we can go. As Bank of Canada deputy governor Timothy Lane noted in a speech this week, the break-even price for oil sands (recognizing both cash costs for production and the costs of developing these expensive projects) is about $60 a barrel for existing projects and up to $100 for proposed new developments. Shale-oil plays become unprofitable in the $50-$60 range.

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No wonder, then, that once the market crossed the $50 threshold, producers of these unconventional oil sources ramped up the budget cuts for future development and production capacity.

"At $50 a barrel, the industry can neither grow nor even sustain output to meet future demand," said energy economist Peter Tertzakian, of ARC Financial in Calgary, in a research note this week discussing the notion of an oil price war. This means less growth in supplies, even as global demand continues to rise (albeit at a historically modest pace, at least in the short term). The result? A tighter supply/demand balance, which will return upward pressure to oil prices.

It's important to note, too, that while most OPEC producers (especially heavyweight Saudi Arabia) can still turn a profit at these prices, their government budgets are another story. Most OPEC countries need crude prices to average $100 or more to balance their budgets.

Prices below $50, if sustained, would gut their finances, trigger soaring deficits and strain their ability to deliver on programs for their citizens. Some of these countries have enough money in the bank that they could fund deficits for several years, but most would probably be in trouble within a year or two.

So, OPEC won't support low prices indefinitely, and it's neither necessary nor in the cartel's own interest to push them much lower. Eventually it will get what it wants – which is a return of higher prices without OPEC having to give up production or market share to get there. It wants to force the cuts on someone else.

But don't mistake this gambit with a new era of cheap oil. The economics won't support it.

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