OPEC decided to defer any further cuts in output. In response, oil prices slid. In the short term, this is the natural reaction of the market; however, OPEC has delivered a powerful message. The message is simple. OPEC is motivated to cut production in order to prevent prices falling below the marginal cost of production. Once prices fall below marginal cost, "new production" cannot be brought on to the market, because the marginal cost of production exceeds the marginal revenue; thus production cuts make little sense. It is my view that the action of OPEC is one which will put a floor under oil prices.

Today, OPEC controls 40% of global production; over the years, I expect OPEC will lose Nigeria and Angola, while it may gain new members from amongst the former Soviet Union. The reason is simple; OPEC will find within it a big conflict of interest if it controls supply from both high marginal cost producers and low marginal cost producers. OPEC will remain very strong and it is likely that over time they will get growing support from non OPEC high and low marginal cost of production producers.
Now let me clarify; the marginal cost of production of OPEC is low, very low; the OPEC oil industry can remain profitable even at $15/barrel. The marginal cost of production from oil sands (Canada) and deep/ultra-deep water (United States, Brazil, Angola, Nigeria) is far higher and it is these which will bring new production on market.

At present, price levels marginal producers will be forced out of the market. Presently, a production cut is automatically executed without OPEC making any sacrifice on volume because the high marginal cost producers shall withdraw from the market. There are certain OPEC members (Angola and Nigeria) which might suffer from the OPEC decision because they remain high marginal cost producers. For a low marginal cost producer, volume becomes increasingly important in a market where prices fall; this is not the case for a high marginal cost producer.

Now, the marginal cost of production for deep/ultra-deep water (main new production expected from Brazil, United States and Angola) is near enough $60 per barrel; the marginal cost of production for oil sands (Canada) is much higher. Realistically, even with a significant economic slowdown, demand growth will surpass production growth. If production growth is to come to market, oil prices must sustain over $60. Saudi Arabia has opined that the fair price of oil is about $75 per barrel; I do not see them as being far off the mark, because at this level, marginal producers of oil will receive a reasonable but not excessive return on investment assuming a long term marginal cost of production of $60 per barrel.

In my view, the marginal cost of production will fall. Oilfield service and driller resources have been stretched while demand remained elevated. In this environment, the oilfield services and drillers have enjoyed considerable pricing power. For this reason, the marginal cost of production has remained high with capex inflation running at 12% and more for oil producers; at the same time opex inflation has remained elevated at over 6%.

Now considerable new capacity has been added by oilfield services and the drillers; some has already entered the market and much more shall come into the market between now and 2012. As new capacity enters the market and as demand eases off in light of falling oil prices, industry inflation levels will retreat. Thus, in my view, the long term marginal cost of production should fall within a range of $48 to $53 per barrel. If new production is required as a consequence of rising demand, long term oil prices can be expected to range from $55 to $61 per barrel. At this level, oil producers are provided a reasonable return on investment.

Oil demand today is in the region of 85.893 million barrels per day. Oil production is 85.619 million barrels per day. There is little surplus production capacity outside of OPEC and OPEC surplus production capacity runs are approximately 1.7 million barrels per day. The market is well supplied today. What about tomorrow?

In terms of future visible production, amongst OPEC, Saudi Arabia has the ability to bring new capacity onto the market. The Manifa field in Saudi is capable of adding 900k barrels per day, while re-starting Damman would add a further 75,000 barrels per day. Saudi Arabia is unlikely to increase its production capacity at oil prices under $75 per barrel. Outside of the OPEC, there is visible production able to come to market of 1 million barrels per day from United States (447k barrels), Brazil (291k barrels) and Azerbaijan (268k barrels). Brazil and United States bring new production from deep/ultra-deep water with high marginal costs of production. Azerbaijan has a lower marginal cost of production; nonetheless its source in the Caspian Sea. The Caspian is an expensive operating environment because it is land locked which makes transportation an expensive proposition; in addition because the Caspian Sea is land-locked, the cost of bringing offshore drilling equipment is high; so while cost of production is lower than deep/ultra-deep water, it is not cheap. Offsetting these visible production gains are visible production declines in the North Sea (282k barrels) and Mexico (287k barrels); on a global level, net non OPEC visible production capacity will increase by 105k barrels per day.

So in terms of visible production capacity we have 85.619 million barrels per day capacity today; add to this OPEC surplus capacity of 1.7 million barrels per day and visible Saudi Arabia additional potential capacity of 975k barrels per day and we come to 88.336 million barrels per day. Add on the non OPEC visible capacity net addition of 105k barrels per day and we have total expected and visible future production capacity of 88.441 million barrels per day. Production capacity not presently visible can expected to continue to come to market as and when prices and demand justify investment. Amongst the high cost of production producers, there is plenty of "not presently visible" opportunity in the deep/ultra-deep water & harsh environment theatre; I see great promise in Angola, the Gulf of Guinea (in fact most of the African West Coast), Brazil and United States; Canadian oil sands will one day provide a valuable source of oil.

There are other sources of incremental high marginal cost production such as Russia, Venezuela, Nigeria and Equatorial Guinea; however due to instability inherent in these States, it cannot be reasonably relied upon. Iraq, Russia, Kazakhstan, Turkmenistan and Azerbaijan remain opportunities for lower marginal cost producers; but once again stability within the jurisdiction is an issue. India and China also have high marginal cost of production potential, albeit with not as much promise as the preceding countries.

From a supply perspective, compare the expected and visible future production capacity of 88.441 million barrels per day with demand of 85.893 barrels per day and you will understand why there was no fundamental reason for oil to trade at $147 per barrel. Now keep in mind that at least 7 million barrels per day of this production comes from high marginal cost producers; to keep this production on market, oil prices must remain over $60 per day. Just as there was no reason for oil to trade at $147 per barrel, there is absolutely no fundamental reason why oil should trade at levels below $60 on a long term basis.

From a demand perspective, we have the same story; cheap oil is history. During 2000, oil demand was at 76.715 million barrels per day; this level of demand could be significantly satisfied by the low marginal cost producers. Thus, in the past as expectation of future demand growth were optimistic, we saw a significant rally in oil prices, because it was required to bring new production online. As future demand growth expectations reduced, prices collapsed because present demand could be satisfied by low marginal cost producers. The low marginal cost producers cannot satisfy today's demand of 85.893 million barrels per day during 2008; the best they can do is 81 million barrels per day; the last 4.893 million barrels must be paid for to compensate the higher marginal cost producers and it is at this higher level that the price of oil will settle.
In looking at demand for oil during 2008; United States demand has shrunk from a peak of 20.687 million barrels per day during 2006 to 19.562 million barrels per day during 2008. This level of demand is beneath demand during 2000, 2001, 2002 and 2003. In my view significant further contraction in demand is highly unlikely, even when confronted with a deep and prolonged recession. China on the other hand has seen demand increase from 4.797 million barrels per day during 2000 to 8.004 million barrels per day in 2008. This economy continues to grow and energy demand will remain elevated even in a slow down.

As for the rest of the world; I look at it in distinct segments. The OECD Ex United States includes several mature slow growth economies in demographic decay, these economies are at greatest risk of contraction. Non OECD Asia (Ex China) includes moderate growth economies; some contraction in energy demand can be expected amongst these economies. Former Soviet Union & Eastern Europe are high growth economies; slowing growth in energy demand can be expected, however demand for energy will not contract for several years. All other (including Emerging Markets India, Brazil) includes economies with high growth but with significant slow-down risks; energy demand growth will slow but with little risk of an outright contraction.

Until something fundamental changes (new oil alternative or new significant low marginal cost fields), from here on energy will be in an irrepressible bull formation; the upswings will be higher with the downswings being less severe. Oil can trade at below $60 per barrel if demand contracts to 81 million barrels per day because at this level of demand the supply from high marginal cost producers is not required. Even with demand at 81 million per day, prices would need to be substantially higher than the marginal cost of production of the low cost producers as long as there is an expectation of demand growth from these levels.

As illustrated in the chart above, demand destruction of this magnitude is not something I can contemplate even in a deep and prolonged recession; the only other reason demand destruction of this magnitude can occur is through new technologies providing a new source of energy capable of replacing oil; neither are remotely visible today. Long term oil prices can also fall with a sustainable decrease in the marginal cost of production; this again will require new technology – none in sight today. Oil prices can also fall if a new low marginal cost of production source is found; this needs to be a significant find – nothing below 4 million barrels per day will reduce dependency on high marginal cost sources; once again nothing of this magnitude is remotely visible.

My conclusion: Go buy. Oil is finally trading at and below fair value; it might fall on sentiment, valuations might get better, but no one can time the market to perfection.