Iran recently reached an agreement with world leaders to limit its nuclear program in exchange for lighter economic sanctions. In the wake of this deal, some pundits speculated that Iran’s nuclear deal could push oil prices down and threaten the US shale oil boom. If you are in investor in the energy sector — particularly if you are invested in oil producers — this is well worth a discussion of the potential implications.

Let’s review how oil prices came to be where they are today. It was just 15 years ago, in December 1998, that the price of West Texas Intermediate closed below $11/barrel. At that time there was a lot of spare oil production capacity that could be brought online in case of a disruption in an oil-exporting country, so there was little or no fear premium priced into oil.

At those low prices, oil producers weren’t investing a lot of money in new capacity, but global oil demand continued to grow. In 1998, global demand for oil was 74.3 million barrels per day (bpd). By 2012, demand had increased to 89.9 million bpd — an average annual increase over that time frame of 1.1 million bpd.

It is true that in the West — the US and Europe — oil consumption was pretty stagnant over that period of time. This has led to puzzlement for many over the steady upward march of oil prices over the past decade. The short answer is that the West isn’t the entire world. The developing world more than made up for what the West wasn’t consuming.

While the oil producers underinvested in capacity as oil prices languished, demand for oil in the developing world marched on unabated. Every year the world demanded a million more barrels of oil, and so what may have been 8 or 10 million bpd of spare capacity in 1998 was significantly eroded by the middle of the next decade.

As spare capacity eroded, the price of crude oil started to climb and became more volatile. In early 2002, WTI could still be had for under $20/bbl, but the price rose more than 50 percent by year end. 2004 saw the price blow through $40/bbl and $50/bbl, and in 2005 Hurricane Katrina exacerbated the tight supply situation that had developed, pushing crude to the brink of $70/bbl.

By this time, the price of crude had the world’s attention, and OPEC and the rest of the world’s oil producers were all trying to respond to the situation. OPEC increased production, and oil producers in the US responded with a fracking revolution that would reverse US oil production declines. But there is a multi-year lag between strong price signals and a demand response, and by mid-2008 the price of oil reached nearly $150/bbl.

At that time many (including me) thought the price of crude had risen too far too fast, and by the end of 2008 it had crashed to the $30s/bbl. But the world had changed a lot since 2004 — the last time oil prices were in the 30s — and in 2009 prices recovered to $80/bbl, and by 2011 they were back above $100/bbl.

According to the US Energy Information Administration (EIA), the weekly average price of WTI has traded up near $110 this year, and traded below $90 only once. The price of Brent crude has spent the year mostly $5-$15/bbl higher than the price of WTI.

So what does any of this have to do with Iran? Over the past couple of years, Iran’s oil exports have fallen by about 1.5 million bpd as a result of the sanctions. If they suddenly returned to previous export levels, indeed there would be a temporary decline in the price of oil as the market absorbed the extra supply — and, more importantly, before OPEC responded. But there are a number of factors that will prevent this deal from affecting oil prices very much or for very long.

First, remember the earlier graphic? The world didn’t stand still while Iran has been subject to sanctions. Demand for oil increased by 1.1 million bpd each year, on average. Second, Saudi Arabia increased its production as a result of the sanctions, and it will roll its production back as Iranian oil exports hit the market. The Saudis like oil at $100/bbl, and with troubles in other OPEC nations like Venezuela, Nigeria, and Iran, Saudi Arabia still exerts a lot of control over the world oil markets.

Finally, a lot of new oil production has come online in the US over the past six years, but that’s a result of production techniques that require a higher price of oil to be economical. I have said before that I expect a bottom for oil over the next decade that could drop to $70/bbl under certain circumstances, but at that level you will see some oil production in the US shale plays start to shut in, which will push prices back up.

Oil prices initially dropped on news of the deal with Iran, but after a couple of trading sessions the news seems to have been shrugged off. That’s not to say that oil prices won’t be weak in coming months. We have been stating for months that our expectation is that we are entering a period of weakness, but that’s relative (and in my view temporary).

This deal with Iran may add to that weakness, but not because of the supplies it would add to the market. Saudi Arabia will ensure that those supplies aren’t a net addition to the market. Rather, any signals that Iran is ready to cooperate with the world community may take some of the fear premium out of the price of oil.

As spare capacity diminished over the years, oil prices became more volatile partially due to a “fear premium.” The way this works is that if there are 10 million barrels of spare capacity in the world, but 4 million barrels of production/capacity are in geopolitical hotspots, then there isn’t a great deal of concern and so oil prices are more influenced by fundamental factors.

But if there are 2 million barrels of spare capacity and 4 million barrels of production/capacity in geopolitical hotspots, oil is going to trade higher than the fundamentals would otherwise dictate because of the fear of losing capacity and developing a supply shortfall. The tighter the spare capacity and/or the more oil capacity that’s at risk of being taken off the market, the greater the fear premium. At times this fear can become extreme, as it did in mid-2008 when oil prices were pushed to nearly $150/bbl.

The final reason oil prices won’t fall too much and remain there is that the marginal cost of oil production is too high. In 2011 the Wall Street Journal reported that the marginal cost of oil production was $92.26 a barrel for the 50 largest listed oil and gas companies. The expectation was that the marginal cost would reach $100 a barrel this year. I suspect the marginal cost is actually a bit less than that, as this would imply that oil companies are losing money on marginal barrels at current prices. I don’t think this is the case. But in order to understand the impact of marginal production, see this graphic put together by my friend David Murphy:


Source: Data and Graphic Compiled by David Murphy at The Oil Drum

While I don’t necessarily agree with all of the numbers for the various sources, the concept is important. As the demand for oil has grown, the world has tapped into ever more expensive sources of oil. The easiest and cheapest oil has been produced, so year after year costs for producing oil continue to rise. As long as demand for oil remains strong, prices can’t fall far because producers would start losing money on the marginal barrels. If the price stayed low for long enough, the producers would start to shut in production.

On the other hand if some new invention came along that cut the world’s oil demand in half, the price of oil could easily fall back to $30 or $40 a barrel. The casualties, as shown in the graphic, would be the US oil industry, Canada’s oil sands, and lots of deepwater oil. But that’s nowhere on the horizon, and if something legitimate like that ever does appear, you should hear about it here first.

For now, you can expect a small impact from the deal with Iran. But the oil markets don’t operate in a vacuum. What Iran does will impact what Saudi Arabia does, and as each of those OPEC members makes its moves the developing world will continue to increase its demand for oil.   

(Follow Robert Rapier on Twitter, LinkedIn, or Facebook.)

Portfolio Update

Sticking With Seadrill Amid Stormy Seas

Last week’s earnings report by Seadrill (NYSE: SDRL), the leading supplier of offshore rigs, was nowhere near as strong as the prior quarter’s number, so it seems only fair that the stock has now coughed up its strong late summer gains. The question is whether Seadrill’s management is right in writing off the recent weakness in its market as a temporary pause rather that a lasting downturn. So far, the market is giving the company the benefit of the doubt and given its strong long-term fundamentals investors would be well advised to do the same.

Seadrill’s latest results were muddled by consolidation of the Sevan Drilling acquisition, which inflated overhead even as the near-sold-out current utilization rate capped revenue upside. As a result, earnings per American Depositary Receipt fell moderately short of analysts’ consensus estimate. On the bright side, revenue was up 17 percent year-over-year and next year’s slate of new builds already under contract looked promising enough for Seadrill to boost the dividend by 4 cents to 95 cents a share, for an annualized yield of 8.8 percent at the current price.

But the company’s near-term market outlook grew notably more cautious:

“The fundamental outlook for the offshore drilling industry remains firm. Exploration and production companies continue to view deep and ultra-deepwater acreage as attractive areas to invest capital. Several oil companies are however encountering a period in which cash flows are challenged and budgets must be re-examined. It is typical during these periods for project commencements in all regions to slow on the margin before growth capital is deployed in the most impactful projects that will replace reserves and grow free cash flow.

“As a result of the pause in upstream spending we have observed a decline in the overall number of fixtures, lead times and contract duration. We also expect to see a number of sublets adding to near term available supply. Contrasting with 2012 when the market was under supplied, based on these observations it is clear that the market is adequately supplied currently and may encounter some challenges in 2014. Importantly, these challenges will be acutely felt by lower specification assets while Seadrill is positioned in the high end of asset classes where utilization is likely to remain at 100 percent.”

A little lower, Seadrill offered this pep talk:

“The pace of contract additions has undoubtedly slowed from the pace seen in 2012 as customers re-evaluate spending plans. The Board is confident, based on our management teams’ bottom up analysis and conversations with customers, that this is a momentary pause before oil companies restart their spending in the most impactful projects offshore. Any meaningful reduction in capex by oil companies in the years to come will reduce production and likely lead to significantly higher oil prices. Our customers are acutely aware of the damage done by under investment in past cycles and are determined to replace reserves and grow production and avoid losing a generation of engineers. The fact that the major oil companies even in a reduced capex growth environment are still increasing spending in ultra-deepwater areas illustrates the attractiveness of our positioning.”

Significantly lower crude prices would certainly test Seadrill’s confidence in its customers’ perseverance, but that risk aside it’s hard to quarrel with a company that continues to trounce the competition while providing attractive returns. In addition to its juicy yield, Seadrill has delivered a 17 percent capital gain year-to-date. SDRL remains an Aggressive Portfolio Best Buy below $50.