Despite the recent pull-back in commodity prices, “in the long run, we continue to believe that oil and gas prices will trend upward,” says New York-based Sanford C. Bernstein & Co. LLC’s senior research analyst, Ben Dell.


“For oil, prices should continue to cycle between the cash cost at the bottom, about $45 to $50 per barrel, and the price of demand destruction, about $110 to $125, at the top,” he says.


The peaks and troughs of the oil cycle will depend on near-term supply and demand. Currently, prices are affected by the recent peak, driven by strong non-OPEC demand and weak supply growth, but will become corrected by the marginal cost of supply.


The price range is defined to the upside by 1.6 times the marginal cost. The downside is defined by 0.6 times the marginal cost. Future prices should stay at a premium to the marginal cost due to tight spare capacity, Dell says.


The scale of the correction will be driven by the magnitude of the current demand event (the global drop in GDP) and the magnitude of any late-cycle supply growth, but prices will swing to extremes based on major events.


For example, during the 1991 Iraq invasion and the 1999 Asian financial meltdown, oil traded between the cash cost and the marginal cost. But since early 2005, a combination of record-low interest rates, surging global GDP, the Katrina hurricane, wars in Iraq and Afghanistan and Nigerian supply disruptions have caused oil to trade between the marginal cost and the price of demand destruction.


“We continue to believe that North America defines the marginal cost of supply and that this is rising at circa 10% per annum,” says Dell. “The marginal cost in North America is expected to rise from $75 to $80 per barrel today, to circa $105 by 2012, with the private and microcap E&Ps being the largest component of the high-cost producer.”


Industry data now suggest that $80 per barrel is close to the marginal cost of supply today, but that it is rising. Some private players have marginal costs of about $80, although scale is a key factor in the economics of production. Upstream costs are highly sensitive to scale, as is cost inflation. While the aggregate cost for private players is $55.93 per barrel, many fields have marginal costs above $80.


However, in the short term, demand destruction is now being seen in the U.S., U.K., France, Germany and Japan, where demand growth rates are negative. U.S. demand fell 4% in May. Japan’s consumption temporarily benefited from a short tax break in early 2008, but that reversed in June.


“We continue to foresee consumption growing in Latin America, Africa and some Asian countries, but the rate of growth is decelerating as higher pump prices, higher interest rates and lower GDP moderate consumption patterns,” says Dell.


Also, Chinese demand growth appears to be slowing, due to reduced traffic in the first half of 2008. The decline was caused by an 18% increase in retail fuel prices and the government-mandated reduced traffic in and around Beijing for the Olympics.


Meanwhile, the Middle East will most likely see moderate demand in six to 12 months as commodity prices drop and the U.S. dollar strengthens. These factors are causing the price of oil to be depressed in the short term.


Also, Dell notes his oil-consumption estimates are slightly lower than estimates by the International Energy Agency, because “we believe the IEA’s estimates for demand are unrealistically optimistic and the agency has failed to react to the worsening economic environment.”
The depressed prices, and current financial situation, are affecting U.S. producers.


“I think we’re going to see companies coming out of this quarter cutting capex and cutting land acquisitions,” says Dell. “I think we are going to see some of the rig counts flatten off.”


As producers’ capex budgets are cut, so is production, once again reducing supply. These factors, and the future limits of Saudi spare capacity, will lift prices going forward, although possibly not

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