The marginal cost of production is often thought to be the floor for commodity prices, but in reality this may not be true, at least not in the short term. As a general rule of thumb, if prices start to fall below the 90th percentile in the cash cost curve (also known as the operating cost) then production is likely to be curtailed. Morgan Stanley estimate this price in the oil market at $35-$40 per barrel.
“In commodities without a cartel, existing production must be shut-in. If true, marginal cost of investment is not the relevant metrics, it’s variable operating cost, which is closer to $35-$40/bbl on the high end.”
Even if a particular oil well is operating at a loss, there is a good chance it will continue to operate. Once the initial investment has been made, the incentive remains to continue producing as long as the price remains above the project’s operating cost. This will usually be much lower than the break even rate or marginal cost of production.
If the oil market is now operating as a ‘real’ market, i.e. not being controlled by OPEC then this would provide more of a fundamental basis for their argument that Brent crude prices could fall to as low as $43 per barrel in 2015. However, as we saw in 2008 when prices fell to a similar level, oil prices quickly rebounded to cover the marginal cost of production.
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