Last year was a good year for oil. The price of Brent crude, the global benchmark for oil, remained above $100 per barrel for most of the year. But now, as a new year kicks off, people want to know whether oil prices are headed higher or lower.

It's certainly an important question. Not just for oil companies, but for consumers and other businesses as well. While it's true that commodity prices are virtually impossible to predict with a high degree of accuracy, there is compelling evidence that oil prices should remain high.

Or, to look at it a different way, there is good reason to believe that they are at least unlikely to fall below a certain threshold level. Let's take a closer look at why.


Determinants of the price of crude oil
The price of Brent crude reached a three-month high last week, bolstered by a string of optimistic global economic data and geopolitical concerns about North African oil supply in the wake of a terrorist attack in Algeria. ICE March Brent crude rose to nearly $114 a barrel on Friday and started off this week at levels above $113 a barrel.

Brent prices have risen nearly 2% since the start of the year, as recently released economic data from the U.S., China, and the eurozone have instilled a renewed sense of optimism about the global economy. Concerns about North African supply, as well as reduced production from Saudi Arabia, have also contributed to the slight increase in prices.

While there are a host of factors that impact crude oil prices, such as global supply and demand fundamentals, geopolitical risk, speculation, and monetary policy, marginal production costs have proven to be a remarkably accurate indicator of the price of oil. In fact, according to a note by Bernstein Research, the marginal cost of production is "the most important factor driving oil prices over the long run."

The relationship between the price of oil and the marginal cost of oil production, which refers to the expenses associated with producing the last barrel, is well documented. For instance, between 2001 and 2010, the average annual price of Brent increased 228%, while marginal production costs among the world's 50 biggest public oil companies rose 229%, according to calculations by Bernstein Research.

It boils down to the incentives facing oil companies. If the cost of producing that last barrel of oil exceeds the price they can get for it, they have no financial motivation to produce it. Herein lies the first major clue as to the future direction of oil prices - production costs have risen sharply in recent years, which, some argue, has effectively placed a floor below the price of oil.

Spike in production costs
The Bernstein Research note analyzed production costs for the 50 biggest publicly traded oil producers and found that cash, production, and unit costs in 2011 increased at a rate much higher than the 10-year average.

Specifically, they found that production costs in 2011 rose 26% year over year, while the unit costs of production rose by 21% year over year, coming in at $35.88 per barrel. Among the 50 oil producers surveyed, the marginal cost of production rose 11% year over year, coming in at a whopping $92 per barrel in 2011.

Energy companies are well aware of this development and have been doing everything they can to protect themselves, including major initiatives to lower costs. For instance, Halcon Resources is planning dramatic cost reductions in 2013 to help offset the relatively high operating costs of its mature producing assets.

Meanwhile, Kodiak Oil & Gas has already seen a dramatic reduction in operational expenses through improved fracking techniques, which has led to a sharp decline in the number of days taken to drill a well. And LINN Energy , through water-management initiatives, has benefited from major expense reductions in its Granite Wash and Permian Basin operations.

Why productions costs have risen
The reason production costs have increased so sharply has to do with changes in the marginal source of supply. A few decades ago, U.S. oil producers could easily extract oil for under $20 a barrel, but those days are long gone. As fields of so-called "easy oil" have quickly been depleted, energy companies have been forced to venture out of their comfort zone and into new and harsh terrain in the pursuit of black gold.

For instance, Royal Dutch Shell is hoping to drill for oil off the coast of Alaska - a plan that has received intense scrutiny and opposition by environmental groups, as well as the CEO of Total. Similarly, ExxonMobil and Statoil are planning to explore for oil in the harsh Arctic waters near Russia.

These examples are illustrative of a major shift in global oil supply and suggest that the world is becoming increasingly reliant on unconventional sources of oil, such as shale and deepwater. While these unconventional sources hold vast promise in terms of the quantity of potentially recoverable hydrocarbon resources, they are accompanied by exorbitantly high costs due to the need for more technologically sophisticated equipment.

Final thoughts
Because oil prices are determined at the margin, the net impact of this shift toward unconventional sources has been upward pressure on crude prices. Despite media coverage suggesting that oil companies are raking in more cash than they know what to do with, the evidence suggests that high marginal production costs are taking their toll on even the most expertly managed operators.

There are other factors at play here, too. OPEC member countries, which account for more than a third of global oil production, have incentives to maintain oil prices above a certain threshold. For instance, Saudi Arabia probably requires oil to be at least $80 a barrel in order to keep its budget in order. Other important players in the global oil market, such as Russia and Venezuela, have similar minimum requirements.

All in all, the world is becoming increasingly more dependent on unconventional sources of oil. Currently, unconventional oil accounts for a relatively paltry 3% of global supply, but by 2020 it is projected to account for about 7%, and by 2035, 10%, according to the U.S. Energy Information Administration. Since unconventional oil is much costlier to extract, its associated higher production costs should continue to exert upward pressure on global oil prices, helping maintain prices above a certain threshold.

Kodiak Oil & Gas is a dynamic growth story, offering great opportunities, but with those opportunities also come great risks. Before you hitch your horse to this carriage let us help you with your due diligence. To see if Kodiak is currently a buy or sell, check out our new premium report, which comes with a year of timely updates and analysis.

The article Why Oil Prices Are Likely to Remain High originally appeared on Fool.com.

Fool contributor Arjun Sreekumar has no position in any stocks mentioned. The Motley Fool recommends Statoil (ADR) and Total SA. (ADR). Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

Copyright © 1995 - 2013 The Motley Fool, LLC. All rights reserved. The Motley Fool has a disclosure policy.


Increase your money and finance knowledge from home

Introduction to ETFs

The basics of Exchange Traded Funds and why ETFs are hot.

View Course »

Investing in Emerging Markets

Learn to invest in a globalized world.

View Course »

Add a Comment

*0 / 3000 Character Maximum

10 Comments

Filter by:
Gumby

Yeah, oil prices will remain high becasue you will go back to guzzle gasoline if it comes down in price again. Why cannot we just reduce gasoline consumption no matter what... This is not how we behave.. So oil traders has a responsibility to keep oil supply availabe as fairly as possible.. The rich couldnt care which way oil prices go , but you average Joes has a lot counting on oil prices and will lose big if oil prices go up, Right? So it is entirely UP to you average Joes to keep your oil addicition down or else. The rich cannot be more delighted to have you waste oil and gasoline for joyriding or whatever.. The rich owns oil stocks and they cannot lose.. It is you average Joes who lose !! No politican can ever dare explain this above to you as you will as sureasfire them out of office!

January 29 2013 at 1:33 PM Report abuse rate up rate down Reply
Gumby

I posted almost 100 clips at Youtube.com/junkyardnut, so you will need to make guesses which ones I am showing about solar mirrors that you can use to heat your homes powerfully! I posted about 3 doxens of them so not all of my clips are about solar mirrors.

January 29 2013 at 1:27 PM Report abuse rate up rate down Reply
Gumby

The rich says that solar energy is not competitive simply because they dont need it!! It is YOU!! who needs solar energy more than the rich does... If you agree, then why are you still using oil , nat gas, coal, etc even firewood that makes you sick and die young!! So therefore, it is not the rich's problem but YOURS yourselves!! Yeah, solar chips are not cheap but there is a cheaper idea that doesnt make electricity or hot water but precious heat that you pay through your noses to your utility to heat your homes... What is it? Mirrors!!!! See? Yeah , mirrors! What for? you ask me?? To capture more sunlight and reflect through your windows to heat your homes.. Impossible? Not! It is possible and I am using mirrors myself... Go to youtube.com and search for my clips.. I am the Junkyardnut at youtube.com.. Check it out, dudes!! It is cool and you will love it... Be forewarned! Mirrors are dangerous to handle and you have to be careful !! It can be deadly!! Why am I persuading you to use deadly dangerous mirrors that can cut you and kill you if you dont know what you are doing? Well, I may be crazy but my mirror solar idea works too well to ignore!! If you feel it is not wise to use deadly dangerous mirrors, fine, you can instead talk about it .. I need as many of you as possible to spread my idea until our manufacturers finally bows and start manufacturing safe mirror home heaters that saves you money with utility bills. Come watch my videos about my solar mirrors.. dont watch my drum videos unless you want to.. I want you to watch my solar mirror videos !! Need for solar speed!!@

January 29 2013 at 1:23 PM Report abuse rate up rate down Reply
Gumby

The rich is not complaining , huh?

January 29 2013 at 1:15 PM Report abuse rate up rate down Reply
Gumby

Don't you have anything to say??????????????????????????????????????

January 29 2013 at 12:31 PM Report abuse rate up rate down Reply
Gumby

ERROR!! We're sorry your comment could not be added due to technical difficulties. Please try after some time.
?????????????????????????? or just shut up and go away??????????????

January 29 2013 at 12:30 PM Report abuse rate up rate down Reply
Gumby

ERROR!! We're sorry your comment could not be added due to technical difficulties. Please try after some time.
??????????????????????????

January 29 2013 at 12:29 PM Report abuse rate up rate down Reply
Gumby

What technical diffciulties ?? I had to refresh and found my comment posted ok despite the pop up window cautioning technical difficulties... Fix it! What technical diffciulties ?? I had to refresh and found my comment posted ok despite the pop up window cautioning technical difficulties... Fix it! What technical diffciulties ?? I had to refresh and found my comment posted ok despite the pop up window cautioning technical difficulties... Fix it! We're sorry your comment could not be added due to technical difficulties. Please try after some time.

January 29 2013 at 12:28 PM Report abuse rate up rate down Reply
Gumby

What technical diffciulties ?? I had to refresh and found my comment posted ok despite the pop up window cautioning technical difficulties... Fix it! What technical diffciulties ?? I had to refresh and found my comment posted ok despite the pop up window cautioning technical difficulties... Fix it! What technical diffciulties ?? I had to refresh and found my comment posted ok despite the pop up window cautioning technical difficulties... Fix it!

January 29 2013 at 12:28 PM Report abuse rate up rate down Reply
Gumby

If any of you dont want our oil companies to go to drill in sensitive places , then you have to use less oil.. and even firewood, too!

January 29 2013 at 12:17 PM Report abuse rate up rate down Reply