What price is the "right" price?

To the left is a list of how far each of the stocks we've been following is below its 52 week high.  Note that the S&P is basically at its 52 week high.  It is hard to say if the declines are justified, but so far I'm not tempted to step in and buy.  One thing that I would point out is that the 11.8% decline for Exxon off its high seems far too modest given the carnage among the E&Ps.  The majors are somewhat insulated from oil price moves because of the structure of production sharing contracts in foreign countries, and also because they derive earnings from petrochemicals, refining, and retail operations.  But it is hard to reconcile the drama in crude prices with how well the two american majors have held up.

One thing that is scary about the current situation is that there is really no way of knowing what the price of crude will end up at because crude prices are all about perception in the short term.  Below is the 2004 copper "cost curve".  This chart has an incredible amount of information about what the price of copper "should" be.  Each of the bars on that chart represent a mine or a group of mines.  The height of that bar is the estimated operating cost net of production credits to produce 1 lb of copper from each of those sources.  A production credit is the value of other recources from the same mine.  For copper it might be gold or molybdenum or some other desirable metal.  The reason that the mines furthest on the left of the chart are in negative teritory is that you could still economically run the mine even if you threw all the copper away, because the bi-product credits alone would make the mine economic to run.  The width of each bar on the chart represents the amount of copper production available from that source annually.  Now imagine a scenario where copper demand declined to 14,000 kt/year.  The price could theoretically decline to about $1.25 per lb.  This is the price at which all production above 14,000 kt/year should theoretically shut down (in 2008 according to the mining company BHP). It would be totally impossible for prices to fall to $.50 per lb for any length of time, because nearly all mines would have to cease operation.  Because of this it is possible to determine approximately where the price of the commodity "should" be.

Oil does not have a meaningful short-term supply cost curve.  If you google search "oil supply cost curve" you will get many results, but none of them will come anywhere near the precision of the chart above, because such precision is totally impossible for oil.  The reason for this is that for a copper mine, while there is significant upfront capital cost, the bulk of cost is in operating cost.  The majority of the dollars spent to getting copper out of the ground in 2014 was spent that same year operating the mine and refining the copper.  For a barrel of oil pulled out of the ground this year, the bulk of the spending happened in prior years in the form of capital expense.  There is no way to know what profit or loss may come from a dollar of capex spent today.  Operating costs are typically far below the revenue derived from production.  So unlike for the copper mines, there is little chance that someone will shut off supply to balance the market for reasons of economic self-interest.  Over the longer run, lower prices will halt new investment, which will gradually cause a decline in supply to balance the market, or new demand may be stimulated by lower prices, but this may take a long time indeed.  The highest operating cost producers are assumed to be the Canadian oil sands operators, but the largest of those, Suncor, recently reported cash operating costs of $34 per barrel for their oil sands operations.  Western Canada Select has traded at up to $40 discounts to WTI in recent years, and the oil sands kept producing.  All this suggests that for serious supply to come off the market in the short term the price may have to fall far lower.  Few believe the price could stay in the 30s for long, since much higher prices are needed to justify the capital investments needed to replace the production declines from existing wells, but if OPEC is not going to take the reigns and balance the market, there is really nothing to prevent further declines in the short term.