NEW YORK (TheStreet) -- Think oil prices are only about production supply and consumer demand? Think again.
When OPEC announces production increases or decreases, it can affect the supply and therefore the price of oil, but factors such as U.S. production, oil storage capacity, reservoir pressure, and local energy needs affect pricing as well. It's one reason why oil experts make wildly different predictions for the direction of prices with some betting that oil will go back up to $100 a barrel and other predicting it will drop to $20 a barrel.
Take, for instance, reservoir pressure. Pressure underground in a large oil reservoir is managed to preserve the natural pressure that already exists. This means that production is constrained by the reservoir pressure profile. If oil is removed too quickly or too slowly, the reservoir could be damaged and oil recovery will be affected. Many have wondered why OPEC has declined to cut production despite plummeting prices and this could be part of the reason.
Another potential reason Saudi Arabia can't cut production is its domestic need for gas. Oil is at high pressure underground and has dissolved gases. When this oil is brought to the surface, dissolved gases are liberated at the low pressure on the surface. These gases have high heating value and become part of the utility system to service heating, cooling, cooking, furnaces and other local needs. The volume of oil produced is linked to these gas needs, which, in turn, are related to oil production. The gas-oil ratio, as it's known, is different for different reservoirs.
Image courtesy of Oil & Gas Journal. It originally appeared in the December 2011 article, "Gas plant improves C3 recovery with Lean Six Sigma approach" by Kamarul A. Amminudin, et al.
This diagram of the process described above illustrates the relationship of oil and gas at the Aramco processing plant in Khurais, Saudi Arabia. Dry Sour gas is sent to the sweetening unit to remove the sulfur before it can be used in utilities. Oil is stabilized (to remove light gases) before it can be used elsewhere.
So, supply isn't as elastic as it might seem.
Then there is the issue of oil storage capacity. The current oil surplus, spurred by increased U.S. production, has led to fears of storage capacity limitations. If storage is at limits, any change in supply or demand won't change prices much because stored oil will help sate demand before it pushes prices up.
And that leads us to the U.S., and its unique production issues.
OPEC is the most efficient producer -- meaning that it costs less for OPEC states to actually get oil to market -- and therefore can afford to produce as much oil as it can, which has helped give rise to the current glut.
However, a period of oil prices above $100 a barrel made it cost effective for the U.S. to make heavy investments in new technology and production. While Saudi Arabia is thought to be able to profit off oil that sells for as little as $20 a barrel, U.S. producers at new wells need prices as high as $70 a barrel.
Oil prices are currently below $70 a barrel, meaning that some U.S. wells aren't profitable. As a result, certain wells have shut down, but whether they will remain shut and cause a long term reduction in supply isn't clear. Future production will depend on the planning efforts of U.S. producers which have to guess whether, long term, prices are on an upward or downward trend. If many bet prices will decline, they will reduce their capital spending on new wells, production will be constrained and, voila, prices will go up.
That gets us back to trying to predict the direction of oil prices. As we said, it's complicated.
This article is commentary by an independent contributor. At the time of publication, the author held no positions in the stocks mentioned.