Oil price touched $147 for a barrel of WTI on July 11, 2009. Then the world economy was hit by the worst recession since the Great Depression. This global recession triggered a precipitous collapse in the oil price.  In January 2009, it dropped to $32 a barrel and many people predicted that it will drop further to $25 a barrel and will also linger there for some time. That low price did not fit well with the oil fundamentals. It reversed itself and started to move up to reach $50 in April. It hovered around there for a short while, and some market participants thought that $50 was the fair value.  But the price rejected the presumed fair level and climbed up to more than $70 a barrel. It seems now that it is resting around $70 in the middle of this global recession. There are people who still think that cheap oil will come back and stay. I believe that oil price can not linger long below $60 a barrel.

The rationale for this assertion lies in the components of the oil price and the values they command. The first component is the marginal extraction cost (MEC).  In economics, the marginal cost of the most expensive product in the market usually places the floor below the market price for that product. In the oil market, the MEC in the most expensive area categorizes the floor for the oil price. It is not the MEC for the oil in Iraq and Saudi Arabia, which costs about $ 3 a barrel, but the MEC for deep water off the shores of the United States that forms the price floor. The MEC for the expensive oil ranges $60-$80 a barrel. Thus, $60 a barrel should be considered the lasting floor for the oil price even during recessions. The era of cheap has gone!

The oil price has other components, in addition to MEC. Oil is a depletable resource and the cost of depletion for the marginal barrel is added to MEC. In economics, the depletion cost is known as the marginal user cost (MUC) which rises with more extraction. Oil has been depleted in many parts of the world including the North Sea, Mexico, Dubai, Angola, Vietnam, among others.  The depletion rate is expected to accelerate over time as demand outpaces supply.

The oil market structure can not be categorized by perfect competition. Thus, oil price should be higher than total marginal cost which includes both MEC and MUC. In other words, there is a monopoly or market power in the oil price. Regardless, how OPEC is characterized, whether as a cartel or a dominant firm, the oil price should be higher than the total marginal cost. Thus, market power adds to the price of oil about total marginal cost, resulting in a price that is higher than $60.

Oil is also sensitive to global geopolitics, particularly in the areas where oil is produced. As everyone knows, political events in the Middle East, Nigeria, Russia and Venezuela positively impact oil price. Therefore, oil price embeds a component that captures geopolitics. This component is known as the fear premium and is very volatile as it increases significantly during crisis and subsides when the world is living in peace.  Sometimes, the fear premium is temporary while other times it is permanent. The 1973 oil embargo and the 1970 Iranian Revolution are landmarks for an almost permanent fear premium. This component as well as the market power component should place oil price higher than total marginal cost.

Finally, oil price is subject to the vagaries of speculators. This part can be the most unstable component in the oil price as it can be stretched out to challenge in magnitude the other four components combined. The speculative component is probably responsible for the oil price to reach $147 a barrel in summer 2008. This component commands more importance when the marginal barrel matters more. This is something that should be expected to occur starting in 2010.

Based on the above factors, we can conclude that the 2009 price of oil should stay above $70 a barrel and should tantalize $80 before the end of the year.