why have oil production costs fallen so much?

rules for commodities

From years of analyzing oil, gas and metals mining–as well as watching agricultural commodities and high-rise real estate out of the corner of my eye–I’ve come to believe in two hard and fast rules:

–when prices begin to fall, they continue to do so until a significant amount of productive capacity becomes uneconomic and is shut down.  That’s when the selling price of output won’t cover the cash cost of production.  Even then, management often doesn’t reach for the shutoff valve immediately.  It may hope that some external force, like a big competitor shutting down, will intervene (a miracle, in other words) to improve the situation.  Nevertheless, what makes a commodity a commodity is that the selling price is determined by the cost of production.

–it’s the nature of commodities to go through boom and bust cycles, with periods of shortage/rising prices followed by over-investment that generates overcapacity/falling prices.  The length of the cycle is a function of the cost of economically viable new capacity.  If that means the the price of new seed that sprouts into salable goods in  less than a year, the cycle will be short.  If it’s $5 billion to develop a gigantic deep-water offshore hydrocarbon deposit that will last for 30 years, the cycle will be long.

boom and bust spending behavior

During a period of rising prices, cost control typically goes out the window for commodity producers.  Their total focus is on adding capacity to satisfy what appears at that moment to be insatiable demand.  Maybe this isn’t as short-sighted as it appears (a topic for another day).  But if oil is selling for, say $100 a barrel, it’s more important to pay double or triple the normal rate for drilling rigs or mud or new workers–even if that raises your out-of-pocket costs from $40 to, say, $60 a barrel lifted out of the ground.  Every barrel you don’t lift is an opportunity loss of at least $40.

When prices begin to fall, however, industry behavior toward costs shifts radically.  In the case of oil and gas, some of this is involuntary.  Declining profits can trigger loan covenants that require a firm to cease spending on new exploration and devote most or all cash flow to repaying debt instead.

In addition, though, at $50 a barrel, it makes sense for management to:  haggle with oilfield services suppliers;  do more ( or, for some firms initiate) planning of well locations, using readily available software, to optimize the flow of oil to the surface;  optimize fracking techniques, again to maintain the highest flow; streamline the workforce if needed.   From what I’ve read about the recent oil boom, during the period of ultra-high prices none of this was done.  Hard as it may be to believe, getting better pricing for services and operating more efficiently have trimmed lifting expenses by at least a third–and cut them in half for some–for independent wildcatters in the US.

 

This experience is very similar to what happened in the long-distance fiber optic cable business worldwide during the turn of the century internet boom.  As the stock market bubble burst and cheap capital to build more fiber optic networks dried up, companies found their engineers had built in incredibly high levels of redundancy into networks (meaning the cables could in practice carry way more traffic than management thought) and had also bought way to much of the highest-cost transmission equipment.  At the same time, advances in wave division multiplexing meant that each optic fiber in the cable could carry not only one transmission but 4, or 8, or 64, or 256…  The result was a swing from perceived shortage of capacity to a decade-long cable glut.

My bottom line for oil:  $40 – $60 a barrel prices are here to stay.  If they break out of that band, the much more likely direction is down.

 

how low can the crude oil price go?

This is my response to the comment of a regular reader.

There’s no easy answer to this question.  I have few qualms about putting a ceiling on the oil price.  In round terms, I’d say it’s $60 a barrel, since this is most likely the point at which an avalanche of new shale oil production will come on line.  Also, for investing in shale oil companies this number doesn’t matter than much, so long as it’s appreciably above the current price.

A floor is harder.

a first pass through the issue

We can divide the source of oil production into three types.  I’m not going to look up the numbers, but let’s say they’re all roughly equal in size:

–extremely low production cost, less than $5 a barrel, typified by production from places like Saudi Arabia

–very high production cost, like $100+ a barrel, which would be typical of exploration and production efforts of the major international oil companies over the past decade or so, and

–shale-like oil, with production costs of maybe $35 -$40 a barrel.

In practical terms, there’s never going to be an economic reason for the low-cost oil to stop flowing.

Shale oil is basically an engineering and spreadsheet exercise.  The deposits are relatively small and the cost of extraction is almost all variable.  So shale will switch on and off as prices dictate.  We know that at the recent lows of $25 or so, all this production was shut in.

The very high production cost is the most difficult to figure out.  Of, say, $100 in production expense, maybe $70 is the writeoff of exploration efforts + building elaborate hostile-environment production and delivery platforms.  This is money that was spent years ago just to get oil flowing in the first place.  What’s key is that for oil like this is that the out-of-pocket cost of production–money being spent today to get the oil–may be $30 a barrel.  From an economic perspective, the up-front $70 a barrel should play no role in the decision to produce oil or not.  So, dealing purely economically, this oil should continue to flow no matter what.

second pass

First pass says $30 – $35 a barrel is the low;  $60 is the best the price gets.

Many OPEC countries (think:  Saudi Arabia again) have economies that are completely dependent on oil and which are running deep government deficits.  Their primary goal has to be to generate maximum revenue; the number of barrels they produce is secondary.  If so, they will increase production as long as that gives them higher revenue.  Their tendency will be to make a mistake on the side of producing too much, however.  Their activity will make it very hard to get to a $60 price, I think.

On the other hand, shale oil producers who can make a small profit at, say, $35 a barrel may tend to shut in production at $38 – $40, on the idea that if they exercise a little patience they’ll be able to sell at $45, doubling or tripling their per barrel profit.

third pass

Second pass argues for a band between, say, $40 and $55.

Bank creditors don’t care about anything except getting their money back.  They will force debtors–here we’re talking about shale oil companies–to produce flat out, regardless of price, until their loans are repaid.  This was an issue last year, and what I think caused the crude price to break below $30 a barrel.  I don’t think this is an issue today.

There’s a seasonal pattern to oil consumption, driven by the heating season and the driving season in the northern hemisphere.  The driving season runs from April through September, the heating season from September through January.  February-April is the weakest point of the year, the one that typically has the lowest prices.

If the financial press isn’t totally inaccurate, there are a bunch of what appear to be poorly -informed speculators trading crude oil.  Who knows what they’re thinking?

my bottom line

This is still much more of a guessing game than I would prefer.  I see three positives with shale oil companies today, however.  Industry debt seems more under control.  Operating costs are coming down (more on this on Monday).  And seasonality should soon be providing support to prices.

 

 

 

the wobbly crude oil price

Over the past week or so, the world crude oil price has dropped by about 10%–although it is rebounding a bit as I’m writing on Wednesday morning.

I have several thoughts:

–this is the weakest part of the year for crude oil demand, since the winter heating season is over and the spring driving season is yet to begin

–the surprising aspect of recent crude oil prices is not that they are weak, but rather how strong they have been in January and February in the face of a rising rig count in the US and a milder than average winter in heavily populated areas around the world

–hard as this may be to believe, the price drop suggests to me that many traders in the crude oil market are new to the game, and for some reason haven’t filled themselves in beforehand on the basic characteristics of the commodity

–since there’s a direct relationship between the price of oil and the price of oil exploration and development stocks, the current odd price action in the crude market makes evaluating and trading in the equities more difficult

–I’ve built a small position in e&p stocks over the past couple of months, so I’m sitting on my hands.  If I owned nothing, I’d be tempted to buy something–although I’d be more comfortable if crude had been gradually declining in price over the past month, rather than exhibiting the panicky behavior of the past week.  This is also predicated on the idea that what’s driving crude is thoughts #2 & #3.

the future of oil mega-projects

My friend Bruce pointed out in a comment last Friday that the shale oil explosion in the US has come very quickly, and as a surprise to most.  Could there be a similar resurgence of the mega-projects that the big international oil companies have typically launched–and are the cause of the huge cost writeoffs they are now making?

My thoughts:

oil

–I assume the current administration in Washington will encourage domestic pipeline construction and reduce/eliminate support for renewables.  This would push further into the future the time when renewables will be price competitive with, and begin to replace, fossil fuels in a widespread way.  At the same time, increased availability of fossil fuels would tend to keep a cap on their price–which pushes the changeover to renewables even further into the future.

–if the chief oil exporting nations think this way (and I believe they do), there won’t be the panicky sense of urgency to produce oil as fast as possible that would prevail if they thought renewables would begin to substitute for fossil fuels in, say, ten years.

–I have friends in the Endless Mountains of Pennsylvania (the Marcellus Shale) who sold the mineral rights to their land to an oil company several years ago.  They tell me there are seven or eight oil- or gas-bearing strata below the one being tapped now.  If this is any indication, profitable shale drilling can go on for much longer than the consensus expects.

–the onshore shale oil/gas wells that smaller independent firms drill tend to use simple equipment, take a short time to get up and running and play out in, say, two years.  If I had to make up an oil price breakeven point for the typical fracked well, I’d say $30 a barrel.

–the offshore megaprojects that the big integrateds specialize in tend to involve very deep wells that take a long time to drill, use quarter-billion dollar+ floating drilling rigs to do so, and which tend to be located in remote, inhospitable, infrastructure-poor areas controlled by potentially unstable governments.  On the other hand, they tend to produce oil/gas for twenty years or more.  Breakeven?  …a gross generalization would be $60 a barrel.

–onshore shale wells in the US tend to cost around $12 million and to produce $35 million in output before they play out.   Fields, say, in deep water offshore Africa or in the Arctic, can require billions of dollars in upfront investment.  In addition, it’s possible that terms will be renegotiated in its favor by the owning government if the wells turn out to be more prolific than expected.  So the risk profile for this type of project is far higher, and the payback period far longer, than from the type of domestic onshore drilling done by independents.  It’s also at best marginally profitable at today’s oil price.  This suggests to me that the big oils will continue to prioritize their lowest risk, but also lowest potential, projects.

–can costs for big integrateds fall from here?  Maybe.  But those for frackers would likely fall in line, too.  And the political risks + the substantial upfront costs caused by challenging physical environments will likely remain for Big Oil projects in spite of future breakthroughs in technology.  So my guess is that the barriers to greenfield mega-projects will remain high.

Of course, neither frackers nor the large integrateds can match the lifting costs for established wells in Saudi Arabia of around $2 a barrel.

Middle East

–Many Middle Eastern oil-producing countries have young, growing populations and economies that are fundamentally dependent on sales of oil.  The government is typically the main employer.  Over the past decade, government spending will typically have expanded in line with oil revenues, to the point where now, with the oil price more than 50% off its highs, substantial government budget deficits are common.  Reorientation of these economies is urgently needed, but is also, like anywhere else, typically opposed by beneficiaries of the status quo.  This is a recipe for political instability.

–the US is likely going to be energy self-sufficient within a few years.   This will lessen the economic motivation for the country to intrude into, ore even maintain an interest in, Middle Eastern politics.  Other motives for doing so will remain, but my guess is that political willingness will wane, as well.

 

 

 

 

 

 

BP Energy Outlook 2016

BP just released its annual Energy Outlook.  

The company is projecting faster development of shale oil, coming mostly over the next few years from the US, than it previously thought.  Renewable energy supply will rise more quickly; (heavily polluting) coal usage will fall faster.  Most of the action will be in developing nations like China and India.  The US will attain energy self-sufficiency in a handful of years, oil self-sufficiency shortly after that.

 

To me, the most interesting topic the release brings up is not actually contained in the report.  It comes from comments by Spencer Dale, BP’s chief economist, during a press conference promoting the new Outlook.

According to the Financial Times, Mr. Dale said that there’s twice as much technically recoverable oil available as the world is expected to need between now and 2050.”

First, “technically recoverable” means only that all of this oil can be extracted from the ground using current oilfield methods.  It does not mean it can be done profitably.  In fact, the choice of the word “technically” suggests BP believes that a significant portion is uneconomical at today’s prices.

Second, according to BP, much of this oil is unlikely to see the light of day…ever.    That’s because global demand for energy is likely to grow by less than 2% yearly.  Most of that will be supplied by renewables and natural gas; oil demand increases by less than 1% annually.

At some point, as the price of renewable energy continues to fall, and absent a decline in the oil price, demand for oil begins to shrink.   Since one might imagine that this drop might not take place thirty years, it may be of little practical concern to you and me.  However, for OPEC countries like Saudi Arabia, which holds perhaps 100 years worth of economically viable oil, and whose economy is radically dependent on petroleum, this is a significant worry.

Investment implications (assuming BP is correct):

–the oil price is unlikely to go up

–OPEC + shale oil will squeeze out higher cost oil production from the rest of the world

–future shale oil company profits will come as much from lowering production costs as from new finds

–big oil firms probably still have plenty of stranded assets (meaning oilfield investments that have become uneconomical and where recovery of the money already spent is unlikely) on their balance sheets.

 

 

 

 

Saudi Arabia’s about-face

About a week ago, Saudi Arabia brokered an agreement among oil producing countries to cap their aggregate output of crude at 32.5 million barrels daily.  This will require daily liftings to be reduced by 1.2 million barrels.  Of that 1.2 million barrels in cuts, the Saudis themselves will account for 486,000, or just over 40%.

This Saudi decision flies in the face of the kingdom’s previous policy and its experience in the 1980s, when it repeatedly reduced production in a vain attempt to stabilize prices.  What happened back then?   …other OPEC countries, with more pressing needs for cash and with relatively short-lived reserve bases (so playing a long game made little sense, just as today), failed to make the output reductions they agreed to.  More than that, they boosted their liftings instead in amounts that more than offset the Saudi cutbacks.  So prices continued to fall, and for years afterward Saudi Arabia lost access to long-time customers.

Over the past two years, because of the bitter experience of the 1980s, Saudi Arabia has refused to reduce its output despite pleas from other OPEC members.  It  has even increased production a bit.

…until now.

What should we make of this about-face?

The superficial arithmetic for Riyadh is clear–reduce output by 5%; the price per barrel rises by 10% as a result; total revenue rises by 5%.  That’s assuming no cheating by other parties.  But in the case of every economically-driven commodities cartel, cheating always happens.  And the Saudis know that OPEC proved itself no different from other cartels 35 years ago.

 

What’s interesting about this case is that for us as investors situations like these, where we have imperfect information, arise more often than we would like to believe.  Rather than obsessing about what we don’t know in these cases, it’s important to see what conclusions we can draw from what we do know.

In particular:

–Saudi Arabia simply can’t have forgotten about its experience in the first half of the 1980s.  It must believe that eventually some parties will fail adhere to their production quotas.  But it must have some reason to believe that this won’t happen immediately

–it’s possible the kingdom thinks that with supply and demand are almost evenly matched, output reductions will cause the crude oil price to rise substantially.  The price rise will ward off cheating

–the Saudis must also think that what they’re doing now is a better strategy for them than that of pumping full-out and keeping prices low.  Why should this be?  My first thought is that Riyadh’s finances are not in strong enough shape to continue to endure $40 a barrel oil

–the Saudis must realize as well that $50+ a barrel will reinvigorate the shale oil industry in the US, capping any possible price rise.  On the other hand, keeping prices at, say, $40 a barrel won’t make shale oil go away.  The industry will simply lie dormant for a while, ready to spring to life again when prices are higher.  On the other hand, they may no longer believe that they can destroy the shale oil business forever by keeping prices low.  they may even fear that technological advances and cost-cutting will make shale viable at $40 if they are allowed to take place.  So, counterintuitively, the best strategy for combating the threat of shale may be to discourage the development of such new techniques by keeping prices higher

my take

Buy shale oil and monitor OPEC closely.

 

 

 

 

 

yesterday’s report on US crude oil supplies

the EIA

Each week the Energy Information Administration (EIA), an independent statistical agency in the Energy Department that collects, analyzes and publishes extensive amounts of energy data, releases a report on US inventories of crude oil.

background

Over the past quarter-century, the typical US crude oil inventory stock level has been around 325 million barrels (excluding the Strategic Petroleum Reserve of 700- million barrels).  The figure shows some seasonal variation in most years, peaking in late Spring – early Summer and reaching a low point in late Winter.  But these swings have usually been relatively mild.  Before the current period of oversupply, for example, the weekly figure had never come in above 375 million barrels.

Between August 2014 and May 2016, however, the inventory number rose steadily from 331 million barrels to 510 million.  Since then, the figure has been gradually declining.  That, and talk of OPEC members placing a ceiling on the cartel’s overall production, have created the belief among speculators on Wall Street that the worst of the global crude oil oversupply might be behind us.

…until now.

the November 2nd report

The November 2nd EIA report shows crude oil inventories leaping by a huge 14.4 million barrels,to a total of 483 million.  While even the 468 million barrel inventory figure of a week ago is way above normal, the shock  to financial markets is that the change–typically one or two million barrels in either direction in any given week–is so big and that it is in the direction of more oversupply.

Even though one data point doesn’t make a trend, this one appears to have let a lot of air out of the balloon of crude oil bulls.

 

I’m still on the sidelines.  I continue to think we won’t the first clear signal of the state of the crude market until the seasonally slack period in late January – early February.