A new study just published by the CGES challenges two myths currently prevalent in the oil industry and investment community. One is that the cost of oil production in the world has reached $100/B. The second is that high oil production costs caused the oil price rise.
The CGES contends that while there has been some increase in oil production cost, it is far lower than the figures commonly asserted. It is a commonly held notion that high production costs caused the oil price rise in the mid-2000s and that they justify the current elevated prices. The CGES asserts that the price of oil has risen for reasons other than rising production costs, and in fact the price rise was a cause, and not the consequence, of higher production costs.
THE TRUE COST OF OIL PRODUCTION
In this analysis the CGES studies and disputes both how quickly and how far costs are believed to have increased. It points out that over the past decades when the price of oil was in the $20/B to $30/B range, oil exploration and field development operations were carried out successfully and profitably all over the world, including in the so-called high-cost areas.
Although costs did increase at a rate greater than inflation, the CGES study maintains that the current fully built-up costs of developing and producing conventional oil (excluding taxes and royalties) in most regions of the world do not exceed $30/B and for the Canadian oil sands are no higher than $50/B. The study provides a global cost of supply curve for conventional crude (and some unconventional oil). This shows that around 33% of the world’s oil costs less than $10/B to produce and nearly 90% has a cost below $20/B.
The study also points to the cyclical nature of the oil services sector. When the prices for rigs, equipment and field services go up, the manufacturers start building more rigs and more suppliers and service providers enter the market. The competition results in a moderation and ultimately a reduction of the prices and charter rates in the services sector. The study provides data showing how this has already happened since 2007.
The CGES states that the rise in the average price of Brent crude from $28.9/B in 2003 to $38.3/B in 2004, $54.6/B in 2005, $72.4/B in 2007and $111.3/B in 2011 – having fallen back somewhat during the great recession of 2008-09 – has not been a consequence of the rise in production costs and these costs do not support the current oil price levels. Even if the cost of production had reached $100/B, one cannot apply to the oil market the economic concept that prices are set by the highest marginal cost.
The oil market is not perfectly competitive. The heavy front-end investment needs and long lead times are substantial barriers that limit new entrants. The oil market is also influenced by government action. For example, access to low-cost areas is limited by governments and most importantly, state-owned oil producing entities restrict oil production to keep oil prices higher than they otherwise would have been.
Similarly, the demand for petroleum products by final consumers is influenced by government policies such as taxes and duties. The price of oil is also driven by factors such as global supply and demand, political uncertainty and speculation. And OPEC, the association of oil exporting nations led by Saudi Arabia, has compounded the structural problem of a lack of overall competitiveness in the oil industry by constraining collectively its output via a quota system when it considers that oil prices are weak and need bolstering.
When the OPEC countries – and especially Saudi Arabia, the organization’s largest and lowest-cost producer – constrain their output, the price of oil obviously ends up higher than it otherwise would have been, yielding greater economic rents for the low-cost producers and providing high-cost producers everywhere with opportunities to earn profits that they would not have otherwise enjoyed.
Moreover, when producers are not operating at maximum capacity the price of oil actually becomes indeterminate in the sense that a producer (like Saudi Arabia) is able to influence the price, up or down, by varying its output in a manner that is unlikely to have anything to do with upstream costs.
While of course production cost can influence oil prices over the long term, in recent years, the cost of production has not played a part in the rise of the price of oil. √
The CGES argues that cause and effect are the reverse of the commonly held view: increasing oil prices have caused the rise in production costs, and have not resulted from them. Arguing that rising oilfield costs are behind the strong rise in the price of oil is ‘putting the cart before the horse’.
Through detailed analysis, the study examines how this has occurred over the past few years. High oil prices led to high revenues for oil companies who used those revenues for increasing their exploration and production activities. This caused an increase in the prices and charter rates for rigs and other field materials and services required for those activities.
This means higher costs for developing fields and producing oil. The growth of oil and gas industry activities was faster and the cost escalation was more pronounced in offshore areas where there was a need to design and build expensive new capital items such as floating production, storage and offloading vessels.
The study carries out a special analysis of the oil sands in Canada and concludes that the above arguments also apply to those operations.
High production costs have been widely put forward as a contributor to the rise in oil prices over recent years. This view is prevalent in both the oil industry and the investment community. In this study, the CGES shows that actual production costs are not as high as commonly perceived and also challenges the view that production costs have played a part in setting the level of oil prices in recent years.
* Excerpts from a study published by the CGES (author Manouchehr Takin), December 2012. Please contact: [email protected] or CGES, 17 Knightsbridge, London SW1X 7LY, UK. Tel: +44 20 7235 4334.