By Michael McDonald
Saudi Arabia continues to talk tough and make headlines for its stance in oil. Last week, the Kingdom's oil minister advocated for a straight forward though painful solution to the current oil glut - wait for the world's most expensive and inefficient oil producers to be forced out of the market.
While the Saudis have implemented a production freeze, and there seems to be increasing room for cooperation with Russia and other nations, the Saudis view still leaves little room for high cost and inefficient producers. At the HIS Conference last week, Oil Minister Ali Al-Naimi was quoted as saying that "Inefficient producers will have to get out… Efficient markets will determine where on the cost curve the marginal barrel resides". Al-Naimi's quote refers to the marginal cost curve which relates to the production cost for each producer of oil. The chart below from the IEA details estimated relative costs of production in a variety of countries. Countries on the high end of the spectrum include Canada, the U.S., and most other non-OPEC nations.
The marginal cost curve above approximates roughly a standard supply curve. High cost producers can only compete on such a curve when demand is very high. Without that demand, high cost producers have little ability to extract oil at a price the market is willing to pay. Now of course, a large part of the costs of oil production are borne upfront in drilling a well, so once the well is drilled, even high cost producers will have an incentive to pump from existing wells. But when prices are below marginal costs of production, no new wells will be drilled. That is precisely what we are seeing in the U.S., Canada, and some other geographies right now.
If we draw a supply curve against the chart of producer costs and add a hypothetical demand curve, we can get an idea of why the current crisis is taking so long to abate. In a free market, price is set by supply meeting demand. And with the current cost structure, as the chart below shows, it's hard to imagine how demand can sustainably rebound strongly enough to push oil prices back over more than $60 a barrel. By the same token, however, it's equally hard to imagine demand being so weak that prices below $30 a barrel are sustainable.
In this situation, what can the U.S. and Canada do to ensure continued relevance in the markets? The key is to lower marginal production costs. This is not easy, but it is possible. In particular, marginal production costs can be lowered in one of three ways:
- Better technology enabling more efficient oil extraction.
- Falling input prices reducing costs of extraction.
- Focus on the most productive assets with the easiest extraction.
In the U.S. and Canada, all three approaches are in progress. Supply chain costs have fallen dramatically, and as the old adage goes, necessity has proved the mother of invention leading to new methods of drilling more efficiently that use less equipment and speed the process up (thus lowering costs). The last point is perhaps the most germane for investors though - there are some sites and likely even entire formations that are simply not economically feasible at present (and probably not economically feasible for years to come).
The sites that are the hardest and most costly to drill are probably a total loss for oil companies for the foreseeable future whether because of the remoteness of the area, the technical difficulty of extracting oil, or the cost of the land. This reality will wipe out some oil companies. Investors should do research on their own, or consult an expert to determine which firms are not going to recover. Those companies and individuals holding out hope for a miracle have little prospect of receiving one.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.