The Great Oil Deception: Part Two

"It is getting much more expensive to find Oil these days."

While it is true that it is getting more expensive to find oil, one has to examine whether that increase is of a permanent nature, as many argue. The reason that it is getting more expensive to find oil is mainly because service, drilling and other costs are sharply increasing. While this may seem like a circular argument at first, my intention is to demonstrate that the cost of finding oil is rising to a cyclical peak, and that it is not secular in nature.

All the data shows that the cost of finding Oil is rising sharply. Why? Very simply, because of a self reinforcing boom in exploration and production, which led to a capacity shortage in oil services and drilling as demand for rigs and services increased faster than supply. Other costs, such as for steel, or the acquisition of existing producing properties, has also increased for the same reason - a shortfall in capacity in various sectors, or an imbalance between supply and demand.

It is, therefore, a cyclical increase in the cost of finding oil, not a secular or systemic one. If the exploration and production sector cuts drilling significantly, say 30-40%, then extra capacity will flood the oil services and drilling market, leading to a plunge in prices and a decrease in the cost of finding and developing oil.

This argument is supported by data from many sources.

The Energy Information Administration [EIA] study entitled Oil and Gas Lease Equipment and Operating Costs has data from 1976 to 2006. The chart below demonstrates the cyclical nature of oil services.


Look at the green line back in the early 1980's when the cost index fell from 123.3 to 82.6 in just five years. This study does not include drilling and completion costs. If you included these, the cyclicality would be even more pronounced. Also, this data is only through 2006. The green line currently is significantly higher.

The same trend can be seen in the HS/Cambridge Energy Research Associates [CERA] Upstream Capital Costs Index. The latest monthly release from May 2008 shows that "the latest increase raised the index to 210 points from its previous high of 198. The values for the UCCI are indexed to the year 2000, meaning that a piece of equipment that cost $100 in 2000 would cost $210 today."


This index tracks "the construction of a geographically diversified portfolio of twenty eight onshore, offshore, pipeline and LNG projects."

As an example, five years ago, it may have cost $250,000 per day to lease a rig to explore deep offshore. Today, if you can find one, it may cost you $800,000 per day. According to Cambridge Energy Research Associates [CERA], day rates can be 30-40% of the cost of an offshore well.

So in a sense, it is getting more expensive to find oil, but people who say this are either ignorant of the reason why or being disingenuous to further their investment case. Bullish investors use this as an excuse to justify that oil prices have to stay higher because the cost to find oil is higher.

Please understand that I am not predicting that these various cost indices will turn down soon, rather am only stating for the record that they can turn down, and have turned down precipitously in the past, once capacity catches up to demand.

If you argue that the cost of finding Oil is permanently higher, you are accepting the argument that industries that have been intensely or even pathologically cyclical for 100 years are no longer subject to those conditions. This is a bold statement to make and you better be damn sure you are right.

Please read my earlier post of the fallacy of demand growth in emerging markets.

Comments

[Enough Wealth]

Even if the cost of production facilties, drill rigs etc. is largely cyclical, that doesn't mean the cost of finding oil isn't on an exponential upward trend. That's because the cost of finding oil depends on the ratio of wells dug to commercial oil fields found. I don't have the data available, but I've got the impression that the number of exploration wells dug per oil find has increased, and the average size of finds has been getting smaller and smaller. Also, although the cost of like infrastructure may return to previous real cost levels after the current speculative bubble in oil and commodities corrects, the nature of production equipment required has changed over time - these days there are few new large oil finds conveniently located on land, instead, new production is off-shore, and tending to be in deeper water (and therefore need more expensive production facilities).

If you have the data, it would be interesting to see a plot of number of exploration wells dug per GL of oil resource found, and also the average size of new production fields brought online over time.

2008 Jun 15 07:41 AM

[2008traveler]

The price of oil, drill rigs, steel, corn and just about anything that you buy in the grocery store has gone up. The real culprit. Printing of money by the Fed. Not speculation. Inflation. Do the math. Calculate how much these same items have increased in Euro, Yen, Swiss Franc, gold and I am sure it will be less. These are just symptoms of inflation not causes.

2008 Jun 15 07:58 AM

[baird]

Everything depends on the long term intersections of supply/demand. I agree that in the long run, whatever that is, reasonably priced alternatives to oil may be developed however it's difficult to see how significant pain can be avoided until then.

2008 Jun 15 08:06 AM

[Gigem77]

China was a net exporter of oil 10 years ago and is now the 2nd largest importer. World spare capacity then was 12 million barrels per day. Now it's less than 1 million and in light sweet crudes it's negative. That is a paradigm shift. Energy stopped being "intensely" cyclical when world production peaked in 2005. Speculation has discovered the inability of producers to bring additional supply to market.

Your other article on emerging markets is so incomplete, it's worthless. You ignore rising internal demand and falling production in OPEC countries. Indonesia just dropped out of OPEC because they are now net importers. Mexico has cut exports to the U.S. every month this year. Their Cantarell production is falling fast. The only country promising increased production is Saudi and their spare capacity is sour/heavy crude that is less desirable.

World production of light, sweet crude is not growing, so even relatively small incremental increases in demand push prices higher.

2008 Jun 15 08:39 AM

[Saildog]

The other issue is that oil is becoming harder to find. Chevrons Jack find appaently cost $100m.

Brazil oil E&P will be extrordinarily expensive and the technology to drill it does not exist. New metals will need development and the cahllenge of lifting 100+ deg C oil through water at 4 deg C has not yet been addressed. I have no doubt all thes issues will be overcome, but it aint cheap.

So I accept the argumant that much of the cost is cyclical, but much is structural too. Brazil is a new oil province. Which is great, but it isn't Ghawar, that's for sure.

2008 Jun 15 08:41 AM

[pachanguero]

Wow.....you are really wrong and stuck in a way of thinking that seems outdated at best. No demand growth in Emg. markets? Dude I have lived there and it is real. Get a passport fool. Then get back to me. Just trash here.

2008 Jun 15 08:49 AM

[mixter]

As a newly graduated geologist it was almost impossible to find employment in the exploration field in 1958. Out of a graduating class of 136, two people were offered jobs, one as a field hand on a seismic crew. The world was awash in oil during that time frame.

I have a 1931 Amerada Oil Co. (now Hess) showing a loss of $1.8million on revenues of $8.9 million. The price of oil had declined from $1.24/bbl. to $0.60/ bbl., and they were lamenting the fact that government restrictions would not allow them to produce anywhere near their maximum production rate. One well in Kern County, CA. was capable of producing 20,000 bbls./day, but was only allowed to produce 2,000 bbls./day. They stated they hoped there would come a time when demand met production capabilities.

All I can do now, is laugh, laugh, laugh!

2008 Jun 15 08:50 AM

[FrankRichards]

So if it weren't for that pesky cycle, the new Brazilian oil could be produced for the same price as the North Sea? And ANWAR as cheaply as Odessa?

2008 Jun 15 08:59 AM

[magor]

Deep sea rigs cost approx. 1 Billion to build. Rigs are built only when there are prior committments. Daily rates are 600K/day & all sold out.
There must be a very high degree of confidence that these huge
investments will bring huge returns. What is the evidence & source
material that would justify my investment?

2008 Jun 15 09:34 AM

[huangjin]

You may enjoy this report from AIER, Is There An Oil Glut In Our Future?
www.aier.org/research/...

One must be sure to separate the long-term from the short-term, but certainly if you believe in the market, high prices always serve to deliver more supply, either directly or indirectly through substitution. Unfortunately, the best substitution is electricity from nuclear generation. The U.S. Congress has restricted ALL forms of energy for the past 30 years. Once nuclear, coal, domestic drilling, solar, wind, etc. are within sight, the future price of oil will decline.

2008 Jun 15 09:42 AM

[lakeside]

I guess you must be correct. In Saudi Arabia where oil almost comes out of the ground is as expensive as drilling for oil under the ocean. No, that can't be right. Explain your thesis to me again. Was this published on April Fool's Day?

2008 Jun 15 09:45 AM

[Xenon]

Fig. 2 shows the index for the cost of oil and the cost of E & P being equal in 2003. For 2007 the cost of oil was double the cost of E & P. So, even if it is cyclical the spread is very large and E & P costs are not going to drop anytime soon.

2008 Jun 15 09:48 AM

[mpkirby]

Let's assume for a moment that the thesis is correct. That the cost of finding oil is in fact a short-term cyclical phenomena.

If we divide the oil in the world into two camps. Oil discovered before 1990, and oil discovered after, the decline in production from established fields isn't being made up from the discovery of new fields AT ANY COST.

In other words, in the past it took 1 single rig X weeks to find significant oil in off-shore drilling.

Now it takes multiple rigs much longer.

Perhaps we just need more rigs. But I suspect the horizon is receding into the distance. And we can't build rigs fast enough to offset decline.

There can still be made an arguement for above-ground reasons driving the problem.

Off-limits drilling in the U.S., combined with nationalized oil companies that under-invest in established fields.

But even if that were resolved today, the resultant increase in production would only stave off the issue for a few decades at most.

Think of it as an insurance policy. We need to invest in reducing our use of oil "just in case" there turns out to be a long-term decline in production. If we are wrong. Oh well. I'll go buy another SUV.

Mike

2008 Jun 15 10:04 AM

[Shaggieman]

Bush's first 4 years of a Republican controlled congress should have drilled ANWR but did NOTHING. It seems like the consumer is right where they want us, over a barrel.

That said, why should the U.S. E&P companies be finding oil for other countries and then we're kicked out after finding it? We're raising the price of our own domestic drilling and gaining very little crude oil. Keep the rigs home and working in our fields and bring down the E&P day rates.

2008 Jun 15 10:10 AM

[ari5000]

Jared Diamond's book "Collapse" covers this kind of phenomenon. Many civilizations -- on Easter Island, the Vikings in Greenland... and so forth faced complete collapse of their civilization due to destruction of key resources. The great Mesopotamian civilizations we read about in school were probably destroyed when nature ruined the rivers causing a decline in crops. Eastern Islanders cut down all the trees.

This world relies on oil more than any other natural resources other than perhaps clean water-- which is also running out in many places. The world will either circumvent collapse by harnessing new renewable resources: wind, solar, tide -- or it won't.

I am glad many people still think oil is in a "bubble". If everyone were aware of how close we are to catastrophe, I'm sure oil prices would triple. Unfortunately the U.S. has done almost nothing to promote new technologies --we've been stuck in a ridiculous war where our military burns insane amounts of fuel each day.

The clock is ticking. This article makes me happy since I know the energy stocks I own are still inexpensive.

2008 Jun 15 10:15 AM

[ari5000]

I hear about ANWR as if it's the answer to all our problems. How come all the people who blame Democrats for not drilling in ANWR never seem to mention the fact that ANWR would provide, at most, a 3% increase in production, dropping our reliance on foreign imports from around 66% to 63%.

Anyone who thinks drilling in ANWR will provide any kind of relief in oil prices is delusional.

2008 Jun 15 10:19 AM

[cynic69]

For those conservatives who think that drilling in ANWAR is the answer to our problems think about this. The only practical way to get the oil to market is to pipe the oil to the north slope area and send it to the port of Valdez via the existing pipe line. The Alaskan pipe line has a capacity of 1.4 million barrels/day. That amout of oil is trivial when compared to the 20 million barrels of oil currently consumed by the U.S. Another aspect is that the oil from ANWAR will not be owned by Americans. The oil will be owned by the company that does the drilling. These folks are going to sell the oil on the world market. If Japan is willing to pay more than the refiners in the U.S. it will all be shipped to Japan. Another reason not to drill in ANWAR is that when energy hoarding begins sometime in the future, it has already begun in Saudi Arabia, the oil in ANWAR could save our butts.

2008 Jun 15 10:52 AM

[truthinvesting]

we need to model Brazil

2008 Jun 15 10:59 AM

[jjason]

On June 3, 2008, testimony given by Professor Michael Greenberger to the US Senate Committee investigating the speculation in oil futures trading is now coming to light. There is not going to be an oil shortage tomorrow and soon we will see oil prices drop as the speculators drop like flies. Then I expect to see investigations into Goldman Sachs and Morgan Stanley and their analysts for "pumping" oil futures contracts and oil prices.

2008 Jun 15 11:05 AM

[CLH]

Its pretty hard to think of any rational reason for not drilling. Saving it? What stupidity. Who cares if people are cold. The myth of global warming is enough for them.

Going without is what socialism is all about.

2008 Jun 15 11:08 AM