Chris B

Crude Reality: How Long Can Oil Stay Down?

Using "production costs" to justify a price for oil without separating fixed and marginal expenses will only lead to confusion. Remember microeconomics? A firm will continue to produce - at a loss - as long as the price is less than or equal to the marginal cost to produce that one extra unit, regardless of fixed costs. This is because at that level, you lose less money producing that extra unit than you would by completely shutting down but still having to pay your fixed costs.

Suppose you are paying interest, maintenance, amortization, insurance, and other fixed expenses to run an oil platform that was built at the height of the oil bubble and can produce oil at a total daily cost of $70/barrel. Your fixed costs are sunk costs - you will owe them whether you shut down or not. Your variable costs, a few extra salaries, parts, energy, etc. add up to maybe $10/barrel, and your fixed costs add up to $60/barrel. If you DO produce a barrel of oil and sell it at $40/barrel, you will lose $30 ($40 revenue-$60 fixed cost-$10 variable cost=$-30 profit). If you DON'T produce that barrel of oil, you will lose $60, your fixed cost. Which would you rather lose... $30 or $60? Easy decision: keep pumping and wait for prices to rise in the future.

At this point, many fields are operating at a loss because that's cheaper than not operating at all. It's a waiting game for the oil companies - a wait for competitors to go out of business or for prices to rise. Considering how flush with cash they are, that wait could go on a long time.