It is generally assumed and taught in any business course that large companies have lower production costs (economies of scale). This should be especially true in business sectors related to commodities, where products are nearly indistinguishable.
The classic example for a commodity business is the oil and gas industry. Although there are many blends with slightly different properties, and prices and transport also costs play a role, oil producing companies don't really have to think about marketing or negotiating their prices (except some minor political exceptions). So the main parameter in terms of profit of an upstream company will be the amount of money it needs to get the oil and gas out of the ground, the production costs. In two of my previous articles, I have calculated production costs of one group of independent E&P companies that was profitable in 2013, and of another group more focused on gas production that suffered losses in 2013. The reasons for those losses were mostly huge impairments due to the shale boom-induced gas price drop in Northern America. In this article, I calculate costs for 4 remaining large independents: Suncor Energy (NYSE:SU), Anadarko Petroleum Corporation (NYSE:APC), Apache Corporation (NYSE:APA) and Noble Energy (NYSE:NBL).
In other articles, I have also calculated production costs for a number of E&P companies. Those numbers may serve for the purpose of comparison:
Oil is hardly ever produced as pure liquid. Normally, it comes as a mixture with natural gas and gas condensate. Although I only consider companies here that mainly lift oil, they also produce significant amounts of gas. Hence, it does not make much sense to apply costs to the production of oil alone. To deal with this issue, the concept of barrel oil equivalent - boe - has been perceived. 6000 cubic feet of gas at standard conditions are about one boe. All costs mentioned below refer to one boe, meaning that are the costs related to the production of 1 bbl of oil, 6000 scf of natural gas or a combination of both. For instance, let's say the price for 1 barrel of oil is around $100 and the price for 1000 scf of gas is about $6. This means 1 boe of oil generates much more revenue than 1 boe of gas ($100 versus $36). As there are also fields that only produce gas, this article tends to underestimate the costs of oil production.
Commonly, costs are divided in costs that can directly be related to production (cost of sales) and costs that cannot directly be related to output (overhead). However, many oil companies are also active in downstream and midstream or other economic sectors (e.g. ExxonMobil in chemical engineering). Hence, I have divided sales, general and administration expenses (SG&A) by total revenues and multiplied it with the revenue of the E&P division to get SG&A for E&P. I did the same for any similar type of cost (marketing expenses, R&D) and for financial expenses. Depreciation of assets, on the other hand, can be directly linked to oil production.
Costs of sales are divided into 3 sub-categories:
- Exploration costs
- Lifting costs
- Non-income related taxes
Lifting costs are the costs associated with the operation of oil and gas wells to bring hydrocarbons to the surface after wells (facilities necessary for the production of oil) have been drilled. This figure includes labor costs, electricity costs and maintenance costs.
Exploration costs are costs related to all attempts to find hydrocarbons. This category includes cost for geological surveys and scientific studies, as well as drilling costs.
Non-income related taxes. As production of hydrocarbons is such a lucrative business, governments also want to have their share. There exists an abundance of different models for how the state can profit from hydrocarbon production (profit sharing, royalties, etc.).
It might be that different companies use different categories for the same type of expenses, but eventually, the sum of all costs should be their total cost for producing 1 boe.
The following figure shows the pattern of the cost model:
Application on 4 Independent IOCs
As mentioned before, I have applied the cost model on 4 large independent oil companies. The first one is Suncor Energy, the largest Canadian independent oil company. Currency conversion used is CAD1 = US -$0.94. In my article about production costs of oil sand producers, I only used the figures from Suncor's oil sand division. In this article, only the E&P division is considered. Suncor got a bit less than half of its production from Eastern Canada and from its international operations, respectively. The rest originates from the United States, and is mostly gas, which decreases the average realized price. The next company investigated here is Anadarko, with a non-liquid production of nearly 60%, with gas mainly produced in the United States. Apache got nearly 60% of its production volume from the USA, and the rest from its international operations (mainly Egypt, UK, Australia and Argentina). The last of the companies, Noble, focuses its operations also mainly on the US, but also got significant production from Israel and Africa.
The results can be found in the table below:
Liquids do not only mean classical oil, but also natural gas liquids - NGL - and bitumen (produced via oil sands).
In this article, the correlation between share of produced liquid and realized price per boe is very high, which means that the individual products of the companies were produced in similar markets and got similar prices (e.g. oil produced in the US with about $100 per barrel).
Suncor Energy was able to get the highest spread between costs and revenue per boe, but also had the highest production costs, while the situation for Anadarko was exactly the opposite (lowest spread, but also lowest costs). In such a situation, it makes more sense to express pre-tax profit as a percentage of realized price. If done so, the companies are again quite similar, but show some kind of graduation: Noble and Apache have the highest margins (both 30.7%), followed by Suncor (27.7%) and Anadarko (24.2%). Nevertheless, all companies were highly profitable operationally, despite the drop in gas prices in Northern America.
Comparison with the mayors
Nevertheless, those companies are no match for the world's major oil producers or even the most profitable independents. Among that, enterprises' margins per boe were much above $25, at realized prices of about $70 (BP being the only exception). The reasons for this may be found in the economies of scale and longer experience, as well as more sophisticated research and technology. Additionally, there is the dependence on the US gas market. Perhaps higher gas prices could make a difference.
In most of my last articles, I have expressed the view that the oil price can never fall below production costs in the long term, and I named $50 as the lower boundary. Taking into account the results of my last articles, I get more and more the impression that the claim is true but much too weak. Just take Suncor as an example: I make the assumption that oil production costs are just the production costs per boe (an underestimate). That means at a North American oil price of $65, Suncor would hardly reach the breakeven point. The company would not be able to convince investors or banks to provide money for capital expenditure. Because oil field production declines over time without additional measures, 136 kboepd would start to vanish from the oil market. The effect increases as other oil companies have similar costs (at least in Canada). A decrease in supply, on the other hand, leads to higher prices.
Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.