This article is the second in a series of articles discussing the most neglected and ignored factors that can have significant impacts on long-term oil prices (NYSE: USO) (See Part 1 here). The title ("The Unstated Case For Long-Term Low Oil Prices") was chosen because the majority of the neglected factors, with few exceptions, exert downward pressure on long-term oil prices. The exceptions, however, will also be covered.
I will be taking a "big picture" perspective, and will consequently be leaving out many details and making some inexact - though roughly accurate - simplifications along the way. This series is not intended to be an encyclopedia on the dynamics of oil pricing. (As one of my former law professors used to say, "A one-to-one [1:1] scale map isn't very useful.") Nor is it intended to be a definitive statement as to what exactly oil prices are going to do. The goal in writing these articles is simply to bring to the attention of investors and analysts those factors having the two characteristics of being both grossly neglected and significantly impactful.
In the last article, we covered the "the unconventional enlightenment." Today, we'll be covering the seemingly mundane issues of full-cycle development costs, operating costs, and fixed financing costs, and - more importantly - the different ways in which they affect companies' decisions to grow, sustain, or cut back on production.
Today's Topic: All Costs Are Not Equal. And, What That Means For Oil Prices
We frequently hear in the media today something along the following lines: "Company X needs oil prices to be above [some stated price] to be profitable," or, "Country Z needs oil prices above [some stated price] to balance its budget." Often, the implication seems to be that if oil prices fall below the stated "minimum" price, somehow this will enact a causal sequence of events that actually results in less oil production from that company or country.
This is false. The error comes from the failure to distinguish between three things: 1) the profitability of an entire company or country, 2) the profitability of the full-cycle development of one of its undeveloped resource projects, and 3) the profitability of continuing to produce from an established resource that has already been developed.
Fully-Cycle Costs vs. Operating Costs
The different roles played by full-cycle development costs and operating costs in affecting company decisions should be familiar to anyone who has ever taken a course in finance. And yet even OPEC - who you would think would be a sophisticated and interested enough party to know better - forgot this point back before the 1986 oil price collapse. Here's an excerpt from Daniel Yergin's book, The Prize, describing what was going through their minds at what they failed to consider:
Was the price [in 1986] now posed for a great fall? Most of the exporters [primarily OPEC] thought so, but they expected no more than a drop [from more than $30 a barrel] to $18 or $20 a barrel, below which, they thought, production in the North Sea would not be economical. On that they were mistaken... Actually operating costs in [one of the North Sea fields] - the cash costs to extract oil - were only $6 per barrel, so there would be no reason to shut-in production at any price above that. Furthermore, it was so costly and complicated to close down operations temporarily that there would be reluctance to do so even if the price dropped below $6. (page 749) (emphasis added)
For those less familiar with the issue, I'll briefly explain:
When companies have large upfront expenses that affect the overall profitability of a given resource project, once these costs are incurred, they are considered "sunk costs" and no longer affect decisions regarding whether or not to produce more oil from that resource. Instead, the company will continue to produce oil from that particular project so long as the day-to-day operating costs are less than the revenues from production.
Full-cycle costs will determine whether or not new sources of production will be developed. Operating costs determine whether or not existing sources will be shut-in and stop producing.
This has special implications for when we talk about the "marginal producer." As demand and price increase, the "marginal producer" (the one that becomes just barely profitable) will be determined by full-cycle cost. On the other hand, as demand and prices fall, the "marginal producer" (the one that becomes just barely unprofitable) will be determined instead by operating costs.
Let's see how this affects oil prices with the help of a few diagrams. We'll begin with the impacts from the "enlightenment" nature of the unconventional revolution (covered in Part 1) to enhance our overall understanding and maintain mental continuity. Think of these diagrams as a step-by-step progression showing how we should modify our thinking about oil prices (like walking step-by-step through an algebra problem in a textbook).
Figure 1: First, we start with the conventional view of the producer supply curve, broken out into incremental chunks representing in approximate terms the prices at which new resources come online. (In reality, these "chunks" would be broken down into much more granular pieces, and the progression of the supply curve much more incremental and not so stair-stepped.) In this case, the tops of each bar represent the oil prices at which each of the resources can be profitably produced when considered from a full-cost cycle perspective.
Figure 2: Next, we bring in the newest source of production, the unconventional shales. As discussed in Part 1 of this series, because these resources were unlocked through an enlightenment-like progression (as opposed to being an exclusively technology-driven development), they effectively insert themselves into the middle of the producer supply curve. This has the effect of shifting the more expensive full-cycle cost sources further to the right. By keeping the same initial supply curve (red arrow) in place, we can see now that prices must fall (blue arrow).
Figure 3: However, now that we know about the differences between full-cycle costs and operating costs, we have to bring that into the picture, too. Since it is the operating costs (represented by the dashed lines within each bar) that determine whether or not a resource will shut-in production, and not the full-cycle costs (represented by the solid lines on top), we need to mentally rearrange these resources to get a staircase pattern with the operating costs. This is the view of how things look when prices or demand are falling and operating costs control the decision-making process. As a result, we can see that prices (keeping the same initial red and blue arrows in place) will need to fall even further (green arrow).
Figure 4: Lastly, because these established sources of production will stay online due to their low operating costs, you can actually end up with a situation where unconventional resources do in fact serve as the "marginal producer," but at a much lower price level than would have been assumed without factoring in the "enlightenment" nature of the unconventional revolution and the different impacts from operating and full-cycle costs. What's more, we can see from the figure that even as demand increases, only minor price increases will be required going forward to bring on new oil production. In other words, factoring in the role of operating costs actually shifts unconventional resources back into the role of marginal producer despite the fact that it has much lower full-cycle development costs than many of the established sources currently producing, and this swap means that new production can be brought on at historically low prices.
Fixed-Financing Costs and Commitments
Now we'll look at the effects (or lack thereof) from fixed-financing costs in determining whether or not a resource will ultimately be developed. This has special significance because it will show how production can actually grow, and not just hold flat, even as falling oil prices cause companies or countries to become unprofitable.
When we say that a company or a country needs oil prices at a certain level, typically what we are referring to is their need to satisfy external financial commitments that have been made to third parties. These commitments have a certain binding quality to them, such as legally-binding debt contracts or politically enacted funding mandates. In any case, these promises made to third parties - despite their impacts on the overall profitability of the various entities involved - are not inherent characteristics of the underlying resources, and therefore do not determine the profitability of the underlying resources.
To take a simple example, if a particular source of oil can produce 5% more resources (measured in dollar-denominated terms) than the dollar-denominated amount of resources utilized in producing it, then we can say, at the resource level, this source of oil can produce a 5% return over that particular time period. However, if we look at things on the company-level, we can get results that vary depending on the capital structure of the company. An equity-financed venture, for instance, would be able to develop this resource and achieve a 5% return overall to the company. On the other hand, a debt-financed venture having to make 10% interest payments on all of the capital invested in order to produce the resource won't be profitable at all. The two different companies have opposite results even though the underlying resource is identical.
This resource-level profitability serves as a maximum level of profitability, which can be translated to the bottom line on the company-level if it is a 100% equity financed enterprise. However, as more debt is mixed in, the overall profitability of the resource to the enterprise is reduced.
Important for our purposes, the maximum profitability determined at the resource level also determines the minimum price at which the resource will be produced. Why? Consider the following: Imagine a debt-laden company that owns a resource which is profitable on the resource level, but which the company cannot effectively make profitable on the company level. This company will likely do one of three things - all of which have the effect of causing the resource to be produced.
First, the company might - out of hope and desperation - continue producing the resource to generate enough cash to make interest payments in the hopes that oil prices will eventually rebound enough for it to repay otherwise unpayable lump-sum principal payments when they come due.
Second, if oil prices do not rebound and the company defaults, the company will go through some form of bankruptcy that will either recapitalize the company under some arrangement that will allow it to be profitable with its current portfolio of resources or that will require the liquidation [SALE] of the assets at distressed prices to producers who, likely through the use of more equity financing, can profitably produce the resource within the context of their capital structures.
Third, the company may try to sell these assets at distressed prices before being forced into bankruptcy in an attempt to dig itself out. In this last case, the result is the same as in the second: The resources will be acquired by a new producer who is able to produce the resource profitably within the context of a less debt-laden capital structure.
Under any of these scenarios, the overall effect is to move the resource, again and again, from one capital context to another towards the 100% equity end of the spectrum. In the event that oil prices fall even further, making the resource unprofitable within the capital context of the newest acquirer, then the process will repeat itself until the distressed asset sells at such a discount as to make a 100% equity purchase an affordable and likely outcome (assuming, of course, that oil prices actually fall to such an astonishing low). Only if oil prices fall below the minimum price required for profitability at the resource level will the resource itself remain undeveloped and unproducing.
Referring back to Figure 4, we can think of this as having a ratcheting-down effect on the full-cycle price level for a given resource. As prices fall, the default/distressed asset cycle will go through this iterative process until the resource under consideration hits its inherent resource-level minimum price for producibility.
Something similar can happen on the country level. Given the difficulty in trying to control global oil prices, countries can try to renegotiate their commitments, or if they fail to do so, there may be a regime change. In either case, it will be in the interest of all of the parties involved, old regimes and new, to keep production flowing. There may be infighting and disruptions along the way, but the ultimate producibility of the resource will continue to be determined by the resource-level profitability of the resource - i.e. whether it produces more resources than are required as inputs to generate the production.
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