Understanding Oil

Crude oil is in the news.  This time, it is because the price is at an historic low and appears to be heading even lower.  Over the past few months, I can’t count the number of times I have read or heard various people offering expert analysis of what this means and what we can expect.  Sadly, most of them clearly have no idea how the oil industry works or the complex way in which technological innovations such as shale oil (or light-tight oil) and tar sands oil are changing the fundamentals of oil markets.  Without understanding the economic basis of the oil industry and how it is changing, there is no way anyone can hope to project what the future holds in store.  So, here is my (hopefully simple and readable) primer on the oil industry intended to help non-experts understand the forces at play.

First, a few caveats.  In this post, I am only looking at crude oil.  That is both because it is crude oil prices that are discussed most often and because this explanation would become lengthy if I attempted to also cover the wide range of rules, geographic factors, market forces and taxes that complicate the relationship between the price of crude oil and the price of gasoline at the pump.  Just understanding crude oil markets should help to understand the risks the world economy faces of the coming months.  Second, I am not addressing the added complexities added by the global effort to combat human-induced climate change.  Instead, I am just looking at how technological changes and economic realities are interacting to create new uncertainties.

The Oil Industry in Just Two Easy Steps

While extracting oil from the earth is an incredibly complex engineering and financial undertaking and almost every oil well could be considered unique, it is actually possible to conceptualize the whole process of consisting of just two simple economic costs.

1) Fixed Costs:  These are the costs of finding oil, drilling wells, setting up a field operation, establishing facilities to do basic things to the oil (such as separating it from the water and natural gas that are frequently present) and – of course – doing the paperwork to get permits, etc.

2) Marginal Production Costs:  These are the costs that go into pumping (or squeezing) out each barrel of oil once all of the fixed costs have already been made.  Marginal production costs include workers’ salaries, fees or royalties paid to land owners or governments, maintenance, the energy to run the operation, etc.

Producing Oil the Traditional Way

For the past 100 years of more, developing a new oil field has been extraordinarily expensive.  The cost of finding oil, drilling lots of holes (only a minority of which produce oil) and installing massive machinery to support the whole process can cost billions or even tens of billions of dollars.  All that money has to be spent before the first barrel of oil is sold.  In some oil fields, such as Kazakhstan’s mammoth Kashagan field in the Caspian Sea or Brazil’s massive Libra oil field, this fixed investment cost exceeds $100 or even $150 billion dollars.  When divided by the number of barrels of oil that investors expect to produce from those fields and discounted for the time value of money, that means that the fixed cost alone for developing these fields is likely to exceed $50 or even $75 a barrel.  Those are just the fixed costs; the marginal production costs for those fields will drive the total cost to produce each barrel even higher.  Needless to say, now is not a good time to be an investor in one of those megaprojects.

While the Kashagan and Libra oil fields are extreme examples, it is not uncommon for the fixed costs of developing a major oil field to represent 40% to 60% of the total cost of producing crude oil.  This is one of the reason why so much oil is produced by gigantic oil companies.  Who else has tens of billions of dollars that they are willing to invest in a project with a 20- or even 40-year payback period?

Marginal Production Costs Drive Production Decisions

No matter how expensive it is to develop an oil field, once it is operational fixed costs take a backseat to marginal production costs in decisions over when to produce oil.  This is because once an oil field is developed, all of the fixed costs become what economists call “sunk costs,” meaning that investors cannot recoup them by any method other than operating the oil field.

To understand this in practice, imagine yourself as the owner of a large, traditional oil field with an expected 40-year lifespan.  Let’s assume that you are not a multi-billionaire and thus had to borrow heavily to develop your oil field.  Your fixed costs for developing this field were high enough that you calculate that loan payments would equal $40 for every barrel you expect to produce.  Now that you have invested all that money, however, the marginal production cost of operating and maintaining the oil field is only about $15 a barrel.  When oil was selling for $100 a barrel, you were happy and rich!  Now that oil is $30 a barrel, however, what do you do?

If you stop pumping oil, you have zero income with which to make your loan payments and you lose everything.  Not good.

If you continue to pump, you will lose money on every barrel you sell.  Nonetheless, the $30 market price is enough keep the field operating and you will even have another $15 available to make at least partial payments on your loans.  It will take some tough negotiations with your creditors, but they are likely to conclude that $15 a barrel in loan payments is better than nothing.  Plus, if you can keep operating through this period of historically low oil prices then you’ll be in a good position to reap high profits – and make high loan payments – once oil prices recover.

Real world examples are more complicated, but the same underlying logic continues to work.  Economics dictates that oil companies will continue to pump oil as long as the price they receive is higher than their marginal production costs, even when they are losing money on every barrel once fixed costs are added to the equation.  In the real world, most producers actually keep producing oil (for a time, at least) even if the price they receive for their crude is less than marginal production costs.  This happens for a couple of reasons.   In the real world, costs don’t drop to zero just because production ceases.  Unless an oil company is ready to abandon an oil field entirely, and therefore abandon all of the massive fixed costs tied up in that field, the company will need to keep a certain number of staff on the payroll, do routine maintenance to keep equipment from rusting from disuse, etc.  The geology of oil production also serves to encourage oil companies to keep pumping even when they lose money on every barrel.  Crude oil does not occur in huge underground lakes of liquid oil.  Instead, it is trapped in rock formations such as sandstone or, more commonly, various carbonite structures.  Once production starts, a combination of natural and man-made forces cause the oil in the rock to migrate toward the wells so it can be pumped out.  If the tap is turned off and production suddenly stops, however, the oil will migrate elsewhere or bond to the rocks.  In either case, the total number of barrels that can be recovered from an oil field can actually decline just because the tap was turned off when it should not have been.  That loss in potential production can represent a huge economic loss, and thus serves as a strong incentive for keeping oil fields pumping even when they lose money.

For these economic and geological reasons, oil producers are loathe to stop producing oil just because they are losing money in the short term.  As long as they believe that the price of the crude oil they produce will eventually rise to profitable levels, they will do everything in their power to keep pumping during periods of low prices.  This is why world oil production does not fall precipitously every time oil prices fall.

New Production Technologies Turn Old Wisdom on its Head

Everything I have said thus far pertains to “traditional” oil wells.  These oil wells are characterized by huge up-front fixed costs and long production life times of 20, 40 or even 100 years.  Nearly all of the remarkable rise in U.S. oil production over the past 10 years comes from a new generation of oil fields that produce crude oil either from shale or other sources that were not considered feasible to develop just a generation ago.  Taken together, these new sources of oil are commonly referred to as “light tight oil.”  It is “tight” because it is more thoroughly trapped than traditional oil and thus takes a lot of energy and technology to get out.  It is “light” because the process of freeing the oil from its rocky prison results in very light rather than heavy oil.

Compared to traditional oil fields, a much lower portion of total costs for light tight oil comes in the form of fixed costs.  Instead, fixed costs tend to be more modest while marginal production costs are quite high.  When you hear in the news that the cost of producing oil from a certain light tight oil field is $60 a barrel, it is a good bet that most of that is composed of the marginal production costs of cooking and squeezing the oil out of the shale or other rock and a somewhat smaller portion is attributable to the fixed costs of developing the well.  Another big difference between the majority of traditional oil wells and light tight oil production is their productive liefspans.  While a traditional oil well typically produces oil for 20 years or more, many light tight oil facilities have a prime productive lifetime of only 18 months or two years.  The wells may be operated after that, but production typically declines considerably after that first, short period of production.  To keep production up, oil companies simply have to develop more and more wells.

Putting it all together, “traditional oil” is characterized by big up-front investments, long project lifetimes and relatively low marginal production costs.  Light tight oil, in contrast, has the opposite characteristics: more modest up-front costs, higher operating costs and shorter lifetimes.  Another way to think of this dichotomy is to imagine two ways of producing one hundred thousand barrels of oil a day for thirty years.  The traditional method would be to find a large oil field, invest billions of dollars to develop it, and then produce oil from that field for 30 years.  The method for producing that same quantity of light tight oil would be to develop dozens or even hundreds of small oil projects to reach your goal of 100,000 barrels a day and then to continuously develop more and more new ones to take over as production from the completed wells declines.

What This Means for Oil Markets and Prices

Analysts familiar with only parts of the overall picture often draw incorrect conclusions.  Anyone predicting multiple years of historically low oil prices is likely forgetting that light tight oil from the U.S. has been the largest source of new oil entering the markets over the past several years.  While many or perhaps even most light tight oil wells that have already been completed will continue to produce even if oil prices are low, oil producers are unlikely to continue investing in new projects unless oil prices rise to at least $50 a barrel.  Even at $50, many light tight oil plays (as the industry calls them) won’t be developed because the cost of production can run to $60 or even $80 a barrel.  Remembering that the majority of existing light tight oil wells will decline to very small production levels within the next 18 months, the decline in U.S. production could come quite quickly.

Similarly, anyone who points to the precipitous decline in investment into new light tight oil wells that has occurred over the past year as “proof” that the age of light tight oil is drawing to a close is ignoring economic realities.  As production from light tight oil wells declines, the U.S. will need to import millions of barrels of day more crude oil, thus driving up world crude prices.  Once crude prices rise, investment in light tight oil will resume.  It is the classic “supply and demand” model of economics.

Life in the Fast Lane

The long lead times, high up-front investment costs and long production lifetimes of traditional oil fields served as a type of brake on market volatility.  Absent a sudden disruption caused by war or a major natural disaster, market and geological realities meant that oil production moved up and down relatively slowly.  While natural and political disasters did cause periodic disruptions, those were the exception rather than the rule.

While light tight oil cannot be developed instantly, compared to traditional oil it is a veritable speedster that has reduced project lifecycles from a few generations to a few years.  For that reason, it has introduced a new element of volatility.  Now that the technology is more well understood, when prices are high investment is likely to flow in rapidly and production to surge even more rapidly than we have witnessed over the past five years.  When prices drop, however, investment will fall just as rapidly with production declines only a year or two behind.

This means that world oil markets will be more volatile in the future than they have been in the past.  Rapid boom-and-bust cycles are a real possibility.  Those cycles could be highly disruptive.  For the foreseeable future, for example, the biggest physical constraint on the rapid development of light tight oil is not geology or engineering but manpower.  As the Dakotas have already seen, the huge demand for labor to constantly drill new wells can reshape a state’s economy almost overnight – both when the demand rapidly appears and again when it disappears.  Huge problems can develop during both halves of the boom-and-bust cycle.

In the past, huge low-cost producers such as Saudi Arabia could play a role in maintaining market discipline among oil OPEC-affiliated and even some non-OPEC producers.  It did this by opening its own oil taps wide as a means of “punishing” countries that produced more than their quota or who were seen by Saudi Arabia as destabilizing markets.  Yes, Saudi Arabia lost money every time it did this, but its low cost of production meant that it could survive low oil prices better than most other countries.  It is difficult to predict how effective this strategy will be in the future.  Saudi Arabia’s game plan worked well as long as other producers had long-term investments at stake and thus shared Saudi Arabia’s desire for a degree of price predictability.  The gambit was further helped by the rather limited number of very large oil producers.  Because light tight oil production depends on the relatively short-term investment decisions of literally thousands of individual producers, “policing” this new class of oil producers is likely to prove extremely difficult.

What’s the Answer?

If you have read this far, you may be hoping to find “the answer” about oil prices.  Sorry, I don’t have it.  I do not know how long historically low oil prices will continue.  I only know that they cannot stay for more than a few years.  Falling investment in light tight oil, particularly when coupled with rising demand in India, China, SE Asia and elsewhere, mean that prices will rise.  Unfortunately, I do not know how quickly or how high they will rise.  There simply is not enough historical data to predict with any confidence what this newly emerging mix of production methods will mean for prices.  The only prediction with which I feel comfortable is that oil prices are going to be more volatile in the future than they were in the past and that this volatility will result in a wide range of economic and social disruptions.