Falling oil prices are throwing business news sources into a tizzy.
Some of the stories about how lower prices will affect U.S. oil producers remind me of the old joke about the museum guard.
When approached by a visitor who queried him about how old the dinosaur skeletons were, he responded, “four million four years and nine months.” The visitor responded, “Boy, how can they date them so precisely?” “Well,” he responded, “they were four million years old when I started here, and I have had this job for four years and nine months.”
That is an example of what logic profs call “the fallacy of false precision.” The same fallacy plagues pundits who give exact figures about the costs for shale oil and gas wells in the U.S. One recent story said they would start losing money when the oil price hit exactly $58. Another said $66 and a third $62.
All ignore the fact that there are two very different relevant categories: wells that have not yet been drilled and those already underway or producing.
Of course, the general theme of this news is correct: Falling world oil prices will reduce the profitability of U.S. oil producers. At some point, they will begin to cut back production, and again at some unknown point, some may go bust. So the issue of production costs is real.
However, most recent news stories, even from sources that should know better, ignore crucial considerations.
The first is that there is not just one relevant “cost of production.” One issue is the cost of continuing to produce from existing wells drilled in the past or from ones where drilling and fracking are well underway. A second is for projects not yet started.
The difference involves two economic concepts: “sunk costs” and “marginal costs.”
The first are costs already incurred that cannot be recouped if the project is abandoned.
If a restaurant closes, the operator can sell a cooler, mixer or a pizza oven, but cannot recover any of the thousands of dollars paid to carpenters, painters and upholsterers for creating a dining room. The latter are sunk costs.
A very high proportion of oil production costs are sunk.
Drilling rig hours, diesel fuel and crew wages cannot be resold.
Steel casing cannot be pulled from thousands of feet down. Nor can used fracking fluid or the trucking to get all these supplies to the site be auctioned off.
The key management rule is to ignore sunk costs.
Instead, look only at how much more it costs to go forward versus what revenues you may gain by doing so.
It may well be that the anticipated revenues will never be enough to pay all the costs that will accumulate to bring the project to fruition.
But that is irrelevant to a project already underway. The only question is if revenue going forward will exceed the additional costs going forward.
These are the “marginal costs,” and in an industry like oil, the marginal costs of completing a project in progress, or of continuing to pump an existing well, are much less than the total costs per barrel that would need to be covered for the overall project to be profitable over its lifetime.
So for an industry facing falling product prices, there are two very different questions.
One is whether to keep pumping an existing well.
This cost can be very low, as long as the well’s production rate stays above some minimal level.
It involves only the electricity, labor for maintenance, the cost of transporting the oil to a selling point and other minor factors.
These may amount to only a few dollars per barrel, or even less.
It is a much different situation for projects not yet built.
Here, few costs have been incurred.
Again, the rule will be to proceed only if the anticipated revenues going forward are greater than the anticipated marginal costs. These marginal costs in this case will be close to the overall total cost.
The planning horizon must include the total anticipated life of the project. It is as dangerous to assume current falling prices will remain low for the next decades as to have assumed the high prices prevailing over the past decade would continue unabated.
A few months of soaring or plummeting crude prices don’t define long-term prices.
Oil prices have fluctuated over the past four decades, and will continue to fluctuate.
Remember that gasoline passed $4.00 a gallon in late spring of 2008 but was briefly below $1.80 by the time Barack Obama was inaugurated.
Yes, some highly leveraged production companies may go to the wall quite quickly.
Yes, the “majors” may have several quarters or even years of poor profits. Companies like Brazil’s Petrobras, that have anticipated a bonanza from extremely deep and expensive off-shore projects, will suffer.
But neither the U.S. nor the global oil sector is going to go entirely bust if $60 is the new normal for several years.
While competing analysts may be quoted as estimating the average per-barrel cost of new projects at $66 or $58 or $75, there is enormous variation around this mean.
A life expectancy of 78 years doesn’t mean most people die at that age.
Some die shortly after birth and some surpass age 100. Most people who make it to kindergarten will live well past 78 years.
Similarly, while the break-even oil price for new projects may average $65, some will need over $110 and others may require only $25 to recover all costs plus a profit over their entire life.
There isn’t necessarily any “normal distribution” of costs over this range. So even if oil prices drop to, say, $55, some new wells will go ahead.
The new shale technologies do have one complication in weighing this mix.
Fracked shale wells have relatively quick rates of decline of production.
Often, this can fall by 80 percent or more in the first three years of pumping.
After that, the rate of decline lessens. It may be profitable to pump them for many more years or even decades if marginal costs are low, as is usually the case.
But often these will be “stripper wells” producing less than 15 barrels a day.
These high “decline rates” of fracked shale oil fields mean that if drilling doesn’t continue at high rates, then U.S. production will begin to fall quite rapidly.
Those who see OPEC’s latest moves as a conscious “war on U.S. shale” by the Saudis and other low-cost global producers tout this as the basis of the cartel’s strategy.
I’m not convinced it is all that thought out for the long-term nor coordinated.
For many U.S. producers to be driven into bankruptcy, prices have to stay low for a long time. But high decline rates mean U.S. output would drop quite fast, thus bolstering prices. Time will tell.
Finally, one should not assume U.S. production costs are set in stone.
The frenetic pace of shale development has turned U.S. oil into an “increasing cost industry,” where average costs go up as the entire industry gets larger.
Drilling rig rental rates, pipe prices and roughneck wages have all been bid up, contributing to high-cost wells.
But as projects are canceled, these will fall, reducing the development costs of still possibly viable projects. And technology continues to advance, driving down costs.
It is far too early to tell how this will play out.
The economy of North Dakota and other shale areas will suffer the longer prices stay down. The general national economy will benefit.
It will be interesting to watch, but don’t expect to know the net effects for years.