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New oil supplies need much higher prices to be profitable

April 14th, 2009 · No Comments

All the major existing oilfields are in decline (or soon are to be in decline), sometimes even steep decline. New oil is largely unconventional and needs much higher prices to be profitable. The result is, well, pretty unpleasant.. The article has many interesting bits on the economics of oil as well.

The Sleeping Threat of Low Oil Prices

Crimped Oil Supply is a Time Bomb

By Chris Nelder
Wednesday, March 4th, 2009

If you need any more proof that the markets are not an efficient discounting mechanism, look no further than the price of oil.

Oil prices in the high $30s to low $40s are nothing short of a ticking time bomb under the world economy, but you wouldn’t know it from watching the commodity markets. Once the global downturn slashed $100 off the price of a barrel, the issue of oil supply seemed to simply fall off the radar of market observers. Falling oil demand is all that anyone seems to care about, but we may pay dearly for taking our eye off the ball of supply.

Marvin Odum, the US President of Royal Dutch Shell worried aloud on Bloomberg television yesterday about the loss of policy focus on oil, as renewables and electric infrastructure upstaged it. “The big risk that I see here is what happens to the energy that runs our economy today, that gives us energy that we can afford, and that is primarily oil and gas.” According to Bloomberg, the company has delayed investment decisions on expanding its Athabascan tar sands project in Alberta, and upgrading its Mars project in the Gulf of Mexico.

I could scarcely agree more.

While the price of oil has crashed from its highs last summer, the costs of production—including labor, steel, rig leasing, and so on—have not declined nearly as much, and their future prices depend heavily on the health of the world economy. One month ago, Shell chief executive Jeroen van der Veer told the Wall Street Journal that while crude prices have rolled back to levels last seen five years ago, the company’s costs have doubled since then. The costs will eventually fall too, he said, but would lag by 12 to 18 months.

Shell’s budget for capital spending this year is roughly $31 billion, a huge sum. Under a barrage of news reports showing that economic activity is still declining, it’s only prudent to hold off on further spending if a delay could save them billions. It also makes sense to delay production if the same oil could be sold in a year or two at twice the price it would fetch today.

Consider the economics of the Mars field as an example. At a water depth of 2,940 feet, it is believed to contain 500 million barrels of oil equivalent. The platform produces some 220,000 barrels per day, at a reported development cost of $100 million. Prior to the development of BPs Thunder Horse platform, it was the most advanced platform in the deepwater Gulf of Mexico, where the best prospects for new US oil production are. The Mars platform was destroyed by Hurricane Katrina, and rebuilt by Shell at a reported cost of $200 million. Assuming those numbers are still correct, at a $300 million total cost the project would pay for itself in 34 years at $40 a barrel, but in only 14 years at $100 a barrel. (By comparison, the Thunder Horse platform produces oil at about the same rate, but has a total cost of around $5 billion.)

Shell is one of the few companies in the oil patch who are increasing their capital spending and increasing dividends in the current uncertain environment. Revenues are off sharply across the industry, and most companies are taking write-downs on revenue, and cutting costs. Occidental Petroleum has announced a 25% cut in its capital spending for this year. ConocoPhillips has sharply cut back on its spending and staff. Chevron is only maintaining last year’s level of investment. Schlumberger has slashed its worldwide workforce by 6%.

The most recent data from Baker Hughes indicates that rotary rigs drilling for oil in the US—an indicator of oil exploration activity—are down 22% from last year to 260 rigs, comprising just 23% of total drilling activity (the rest are drilling for gas). The Canadian rig count is down 38% from last year.

Production from Mexico, our number-three source of imports, is in serious trouble. Its oil output fell 9.2% in January to its lowest level since 1995, but its exports are falling much faster, at a 20% decline, according to Pemex. (As I explained last June in “The Impending Oil Export Crisis,” exports fall faster than overall production.) The decline of Cantarell, one of the four “supergiant” oil fields in the world, has accelerated to 38% per year. At the current rate, Mexico’s oil exports will cease altogether in seven years or less. Widespread civil unrest already plagues our southern neighbor, where drug cartels have taken to open war with the government, and the crashing of its top export is sure to make matters worse.

Things are no better in the Middle East. OPEC reports delays of more than 35 of 150 planned upstream projects, with some postponed until after 2013. Additional project delays are expected.

Too Cheap to Lift

Simply put, the biggest threat to supply is that oil is now too cheap to increase its production. While it’s true that lifting costs for older, mature projects range from $10 a barrel in Saudi Arabia to about $15 a barrel in Russia, Alaska, Norway and the UK, all of those areas are past their peaks and into decline. It’s the cost of new oil that we should be worried about.

With the world’s oldest, largest, and cheapest fields either already in decline or soon to be, we are now depending completely on difficult, unconventional oil projects like deepwater, tar sands, and oil shales to manage any increase at all in supply. My research suggests that oil needs to be at least $65/bbl to sustain investment in these incredibly capital-intensive projects.

According to a new study by Deutsche Bank, the cost of new oil projects in the world’s remaining growth areas—namely, the Gulf of Mexico, Brazil, Nigeria and Angola—plus a 15% rate of return ranges from $60-$68 a barrel.

According to a recent study by Brad Setser for the Council on Foreign Relations using data from the IMF and other sources, Saudi Arabia, Kuwait, Algeria and Libya all need $50-60, and Russia needs $70, to break even on production and meet their budgetary needs. (These numbers are averages across many different kinds of reservoirs with different cost structures, but do reflect the real forward production cost.)

Saudi oil minister Ali al-Naimi has warned that the world needs $75 oil to ensure future supply, and that current prices “are wreaking havoc on the industry and threatening current and planned investments.”

The real bar is probably even higher. Credible experts maintain that oil will have to remain above $100/bbl for a good length of time before oil companies are willing to commit enormous amounts of capital to the expensive, risky, and decades-long projects that remain to be developed.

Clearly, no one is going to step up to spend billions of dollars to develop new oil projects until oil is holding firmly above $60.

Without those projects, we are headed for a quick slip down the back side of Hubbert’s Curve. Deutsche Bank calculates the global loss of oil production due to poor economics at 700,000 barrels per day with oil at $30 a barrel, of which more than half would be lost production from tar sands. At $20 a barrel, fully 3.5 million barrels per day (mbpd) would be uneconomical to produce.

Tags: Oil