2015: The Year of the Marginal Cost

It is said that little drops of water make a mighty ocean. Little drops of oil on the other hand…..perhaps can cause the perfect storm. To put this in context let us revisit this quote from 2012 for context:

“Bernstein’s energy analysts have looked at the upstream costs for the 50 biggest listed oil producers and found that — surprise, surprise — “the era of cheap oil is over”:

Tracking data from the 50 largest listed oil and gas producing companies globally (ex FSU) indicates that cash, production and unit costs in 2011 grew at a rate significantly faster than the 10 year average. Last year production costs increased 26% y-o-y, while the unit cost of production increased by 21% y-o-y to US$35.88/bbl. This is significantly higher than the longer term cost growth rates, highlighting continued cost pressures faced by the E&P industry as the incremental barrel continues to become more expensive to produce. The marginal cost of the 50 largest oil and gas producers globally increased to US$92/bbl in 2011, an increase of 11% y-o-y and in-line with historical average CAGR growth. Assuming another double digit increase this year, marginal costs for the 50 largest oil and gas producers could reach close to US$100/bbl. While we see near term downside to oil prices on weaker demand growth, the longer term outlook for higher oil prices continues to be supported by the rising costs of production.”

The current oil price has hit $48 per barrel, an over 5-year record low and it goes without saying that high-cost producers of oil are in for a torrid time at sea; a perfect storm is indeed brewing. The Oil price is one chaotic variable to predict and most of us never seem to get it right. Speculation is rife of a price war, OPEC versus non-OPEC, USA vs Russia, Saudi Arabia vs Iran. Will economies and governments tumble; will China’s economy rebound from the massive gains of a lower oil bill? There is a vast pool of analysis out there to support various theories of how these developments will shape the world.

For us, the single biggest game changer is the unit cost of production. This will signal which regions, governments, economies, operators, projects and concepts will rise and fall, prosper and fail. The unit cost of production has always existed as an indicator of efficiency and a channel towards profitability, healthy rate of return and reasonable payback from hard-won investment dollars. This is not news to the industry.

What is news to the industry however is the reality check that era of cheap oil may be on its way back. What with the US incremental shale oil production and the realization that there are low-cost producers willing to weather the current US and China demand-driven price crash many a corporate board will realize all of a sudden that producing at upwards of $65-$70 a barrel may require a profit hit in the short term and where cash flows are not strong, we expect weak businesses to go bust once inventories wear thin. There is general consensus that the oil price will rally to a medium term value of $70-$80 per barrel however how low the price will fall is what is unclear. We will have to benchmark against the lowest unit production cost for the Saudi Arabia the swing producer.

What are the potential impacts of the unit cost era? The anatomy of industry costs will evolve significantly in 2015. What are the healthy components of the production cost profile and what are the not-so-needful aspects? What stays and what goes; do you need as many rigs for the drilling programme; how optimal is the number of days in the drilling campaign. Do you need so much capital or expense outlay to produce an incremental barrel of oil? Operators are going to pay particular attention to the bang-for-the-buck element of the business in 2015 than in recent times. Investment dollars will experience flight from high-cost projects to low cost or high-price projects; this will mean that alternative and renewable energy may experience a renewed boost as capital flight from currently expensive oil projects will find some safe investments in this industry. All of a sudden some commercial operations assume a higher factor of risk due to potentially lower cash flows and a consequent inability to sustain operations- particularly for capital projects. However borrowing from the BP Macondo experience we have learned that major players in the Oil industry have deep pockets, huge reserves and have evolved to be able to deal with short term shocks.

The current oil price scenario is a short term phenomenon that will have huge behaviour-modifying implications this year; margins will matter more than ever before, every little drop of oil will matter.