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Random Thoughts on Oil and Multiple Equilibria Supply/Demand Points February 23, 2009

Posted by DustinRJay in Uncategorized.
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Oil prices have tumbled dramatically from $147.27 on July 11, 2008 to $38.00 on February 23, 2009.  Many experts have weighed in that oil prices were a speculative bubble.  The rationale for higher oil prices stemmed from emerging demand from China and India, coupled with oil supply being relatively flat in response to higher and higher prices and was featured in a number of bullish economic reports, most notably Merrill Lynch and CIBC.

Since then, oil demand has dropped, and oil prices have declined.  Small changes in supply/demand dramatically impact price, (e.g. consumption is down ~5%, yet prices are down more considerably).  Petroleum product infrastructure has been designed for transportation and piping, not storage.

There is a fat tail risk for energy company bankruptcies.  Companies that expanded and acquired heavily and drilled many new wells in a high commodity price environment, may no longer payback the original capital investment borrowed due to poor netbacks.  AJM, McDaniel, Sproule have price decks that result in higher asset valuations, due to oil contango but this is based on a paper valuation that I do not believe fully reflects that the global economy has entered the worst economic recession since World War II.  It may take 2 years to determine bankrupt energy companies from healthy ones as future oil barrels have a high degree of price uncertainty.  The following quickie back of the envelope economics illustrates the difficult economic hurdles the Alberta energy industry currently faces:

Alberta Back of The Envelope Oil Economics

Average new oil well drill production:  Assume 28.3 bbl/oil
Average annual decline: 18% year over year
Average well reserves estimate: 41,300 bbl (as calculated)
Well Cost Estimate: $1,000,000
Tie-In and Facility Cost: $300,000 (estimated average cost per success well)

Edmonton Par: $46.40/bbl
Finding & Development Cost: $31/bbl (as calculated above)
Operating Costs: $14/bbl (estimated based on companies such as Pengrowth and Husky)
Royalties (estimated 20%): $9/bbl
Plus corporate economic hurdle = You Do The Math!

In general, prices are high enough to cover operating costs, but not enough for capital investments.  For the most part, the stock market is very focused on earnings growth and therefore rate is king.  Bondholders require coupon payments, and therefore shutting in production to increase asset value may not be an option due to high debt loads.

When demand increases, there could be a second oil price shock resulting in yet more economic turmoil.  Prices could rapidly climb as current prices are more reflective of operating costs, and would need to shift upward substantially to incorporate finding and development costs and adequately compensate investors (shift in supply/demand equilibria point).

It is likely less expensive to increase production through acquisitions than drilling.  A well capitalized energy company could evaluate shutting in production to increase asset value (as in general, prices are too low to drill), and use existing cash reserves to acquire depressed natural resource assets.


1. Greg Williamson - February 25, 2009

I enjoyed this post, I will also share with my readers on my blog. http://www.gregwilliamson.ca/blog

I have been thinking and hearing lately that we will likely see another oil shock which for these parts will probably see prosperity, particularly in the housing sector again. The real nugget is recognizing that with every oil shock can and often will bring a painful downturn (cue ominous music). This time I will be more careful.

This whole thinking reminds me of the old bumper stickers in Alberta, “God please send me another boom, I promise not to piss all the money away this time”

2. Anonymous - February 26, 2009

Any thoughts on Pervin & Gertz’ latest analysis on heavy oil demand?

3. C - February 26, 2009

your F&D costs are far too high as well as op costs. You also cannot determine all tie in costs are 300k, that is not possible since every project differs.

Oil will come back, there is no doubt. Companies that spent too much thinking it would never end were simply poorly managed….anyone could have made money in the last few years without really trying…now the “real” good management teams will shine through and the others will simply evaporate.

I have been in the industry for 20years in AB and have seen it more than once. Anyway, your numbers are not accurate. $30 oil is fine, just not desirable that;s all. High oil prices are not desirable either. A good balance is better.

4. radley77 - February 27, 2009

Thanks for the comments. I haven’t yet read Purvin and Gertz’s latest research on heavy oil demand although would be interested.

As for the F&D costs, I derived them based on expected average well costs and average rates and declines as per ERCB data. I used the most optimistic decline rate they had listed actually, and the well costs was estimated to be that of an average well cost.

I’ve seen tie-ins that cost near $1 million. At a rule of thumb of $50K/inch mile and most lines are 3″, would cost about $150,000. Also, required would be some facility costs that may include cost of a separator package, possibly injection wells for disposing of water, plus pumps and tanks. So a range for tie-in costs would range maybe from $150,000 to $1,000,000 and that is why I chose $300,000 as an average cost.

As for the operating costs, these were based on what I’ve seen common for energy companies. I’ve listed two references above that refer to 2008 operating costs (Pengrowth and Husky).

5. C - February 27, 2009

Fair enough. However, I am directly involved with all of which you mention on a daily basis and I can tell you market/shareholders would not be happy with a company with ~$30 F&D costs or those op costs. And I can also tell you on $30 oil money can still be made, just obviously not as much.

I remember in 2006 when oil hit ~55 -~60 and people were panicking since it had just come down from ~$80 ?? or so and how the world was ending then too. It’s all psychological, people become complacent and expect things will never end and they always! do. Canada is a commodities/resource based economy, especially Alberta of course, but BC and Sask just as much, and if someone cannot handle an economy like we have then they need to live elsewhere. The swings are a nature of the beast and a person has to prepare for the bad times -during- the good times.

Good job on the blog.

6. Chris - March 8, 2009

I agree with your fundamental point that the cost of production is significant with current oil prices (which are right around your $46 mark right now).

The cost of production in several areas which underwent significant development in the last run-up is the same or substantially higher. I’m specifically thinking about Venezuela, Saudi Arabia and many African countries. When they’re not making money, people get angry, which destabilizes the market (and/or causes production to decrease) causing the price to increase. $40/barrel oil is not going to be the 1-2 year price target.

7. demyMipsype - May 20, 2009

Super article:) hope to visit once again!!

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