Oil Industry Costs Will Rise as Focus Shifts to Growth

The cost of everything from skilled and unskilled labour to engineering contracts, field services, raw materials, equipment, spare parts and rig hire tends to rise and fall with price of oil.

During a boom, prices for labour and equipment escalate rapidly, pushing up the breakeven cost of finding and developing new deposits, and driving the market-clearing price of oil even higher.

In a bust, labour and equipment prices fall sharply, pushing down breakeven costs and helping sustain production at an unexpectedly high level despite the plunge in oil prices.

Pro-cyclical costs include everything from skilled petroleum engineers and unskilled labour, to fuel, rig hire and drill bits.

Pro-cyclical costs apply to a host of other services in the supply chain including catering, accommodation and transportation.

And in the broadest sense, pro-cyclical costs include taxes, royalties and other government charges on exploration and production.

In a downturn, governments cut tax and royalty rates, and offer regulatory relief, to attract investment, only to increase them again during a boom to capture windfall gains.

The pro-cyclical behaviour of costs is a classic example of positive feedback which amplifies the boom-bust cycle in oil prices and delays the process of adjustment following a supply or demand shock.

Pro-cyclical costs ensure crude supply tends to respond sluggishly to even a big change in oil prices ("Oil prices: volatility and prediction", Reuters, 2016).

Rising costs hampered efforts to boost oil production during the 2004-2014 boom; more recently falling costs have hampered efforts to cut output and rebalance the market during the slump.

The best symbol of the industry's cost cycle is the provision of free fruit to employees at BP's giant Sunbury campus near London ("Operational excellence becomes oil industry watchword (again)", Reuters, 2015).

Free fruit tends to be axed when oil prices fall, only to return when prices rise, as the company's priority switches between cost control and employee morale.

Free fruit is a trivial example but multiplied up by thousands of items in the supply chain it shows how the entire cost structure can rise and fall by tens of billions of dollars per year.

Structural v Cyclical
The recent slump in oil prices has been accompanied by brutal cost-cutting across the entire oil and gas industry.

U.S. drilling companies cut their prices by a third between March 2014 and January 2017, according to the U.S. Bureau of Labor Statistics.

Cheaper prices for everything from drilling contracts to labour, fracking sand, pressure pumping and freight have helped lower breakeven prices for U.S. shale producers.

Similar cost reduction strategies have been implemented by state-owned oil companies such as Saudi Aramco as well as major privately-owned companies such as Exxon, Shell and BP.

As a result, breakeven prices for the entire oil industry from OPEC to shale and offshore producers have tumbled since 2014.

The critical question is how much of this reduction is structural and permanent versus how much is cyclical and will be reversed as oil prices start to recover.

Oil industry leaders insist this time will be different and that they will maintain tight control over expenses even as oil prices rise.

Some of the efficiency improvements wrung from the supply chain during the slump are likely to prove enduring.

Standardisation of equipment and procedures, as well as better targeting of production zones, longer lateral sections in wells, and multilayer wells are improvements that will not be unlearned.

Past experience indicates, however, that costs have a large cyclical component and will start to increase as producers shift from contraction to expansion.

Changes in drilling costs, for example, have been closely associated with changes in the number of rigs drilling for oil and gas.

U.S. drilling prices were down 7 percent in January 2017 compared with January 2016, according to preliminary data from the Bureau of Labor Statistics.

But the year-on-year decline has progressively slowed from as much as 24 percent in November 2015, in an indication drilling costs are stabilising.

By early March 2017, the number of rigs drilling for oil and gas in the United States had risen by almost 60 percent compared with the same period a year ago.

As the rig count continues to climb, drilling prices should stabilise, then begin to rise, based on past experience.

Fracking sand prices have already surged, owing to a combination of poor weather, supply problems and a big increase in consumption.

Oilfield service company leaders have warned contract prices have been cut to unsustainably low levels and must increase, at least in the United States.

For the time being, oil industry buyers will continue to hold the upper hand in negotiations, but the balance will shift as the industry returns to expansion mode.

And as the balance of pricing power shifts, costs will begin to escalate, and the industry's estimated breakevens are also likely to increase.

Pro-cyclical costs are a fundamental rather than incidental feature of the supply chain and there is no reason to believe that will change.

Appeals for cost discipline may work in the short term, but in the medium term they are no more likely to be successful than in the past.