This is part of a six-part series on Oil by Eric J. Fox, of Stock Market Prognosticator. Part 1 can be found below. Check back for later parts of the series. -Ilene
Oil and the Great Deception – Part Two
"It is getting much more expensive to find Oil these days."
While it is true that it is getting more expensive to find oil, one has to examine whether that increase is of a permanent nature as many argue. The reason that it is getting more expensive to find oil is mainly because service, drilling and other costs are sharply increasing. While this may seem like a circular argument at first, my intention is to demonstrate that the cost of finding oil is rising to a cyclical peak, and that it is not secular in nature.
All the data shows that the cost of finding Oil is rising sharply. Why? Very simply because of a self reinforcing boom in exploration and production, which led to a capacity shortage in oil services and drilling as demand for rigs and services increased faster than supply. Other costs, such as for steel, or the acquisition of existing producing properties has also increased for the same reason, a shortfall in capacity in various sectors, or an imbalance between supply and demand.
It is therefore, a cyclical increase in the cost of finding oil, not a secular or systemic one. If the exploration and production sector cuts drilling significantly, say 30-40%, then extra capacity will flood the oil services and drilling market leading to a plunge in prices and then the cost of finding and developing oil will decrease.
This argument is supported by data from many sources.
The Energy Information Administration (EIA) study entitled Oil and Gas Lease Equipment and Operating Costs, which has data from 1976 to 2006. The chart below demonstrates the cyclical nature of oil services.
Look at the green line back in the early 1980’s when the cost index fell from 123.3 to 82.6 in just five years. This study does not include drilling and completion costs. If you included these, the cyclicality would be even more pronounced. Also, this data is only through 2006. The green line currently is significantly higher.
The same trend can be seen in the HS/Cambridge Energy Research Associates (CERA) Upstream Capital Costs Index. The latest monthly release from May 2008, shows that "the latest increase raised the index to 210 points from its previous high of 198. The values for the UCCI are indexed to the year 2000, meaning that a piece of equipment that cost $100 in 2000 would cost $210 today."
This index tracks "the construction of a geographically diversified portfolio of twenty eight onshore, offshore, pipeline and LNG projects."
As an example, five years ago, it may have cost $ 250,000 per day to lease a rig to explore deep offshore. Today, if you can find one it may cost you $800,000 per day. According to Cambridge Energy Research Associates (CERA), dayrates can be 30-40% of the cost of an offshore well.
So in a sense, it is getting more expensive to find oil, but people who say this are either ignorant of the reason why or being disingenuous to further their investment case. Bullish investors use this as an excuse to justify that prices have to stay higher because the cost to find oil is higher.
Please understand that I am not predicting that this these various cost indices will turn down soon, only stating for the record that they can turn down, and have turned down precipitously in the past once capacity catches up to demand.
If you argue that the cost of finding Oil is permanently higher, then you are accepting the argument that industries that have been intensely or even pathologically cyclical for 100 years are no longer subject to those conditions. This is a bold statement to make and you better be damn sure you are right.
Please read my earlier post (below) of the fallacy of demand growth in emerging markets.
Oil and the Great Deception
"What matters is growth from the emerging markets, not the United States or other mature markets."
Oil Bulls love to trot out China, and to a lesser extent, India, when discussing the unbelievable growth from emerging markets. I heard a money manager call such growth "massive." Well let’s see just how massive this growth is. In 2006, China consumed 7.2 million barrels a day, and in 2007 it consumed 7.58 million barrels a day. This is "astounding" growth of 380 thousand barrels a day. In 2008, the barrel per day growth is estimated to be 420 thousand barrels. While the growth rate is fairly impressive on a percent basis, the absolute increase is hardly more than a rounding error in an 87 million barrel a day market.
Now let’s look at the "mature" markets that don’t matter. Demand from the 30 countries countries belonging to the Organization for Economic Cooperation and Development (OECD), was 48.96 million barrels in 2007. This demand has been flat for several years and is roughly the same as it was in 2003. This demand will begin to fall, as it has done in the past when oil prices reached very high levels. We have already seen evidence of this in reports on miles driven on U.S. highways which fell 4.3% in March 2008.
Let’s look at what that impact will be:
OECD Demand declines one percent – 490,000 barrel per day decline.
OECD Demand declines two percent – 880,000 barrel per day decline.
As you can see, a one percent decline in demand from "mature" economies would wipe out all China’s absolute growth last year. A two percent decline would be equal to twice China’s barrel per day growth. So emerging markets don’t really matter except in the context of the entire market. Are the OECD demand declines I listed above realistic? Yes, demand has fallen in previous years when prices were high.
