SURVEY: Oil economics turned upside down as low prices fail to bring about production cuts

• Published date: 01 August 2017
• DOI: http://doi.org/10.1111/oet.12497
• Date: 01 August 2017

SURVEY

Lowoilpricesweremeanttoresultintheshutting-inofhigh-costproduction,especiallyintheUS,allowingsupplyand

demand to rebalance at a much higher oil price. Instead , we have rising production f rom the US and else where and

continuing low prices. e link between low crude prices and production in a number of key producers across the world

is examined by Oil and Energy Trends’ Consulting Editor, Dr Paul McDonald.

Oil economics turned upside down as low prices fail to bring about

production cuts

Low oil prices fail to curb production

Oil markets used to operate on the principle that a

fallinoilpricescausedbyanexcessofsupplyover

demand could be reversed by cutting production; and

that the reduction wou ld come primarily f rom the pro-

duction with the highest costs, leaving the lowest-cost

output more or less unaected. is was what was sup-

posed to happen following the fall in crude oil prices

that began in 2014, resulting in both the shutting-in

of marginal product ion across the world and t he dis-

couraging of new pro duction in frontier regions , notably

the shale oilelds of the US, leaving low-cost produc-

tion in areas like the Middle East and North Africa

untouched, aer which the price of crude was meant to

go back up.

Instead, aer falling a little, most high-cost produc-

tion, including US shale, rose and went on increasing

as crude oil prices fell. In November 2016, OPEC and

a few other oil-producing countries agreed to reduce

their production amid condent predictions of a fall i n

high-costproductionandariseinprices.Neitherhap-

pened. Several OPEC countries shut-in low production:

prices meanwhile continued to decline.

What went wrong?

is was not the rst time that production and prices

had not behaved as they were meant to. In March 1983,

OPEC tried to stem a slide in oil prices by agreeing a

system of country production quotas under a collective

ceiling of 17.5mn bpd for the group, with the further

promise that Saudi Arabia would additionally adjust its

production downwards to prevent a surplus of supply

that would force down global crude prices further.

e target in particular was North Sea oil production,

which had grown rapidly under the stimulus of rising oil

prices at the end of the 1970s and early-1980s, and which

was expected to fall once prices began to decline. When

this did not happen, OPEC de cided to act by cutting its

own output. Prices nevertheless continued to fall, along

with Saudi production, until Saudi Arabia was actually

producing less than the UK, whereupon it abandoned

its role as swing producer in September 1985 and there

began a price war amid r ising global production that

took crude prices down to $10/bbl and below. And still

North Sea output went on rising .

In the present era of weak prices, little has changed.

In an attempt to raise prices Saudi Arabia once more

emerged as OPEC’s swing producer in the rst half of

2017 but global prices still failed to go up. High-cost

production,thistimeintheUSandelsewhere,hasalso

carried on rising [1].

Assessing production costs

e high-cost versus low-cost argument is something

of an oversimplication. To begin with, the costs them-

selves have a number of dierent elements. ese

include:

•Capital expenditure;

•Operational expenditure;

•Tax e s ;

•Other costs.

Capital expenditure (capex) is mainly the cost of

surveying and drilling the prospect, completing the

wells and bringing them into produc tion. In the case

of oshore production t here is the cost of pro duction

platforms, which can push capex above $20/bbl: some

six-times or more than that of an oileld in parts of the

Middle East. Added to these are the costs of provid-

ing well-head processing, storage and pipeline or other

transport infrastructure for the oil, along with facilities

for the treatment of any gas, plusme asuresto prevent or

contain oil spills or any other forms of pollution.

In addition to the capex is the expenditure on the

actual production (opex), which may include the use of

third-party pipeline capacity to transport the oil to the

nearest pricing point, such as a storage terminal, as is the

case in the US. Taxesare a further potential cost, to which

may be added a host of administrative costs.

Allofthesemakeitdiculttogiveaccurategureson

the costs of oil produ ction. Moreover, costs var y from

eld to eld according to such factors as the nature of

each reservoir and the size of the reserves contained in

the eld. e cost of b orrowing money for c apex also

varies from one area to another.

ere are nevertheless some gures that may be

used as general indicators of costs, which allow some

kind of ranking of production by country. Figures

produced by Rystad Energy show a marked dierence

between the low-cost producers of the Middle East

© 2017 John Wiley& Sons Ltd