The Relationship Between Oil Price and Costs in the Oil Industry.

• Author: Toews, Gerhard
• Position: Report

1. INTRODUCTION

   The economic profession is still struggling to fully understand the crude oil price and the shocks driving it (Hamilton, 2008; Kilian, 2009; Anderson et al., 2014). The goal of this paper is to contribute to understanding of the determinants of drilling costs and the relationship between drilling costs and the real price of oil. To do that we use data on individual wells from Wood MacKenzie on drilling activity and costs of drilling (Wood Mackenzie, 2015). The information provided allows us to construct two quarterly time series capturing (i) the total number of exploration wells drilled in the oil industry and (ii) the average cost of drilling these wells. We use the constructed time series in combination with the real price of oil to estimate a three-dimensional structural VAR model.

   The proposed structural model of the upstream sector allows us to decompose the variation in the reduced form errors of the estimated VAR into three structural shocks. To identify the shocks we assume a recursive structure. The first structural shock is an oil price shock which is defined as an unpredictable innovation to the oil price. Oil price shocks capture demand shocks in the upstream sector as an increase in oil prices boosts cash flows of the oil companies and raises the profitability of marginal projects. To identify the shock we assume that the oil price is predetermined to drilling activity and costs of drilling. This assumption is plausible because it takes more than three months, and typically more than a year, following the drilling of an exploration well before the global supply of oil can be affected. Moreover, expectations of the future oil price are unlikely to be formed contemporaneously because it takes often more than a year before reasonable estimates of the newly discovered reserves are available.

   The second structural shock is an activity shock, which is defined as an unpredictable innovation to the number of wells drilled. Technological advances in the upstream sector (e.g. deep sea offshore drilling) and an expansion of area available for leases allowed oil companies to explore regions of the world which have not been accessible before. On the other hand, the nationalisation of an oil industry or tougher safety regulations may force oil companies to revert to sources of lower quality and higher costs of extraction. We assume that shocks to activity are predetermined to changes in costs. This assumption is plausible because drilling costs depend on geological conditions and the duration of the drilling which may both heavily vary even within a field. As a result drilling costs are rarely known ex ante even by the operating company.

   The remaining variation in the errors--after accounting for the variation in the oil price and drilling activity--is referred to as a cost shock. By construction these shocks are orthogonal to the contemporaneous oil price shocks and shocks to drilling activity and, thus, may be used to study the effect of exogenous shocks to costs on the price of oil.

   We have three main results. First, following a 10% increase (decrease) in the oil price, drilling activity increases (decreases) by 4% and costs of drilling increases (decreases) by 3% with a lag of 4 and 6 quarters respectively. Second, activity shocks affect the oil price negatively within a year but have only a small and insignificant effect on drilling costs. Third, we do not find that cost shocks have a significant effect on the price of oil.

   Our paper is most closely related in methodology to Kilian (2009) who uses a three-dimensional structural VAR and short-run restrictions to understand the different nature of shocks driving the oil price. As opposed to our approach, he models the world market for crude oil rather than the upstream sector of the oil industry. To do this he uses global oil production to capture supply shocks. To model demand shocks for industrial commodities, he uses dry cargo single voyage ocean freight rates. After accounting for shifts in demand and supply, he argues that the residual variation in the oil price is driven by precautionary demand shocks rather than by supply shocks as has been previously believed. Our work may be thought of as an extension of his work as we take the variation in the oil price (consisting of demand and supply shocks in the crude oil market) as given and use it to decompose the observable variation in the number of wells drilled and costs of drilling.

   Our paper is also related to Anderson et al. (2014). Using data from Texas on drilling activity and rig rents, they present evidence that drilling activity and drilling costs significantly respond to a change in the oil price. On the other hand, they are not able to find any significant relationship between oil price changes and the contemporaneous extraction of oil. They use these results to motivate a theoretical model in which drilling activity is at the centre of deriving an optimal extraction path. In doing so, they are able to rationalize their empirical findings. Our work differs from their contribution in two main aspects. First, and most importantly, their main contribution is theoretical whereas our focus is on the causal identification of shocks and the estimation of the dynamic responses of the variables in the system to shocks. Second, we use data on drilling and costs of drilling covering most areas of the world (excluding onshore drilling in the US), whereas their data is constraint to activity and rig rents in Texas.

   Finally, our paper is also related to a more applied literature which is focusing on the identification and the estimation of the price elasticity of drilling in the oil and gas sector. See Dahl and Duggan (1998) for a comprehensive review of the literature covering also other interesting elasticities such as the size of the discoveries or the success rate of discovering a productive well. The price elasticity of drilling typically reported in these studies ranges between 0.5 and 2.5. We estimate a drilling elasticity of around 0.5 which is at the lower end of the distribution of the estimated coefficients.

   The remainder of this paper is structured as follows. In the next section we provide a discussion on the institutional framework of the upstream sector in the oil industry and drilling costs. In the third section we describe the data. In the fourth section we discuss our identification and estimation strategy. In the subsequent section our results are presented before we conclude.

2. COSTS IN THE UPSTREAM SECTOR OF THE OIL INDUSTRY

   Activity in the oil industry can be broadly divided into three sectors: an upstream sector, which involves locating and extracting the product located under the Earth's surface; midstream sector, which mainly involves the transportation and storage of the product; and downstream sector, which involves the processing, distribution and selling of the final product. In what follows we focus on the upstream sector as we are interested in the determinants of drilling costs and their interaction with the oil price.

   Reservoirs containing the product are typically buried under many layers of rock and may be located onshore and offshore. Thus, drilling represents the core of activities in the upstream sector as it is essential to access the product. Types of wells drilled differ in their purpose. We broadly differentiate between two types of wells: exploratory wells (1) and production wells. The former have the purpose of identifying new reserves. The latter are mostly drilled in known reservoirs to maintain or increase oil production.

   Once the well...