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Using costs to predict the oil price

Thursday, August 27, 2015

People usually the predict future oil price starting with an estimate of what OPEC wants the price to be, said Stuart Amor or RFC Ambrian. But it might be better to start by looking at industry costs.

Microeconomics suggests that over the long term, the oil price should cycle around the marginal full cost of oil supply. The full cost of oil supply includes all capital costs, operating costs, taxes and the required return on capital.

Stuart Amor. Head of Oil and Gas Research with corporate advisory company RFC Ambrian explored this theory in his talk at Finding Petroleum's forum on June 5 2015, 'Cost Reduction in This Era'.

Upstream capital costs doubled from 2004 to 2008, according to IHS Cera's Upstream Capital Cost Index. From 2000 to 2004, and after 2008, they were fairly flat.

You can see a similar shape in the graph of long dated Brent oil prices (which reflect the marginal cost of oil supply), fairly flat until 2004, then a big jump to 2008, and fairly flat after that, he said.

RFC Ambrian defines the marginal cost as the cost of the most expensive 10% of global non-OPEC production.

Looking over back over 20 years, you can see quite a close correlation between the Brent oil price for 3 years in the future, and the supply costs for the most expensive 10% of production, he said.

'The long dated price is the market's best guess at the marginal cost of oil supply, this is the long term structural component of oil prices,' he said.

Many market commentators work on the basis that the price will end up where OPEC wants it to be, he said.

But if you work on the basis that the long term oil price will be equal to the marginal full cost of production, it means that OPEC actually has very little influence in the long term, because most OPEC production is low cost. By effecting the short term supply/ demand balance OPEC has significant influence over whether the spot price trades at a premium or discount to the long dated contract, he said.

RFC Ambrian estimates that the marginal full cost of oil supply is around US$80/bbl and they forecast that the oil price will be between $70/bbl and $90/bbl in the long term, he said.

The long dated Brent contract is down to around US$75/bbl from US$100/bbl just 12 months ago. This is because some high cost projects have been delayed or cancelled and because oil service costs are lower than they were. Current overcapacity in the oil service sector, is now putting downward pressure on the rates the service sector can charge upstream companies.

Short term

Over the shorter term, the market focus has been on how fast US shale oil producers will reduce production. 'We thought US tight oil would peak in June 2015 but it actually peaked in April.'

Shale operators have been leaving drilled wells uncompleted. 'Operators are hoping for lower completion costs later in the year. And they don't want to lock in a loss,' he said.

If OPEC's main short term aim is stopping US tight oil, it will probably wait a little longer, perhaps until early 2016, before reducing production, he said.

OPEC has a track record of being slow to react. 'In 1985 - 1986, OPEC didn't act until 13 months after the cycle [started]. We are only 10 months into this cycle' he said.


Mr Amor was asked if he thinks Iranian production could change the numbers.

Mr Amor replied that they model on the basis that all OPEC production (including Iran) will be steady, so if Iran starts producing more, all other OPEC members will reduce production to make space. This is not too hard. 'There are a few other OPEC countries that I think will struggle to meet their quota levels,' he said.

For example, 'crude coming out of Iraq will struggle in the near term. Iraq isn't paying oil companies what it needs to pay them. For every country that might come up, there's always one that might come down.'

Mr Amor was asked how accurate he thought production data actually is, considering that some commentators believe that Middle East countries lie about their production.

'There are people counting ships in and out and making assumptions of how much oil is there,' Mr Amor replied. 'It is probably reasonably accurate.'

How low can it go?

RFC Ambrian's estimate of the 'marginal cash cost of oil', how much it costs to keep production going (not including exploration and development expenses) is roughly $30, he said.

However oil and gas companies could take some comfort from knowing that the oil and gas price did not approach this cash cost in previous crashes, except for 1998.


Mr Amor was asked about the current investment attitudes in Wall Street, who seem to prefer US onshore operations over deepwater.

'Investors are investing in growth. Shale has been a growth story and that's what they are investing in,' he replied. 'But the growth has come from debt. It is not generating enough cash flow to grow itself at the rate it's been growing.'

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