Friday, November 28, 2014

Breaking Even in a Low Oil Price Environment

With the price of oil hitting levels not seen for more than four years, it's becoming an increasingly important issue for investors who are long on oil company shares, particularly given that some of the resource plays currently in vogue require prices that are far higher than conventional plays to provide a positive return on investment.  As you will see in this posting, this is particularly true for Canada's oil sands operators and companies operating in the American shale oil region.  In this posting, I will look at three different analyses that, in combination, give us some sense of the headwinds facing the oil industry.

Back in mid-2014, Reuters and Natixis published a brief article on the break-even price of producing an additional barrel of oil by geographic region, including both ethanol and biodiesel.  Here is a summary of their analysis:

The marginal cost of producing an additional barrel of oil from the Canadian oil sands is between $89 and $96 per barrel compared to $70 to $77 per barrel for U.S.-based shale oil.

Here is another analysis by the Carbon Tracker Initiative showing the break-even price for the top twenty largest oil projects in the world that require oil prices of more than $95 per barrel:

Note that the six projects that require the highest break-even oil price are all Canadian oil sands projects, both mining and in-situ.  At this point in time, one has to wonder if these high-cost options will be shelved until the price of oil retraces its decline.

From the same report by Carbon Tracker, we find these interesting graphics which show the proportions of high cost potential production for seven major oil companies:

In the worst case situation, Conoco Phillips has a portfolio containing potential projects that require an oil price of at least $75 per barrel and 36 percent require a price of at least $95 per barrel.  In the case of Shell which has the largest potential production portfolio, 45 percent of their potential projects require a market price of $75 per barrel and 30 percent require at least $95 per barrel.

Let's now look at a graph from a monthly commodity report from Scotiabank back in February 2014 which shows the full cycle break-even costs (including a 9 percent after tax return on investment) for selected production regions in North America:

The graph shows us that the weighted average of all breakeven costs for all projects is between $67 and $68 per barrel.  Among the fifty projects examined, Saskatchewan's Bakken resource play has the lowest break-even costs at $44.30 per barrel.  On the other hand, you'll note that the costs for new oil sands mining and upgrading projects is $100 per barrel, well above the break-even costs for existing oil sands production which comes in at between $60 and $65 per barrel.  SAGD (steam-assisted gravity drainage) projects are quite competitive with a break-even cost of $63.50 per barrel.  This accounts for 1.08 million barrels per day of Canada's oil production or 46 percent of Alberta's oil sands output.  It is interesting to see that the break-even costs of the U.S. Baked and Permian Basin shale oil production is quite high by comparison to the oil sands, coming in at $65 to $73 per barrel and $73 to $89 per barrel respectively.

Fortunately, many oil companies use a system of options which insure their production against price volatility.  Unfortunately, all of these come at a cost and as natural gas producers found out, they only shield production for a finite period of time.  As well, in the past, some companies have found themselves on the losing end of the bet when prices unexpectedly changed, leaving them having to declare very significant mark-to-market losses on their positions.

In closing, here is an interesting graph from Natixis showing U.S. oil production, consumption and imports since 2002:

Given the very steep production declines on shale oil producers, unless oil companies are willing to continue to stay on the production treadmill by drilling oil shale resource plays at the current lower price level that we're experiencing, we could quickly find that the purple production line falls back to its pre-2011 level, putting upward pressure on the price of oil once again....unless, of course, there is another recession!

1 comment:

  1. Well done! Please note this might become very destabilizing to the world economy when coupled with other forces like the increasingly wild currency markets. The article below delves in to the risk of contagion from both the euro and yen continuing to lose value.