Recent falls in oil prices alter the financial dynamics of oil extraction. Certain sources of oil entail lower costs than others. For example, conventional pumped oil extraction in high pressure onshore wells costs relatively little to set up and operate, whereas remote oil fields beneath icy seas require specialized equipment and override wages to locate and extract. When the oil price rises, more difficult oil fields become economically viable, when the price falls, the margins of extraction remove the viability of certain sources. Hydraulic fracturing in the United States has provided an unexpected source of oil. However, it has contributed to an oversupply that could soon cause fracking production to shut down; as a matter of fact applications for new U.S. well permits dropped by nearly half last month. US oil production is slowing down because of low oil prices and today we'll explain the reasons for that decline and explore the solutions.
Economics 101
When there is more of a product available for sale than there is demand, then buyers can shop around for lower prices. Different suppliers have different financing models and so those with loans to pay back soon will panic and drop their prices drastically to make sure they sell all of their stock quickly. Those who decide to tough it out soon find their unsold wares piling up. Sooner or later, they have to decide to stop increasing their inventory of unsold product, and shut down production.
The classic market involves many different producers in many parts of the world. Each has different priorities and strategies. However, economic theory applies to all markets and sooner or later the same pattern of actions emerges. The weakest go out of business, or mothball their operations, while the strongest sail through the crisis with only reduced profit margins to show any damage of the period of oversupply. In the oil business, the strongest players are the Gulf states and the strongest of all is Saudi Arabia.
Bubberlin' Crude
Just like Jed Clampett of the Beverley Hillbillies, the Saudis need to do little more than stick a pipe in the ground and pump to get their oil into barrels. Crude oil literally oozes out of the ground and once the Saudis break through the top layer of sediments, the sheer pressure caused by the vast quantities of compressed underground oil means they often don't even need to pump very hard. Under such conditions, start up costs for new wells are minimal. Moreover the Saudis have such cash reserves that they don't have to go to any banks for loans. Saudi Aramco, the state-run oil company can pick and choose which engineering partners they will send along to do all the work for them, and oil extractors compete fiercely for the privilege, forcing Saudi costs down further.
Complicated Structures
Oil forms in pressurized cavities that lie between strata of rocks. The classic Saudi oil field is like a vast underground lake, or river of oil. The conventional US oil fields of locations like Texas had the same characteristics. However, the extra production of oil enjoyed by the USA in recent years is sourced from more complicated geological structures. In that case, Fracking gets oil out of stone. Where oil forms near porous rock, it gets drawn into the rock, rather like water into a sponge. Fracking involves bombarding the rock with a mixture of oil and chemicals to break it down, thus releasing the oil inside.
More complicated oil sources lie in rock strata that have been buckled and ruptured by seismic activity. In these cases, the classic gap between rock layers gets interrupted and chopped into sections by the deformed strata. Enterprising American prospectors made these small pockets of oil economically viable by introducing horizontal drilling. Thus, their drill cuts through the blocking rock structures, enabling them to extract oil from a string of small cavities and reduce the overhead of drilling new wells for each pocket.
Costs
A major factor influencing the cost of extraction is the lifecycle of each type of oil source. Saudi wells last longer. There is more oil to pump within each cavity and so the cost of setting up that well can be written off over a longer period than the cost of setting up a fracking and horizontal drilling operation. A long-term producer can also write off the cost of distribution methods over a longer period. So if a new well can be built alongside existing roads and pipelines, that method will end up cheaper in the long run than fracking in remote and previously unexplored areas where a new pipeline or railroad infrastructure adds to setup costs.
Staff costs are higher with fracking methods because each drilling site is distant from earlier sites. Any oil extractor has to spend time and money locating staff for each project. Those employees then need to be transported and housed. If a well lasts for decades, the same accommodation can be used for staff over a longer period than the short-term nature of each fracking location. The peripatetic nature of fracking also means that staff will be less likely to settle in one place with their families and therefore demand higher wages to compensate for the loneliness of working away from home in freezing -40F North Dakota winters.
Capacity
Fracking is more expensive than extracting oil by conventional methods. Thus, conventional producers can afford to keep extracting and selling their oil at lower crude index prices than frackers. So why bother investing in hydraulic fracturing and horizontal drilling? A high oil price offers an incentive to endeavor. American oil exploration and extraction companies would much rather work in their own country, and in their own language, than have to travel to unstable places and risk hostile cultures in order to make a living. Thus, US oil companies expanded production in their own county once prices reached a certain level where unconventional methods became economically viable. Financiers and investors had little risk of losing their investment. The OPEC countries consistently trimmed their output to match world demand, so projections of oil prices and rates of return created a one-way bet.
American oil producers could just keep increasing capacity infinitely (or so it seemed), because someone else would adjust their output to make room in the market. Prospects looked good for expansion because cutbacks in OPEC production meant America could just keep taking a larger and larger share of the market.
Circumstances
The Saudis and their cheap-oil Persian Gulf neighbors suddenly had enough of making room for American expansion. They knew that they had been obliging to other nations, but felt that they had not been treated with the courtesies that they deserved. Saudi Arabia was particularly angry that America and its Western allies had failed to topple Bashar al-Assad in Syria and they were furious with Russia for blocking initial attempts to oust the Syrian president. The sudden return to market of Algeria, Libya and Iraq meant that OPEC began to overproduce. Under normal circumstances, both this extra production and added capacity from fracking would have prompted the Saudis and their OPEC allies to reduce production to maintain price levels. This year, the Saudis switched tactics and decided to defend their market share no matter where the price went.
A Suivre ...
Economics 101
When there is more of a product available for sale than there is demand, then buyers can shop around for lower prices. Different suppliers have different financing models and so those with loans to pay back soon will panic and drop their prices drastically to make sure they sell all of their stock quickly. Those who decide to tough it out soon find their unsold wares piling up. Sooner or later, they have to decide to stop increasing their inventory of unsold product, and shut down production.
The classic market involves many different producers in many parts of the world. Each has different priorities and strategies. However, economic theory applies to all markets and sooner or later the same pattern of actions emerges. The weakest go out of business, or mothball their operations, while the strongest sail through the crisis with only reduced profit margins to show any damage of the period of oversupply. In the oil business, the strongest players are the Gulf states and the strongest of all is Saudi Arabia.
Bubberlin' Crude
Just like Jed Clampett of the Beverley Hillbillies, the Saudis need to do little more than stick a pipe in the ground and pump to get their oil into barrels. Crude oil literally oozes out of the ground and once the Saudis break through the top layer of sediments, the sheer pressure caused by the vast quantities of compressed underground oil means they often don't even need to pump very hard. Under such conditions, start up costs for new wells are minimal. Moreover the Saudis have such cash reserves that they don't have to go to any banks for loans. Saudi Aramco, the state-run oil company can pick and choose which engineering partners they will send along to do all the work for them, and oil extractors compete fiercely for the privilege, forcing Saudi costs down further.
Complicated Structures
Oil forms in pressurized cavities that lie between strata of rocks. The classic Saudi oil field is like a vast underground lake, or river of oil. The conventional US oil fields of locations like Texas had the same characteristics. However, the extra production of oil enjoyed by the USA in recent years is sourced from more complicated geological structures. In that case, Fracking gets oil out of stone. Where oil forms near porous rock, it gets drawn into the rock, rather like water into a sponge. Fracking involves bombarding the rock with a mixture of oil and chemicals to break it down, thus releasing the oil inside.
More complicated oil sources lie in rock strata that have been buckled and ruptured by seismic activity. In these cases, the classic gap between rock layers gets interrupted and chopped into sections by the deformed strata. Enterprising American prospectors made these small pockets of oil economically viable by introducing horizontal drilling. Thus, their drill cuts through the blocking rock structures, enabling them to extract oil from a string of small cavities and reduce the overhead of drilling new wells for each pocket.
Costs
A major factor influencing the cost of extraction is the lifecycle of each type of oil source. Saudi wells last longer. There is more oil to pump within each cavity and so the cost of setting up that well can be written off over a longer period than the cost of setting up a fracking and horizontal drilling operation. A long-term producer can also write off the cost of distribution methods over a longer period. So if a new well can be built alongside existing roads and pipelines, that method will end up cheaper in the long run than fracking in remote and previously unexplored areas where a new pipeline or railroad infrastructure adds to setup costs.
Staff costs are higher with fracking methods because each drilling site is distant from earlier sites. Any oil extractor has to spend time and money locating staff for each project. Those employees then need to be transported and housed. If a well lasts for decades, the same accommodation can be used for staff over a longer period than the short-term nature of each fracking location. The peripatetic nature of fracking also means that staff will be less likely to settle in one place with their families and therefore demand higher wages to compensate for the loneliness of working away from home in freezing -40F North Dakota winters.
Capacity
Fracking is more expensive than extracting oil by conventional methods. Thus, conventional producers can afford to keep extracting and selling their oil at lower crude index prices than frackers. So why bother investing in hydraulic fracturing and horizontal drilling? A high oil price offers an incentive to endeavor. American oil exploration and extraction companies would much rather work in their own country, and in their own language, than have to travel to unstable places and risk hostile cultures in order to make a living. Thus, US oil companies expanded production in their own county once prices reached a certain level where unconventional methods became economically viable. Financiers and investors had little risk of losing their investment. The OPEC countries consistently trimmed their output to match world demand, so projections of oil prices and rates of return created a one-way bet.
American oil producers could just keep increasing capacity infinitely (or so it seemed), because someone else would adjust their output to make room in the market. Prospects looked good for expansion because cutbacks in OPEC production meant America could just keep taking a larger and larger share of the market.
Circumstances
The Saudis and their cheap-oil Persian Gulf neighbors suddenly had enough of making room for American expansion. They knew that they had been obliging to other nations, but felt that they had not been treated with the courtesies that they deserved. Saudi Arabia was particularly angry that America and its Western allies had failed to topple Bashar al-Assad in Syria and they were furious with Russia for blocking initial attempts to oust the Syrian president. The sudden return to market of Algeria, Libya and Iraq meant that OPEC began to overproduce. Under normal circumstances, both this extra production and added capacity from fracking would have prompted the Saudis and their OPEC allies to reduce production to maintain price levels. This year, the Saudis switched tactics and decided to defend their market share no matter where the price went.
A Suivre ...
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