Oil Price and Industry Costs – Always Take A Closer Look
The Price and Cost Indices Are Now Very Far Apart – Remember This When Prices Rise Again (as they will, oil is a commodity)
At a recent oil conference in London in February an ENI executive made a clear statement on the gap between oil price and industry costs – prices were down 70%, but he saw costs only decrease by 15-20% – equivalent to an all in pricing cost of ca $80/bbl.
Is this correct?
First point – oil prices can change far quicker than oil industry input costs. All the main oil companies are price takers. The swing producer today is the multitude of shale oil players, so the market is drive by macroeconomic supply and demand, rather than any individual company action. This may change, but that’s the rules today.
Second – how to quickly compare oil price and industry costs? IHS (a consultancy) have produced a basket of materials and labour rates to derive an upstream capital project cost index (UCCI) since 2000. This is indexed at 100 for 2000.
The index was flat for its first few years, and data a bit patchy. But the UCCI does try to reflect the trends in a basket of key input costs such a construction worker rates, major equipment costs, drilling costs and so on.
If you index both oil price and UCCI to 100 at 2004, when oil prices started to fluctuate, you get the chart below. I have also added a third line which inflates the UCCI by 10-20% to include a non-standard input cost inflation due to the growing scale of megaprojects. IPA, an energy industry specialist project consultancy, defines this as the megaproject premium.
I have finally time-bound the chart into three sections based on when a major project would have taken FID (Final Investment Decision or Sanction)
2004-2010 – projects are now complete and in operation
2011-2014 – projects in the construction or execution phase
2015-2016 – projects in the near-sanction phase, likely in FEED awaiting FID decisions
What does all this show us?
With such limited data, strong conclusions would be courageous. Here are four tentative observations instead.
1 – The ENI executive seems to be on to something. If you look at the chart since 2014, the oil index has dropped 70% as expected, but the UCCI (if accurate) has only dropped about 25%.
2 – Taking a wider look, since 2004 the oil price has almost tripled, but now sits back below its 2004 pricing of ca $45/bbl. It has been a volatile number, with 2008 and 2009 swinging violently. Cost has been a much calmer animal. But it has doubled over the period, and it reacts far more slowly than price. It barely reacted in 2008-09 before resuming an upward trend, and it is only slowly responding to the latest downturn. This is understandable. Cost is a product of negotiated contracts, and multiple inputs across multiple bilateral arrangements, each one with its own micro-market of demand and supply. Price is a single traded commodity number, reacting rapidly to fluctuating global trends. This means that costs are a follower of price, and a diluted one at that. When prices have surged, costs have (eventually) followed. Note how around 2011 the cost inflation curve actually rose above even high price inflation – with the surge in project activity driving the costs upwards via demand.
Now, with prices down significantly, costs are adjusting, but they will not reduce any where near as quickly – they are still twice as expensive as 2004 if you include the premium. If the oil price remains below $40/bbl say, this has major implications for future oil projects, with higher costs persisting.
3 – Looking at the project FID data – clearly projects sanctioned early in the 2000s and operational now lived through (mostly) a relatively healthy gap between price and cost movement. Although if you take the megaproject premium into account, the gap is less robust, an issue that is now coming back to plague the industry.
For projects sanctioned recently in the high price era of 2010-2014 clearly high prices and high costs went hand in hand – this is where the ever-increasing full-cycle break-even costs of $80-90/bbl feature, and have caused major reversals today.
For projects pre-sanction, the cost-price gap is dire, and none of these projects look sanctionable if the price remains in this zone.
4 – If oil price rebounds to the safe zone of around $60/bbl, this would equate to about 135 on the price index – which still requires a further 30% decrease in industry costs including the inefficiency expense to get alignment with price indexation
What does this mean?
Pre 2004 the oil industry was able to sanction and deliver projects for over two decades at oil prices working in a range of $25-35/bbl.
Since then prices and costs have surged, with the latest downturn in price not yet reflected in costs – the cost-price gap is larger than it has ever been in over 20 years.
Key implications:
- Major projects near sanction today will be postponed or recycled – no near-term scenario can accommodate them
- If the macro-trends keep oil prices at the low end of current estimates – say $40-50/bbl – for a further 12-24 months the project portfolio viability of most majors is under question as the overall decline in costs would be too large to be plausibly achievable
- The industry has a cost problem and maybe a scope problem with too many future projects lying at the frontier / complex end of the delivery spectrum
- Oil firms need to renegotiate project unit costs across all the inputs – but they also need to take action on what this means for the overall portfolio
- Philosophically even a price rebound above $60/bbl will require a major review – the industry will unlikely be allowed to take costs to such dangerous levels again
- Key unknowns such as unconventional oil production and the demand impact of renewables will require strong and plausible plans for prolonged oil price deflation – and there do not appear to be any at the moment
The price and cost indices require careful monitoring now, as do the various oil company project portfolio plans in response.
To be continued …