This piece originally appeared on Oilprice.com.
What is the daily price of oil? It is a flash on a bank sign on Wall Street in downtown Midland. It is something people love to modify readily to justify the acquisition or sales price of a project. It is what people use to gauge investing in the stock and commodities markets. It is something that makes for creating good value benchmark prices in booking company reserves on their balance sheets. It makes for great stories of how you should “get in now” from stock and commodity brokers. It makes for good lunch room talk about how badly the industry is suffering with these low oil prices – did you see what oil prices did today, but I know they will go back up in the next 6 months because, bla-bla-bla!
What it is not? It’s not something savvy veterans to the industry rely on when they are interested in developing oil and gas reserves. Current daily prices should have no bearing whatsoever in determining safe and predictable breakeven price points or a price point risk analysis when acquiring a producing property or drilling prospect. In addition, they should not play a part in determining the worth of mineral rights. Determining values of oil and gas reserves or minerals has nothing to do with investing in the oil and gas futures market. They are two totally different concepts. The rise and fall of daily prices is driven by a different set of factors and has little value when it comes to determining a reasonable acquisition price or overall value for a producing property or development prospect. This is a key point to realize when investing in oil and gas projects.
Uncertainty is dominating today’s oil markets, with world supply and demand issues, daily production cuts, amassing oil inventories and a rising rig count all adding to oil price volatility.
It has been recently reported that OPEC’s efforts backfired on them and lower oil prices have all but destroyed their finances, and now they are losing their hard-earned market share as a result of cutting production.
However, companies are just now realizing a hard lesson learned from the not-so-distant past and that is lower breakeven price points. Some companies like Shell have recently come forward with statement such as: Shell can “make money in the Permian with oil at $40 a barrel, with new wells profitable at about $20 a barrel”.
This $20 or below breakeven price point is nothing new. However, it has been recently looked at hard by many companies and is starting to be re-instated, but at a high cost (cutting jobs and overhead). Even since the 1990’s, $15 to $20 breakeven points have been in place for many smaller companies due to the lower overhead costs associated with running their companies.
What does this breakeven price point cover? The term ‘breakeven’ covers the acquisition/development costs (CAPEX/AFE) and all operational costs specific for either 1) each well individually, or 2) the overall project versus the price for oil or gas. Most companies, that were part of the massive drilling in the late 2000’s, did not take this into consideration this high cost of entry to long term values, which led to many bankruptcies in 2015 and 2016.
You may be surprised to know that in 1859 oil was selling for around $20 per barrel, then dropped to $1 in one year and stayed around that price until 1945 when it started to steadily rise. Yearly average oil prices did not reach the $20 mark again until 1979 – 120 years later. In addition, from 1975 (The implementation of the Petrodollar and prices never dropping below the 158-year average of $11.22) through 2016 (42 years) yearly average oil prices have been over $60 per barrel only 7 times and over $40 only 12 times. In addition, since 1975, oil prices have been below this 42-year yearly average mean price of $31.85 per barrel 69 percent of the time ($20.21).
Since 1975, every ten years or so we have seen a major drop in oil prices. So, you can’t successfully live in a fantasy world thinking that oil prices are going back up to those ultra-high levels anytime soon or stay there for a long time. If they do, great! That should be your windfall, not what you are counting on for profitability.
With all that being said, here is an example of why you shouldn’t depend on or buy into the argument that higher prices are sustainable over long periods of time and quick rebounds are destined to happen. One year after that record yearly average high in 2008 ($91.48) oil dropped 58 percent for a yearly average price of $53.48 per barrel. However, yearly average prices started going back up again to reach its second all-time peak four years later in 2013, when the yearly average price of oil reached $91.17 per barrel. This trend was short lived, too. Prices immediately started dropping to reach a $48.80 average for the year 2015. This was a 53 percent drop in just 2 years.
Even though prices dropped by 50 percent in one year from 2014 to 2015 and dropped even further in 2016 to lows not seen since 2000 and 2003, everyone still believes that much higher, sustainable oil and gas prices are just around the corner. There‘s nothing wrong with hoping their crystal ball is clean, but depending on it for profitability can lead to bankruptcy!
The 158-year average price of $11.22 is not attractive or feasible in today’s economy, especially taking into consideration inflation, cost of developing and producing, cost of money and current world conditions. Can we say with certainty that we are never going to see oil prices of $11.91 (1998) again? We don’t see how, but with all that is currently facing our country and its volatile financial future along with world events, who’s to say? However, this number of $11.22 is still significant in that it should represent a significant part of breakeven price point scenarios for companies, particularly when considering acquisition and development costs versus recoverable reserves.
In late 2015, the president of an international oil company was being interviewed on CNN. He was asked how his company was going to be able to survive if oil dropped to $30 per barrel for a long period of time. He smiled and told the interviewer that if prices did drop to that level they would be expanding their operation and looking for new acquisitions. The reason he gave was that their company’s overall breakeven price point was less than $15 per barrel, which allowed them to capitalize on a distressed market with lower drilling and completion costs. In addition, he went on to say that he hoped oil prices would drop below $30 to weed out competition.
In March of 2017, an executive of Statoil was quoted in a Bloomberg report that their breakeven price point for some of their major fields were now well below $30 and in some cases around $12.
If you stop and think about it, you can’t drive a car without looking in your review mirror. So, too, you shouldn’t try to guess what oil and gas prices are going to do in the future without looking back at history.
Food for thought: Here is an interesting point of view regarding drilling costs vs oil and gas prices. When oil and gas prices rise, so do the costs of drilling and completion. However, if you look closely at the higher price timeframes you’ll notice something very interesting – actual margins from higher oil and gas prices compared with the higher drilling and completion costs are relatively the same margins as when commodity prices and drilling costs are down.
So, with that being said, why not drill all you can when drilling and completion costs are significantly down, rather than waiting for oil prices to increase before drilling. Thus, when prices do go up, you have a realistic chance of cashing in on a true windfall. In like manner, if you wait to drill until prices are higher, you diminish your true upside potential.
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A wise old production engineer once told me that in order to maintain a company’s operational capabilities, at a minimum you need to replace every barrel of oil you produce with two barrels due to production declines and company growth needs. So, keeping that in mind, it is also a good idea for companies to be able to continue to develop their leases even during daily pricing downturns, like the gentlemen on CNN and with StatOil, and have those development costs calculated in their initial breakeven price point.