The Economics of Oil Extraction

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The Economics of Oil Extraction

Despite advancements in specific techniques of providing alternative energy, most of the globe continues to rely on fossil fuels, oil being a notable example. Though it is unsettling to consider that much of our infrastructure is based on a finite resource, we still have a long way to go before we have to worry about a world without oil. In this post, we’ll look at the economics of oil extraction and how production choices are determined.

The Variability of Oil

One of the most misunderstood elements of oil is its variety, both in how and what it is deposited. Oil is categorized into two types based on two characteristics. The first categorization is light or heavy; this is based on API gravity, which is a density measure. The second categorization is sweet or sour, which indicates how much sulfur is present in the oil. While light, sweet oil still requires further processing, it is significantly simpler to convert into a high-value final product like gasoline. The processing and refining of heavy, sour oil is more intensive. Oil derived from Alberta’s tar sands (heavy, sour oil) costs more to process than light, sweet oil extracted from Texas.

Aside from the oil, there is the deposit’s character. There is still a surprising quantity of oil in the planet, but extracting it is becoming more difficult. Some of this is due to the physical creation of the deposit, such as bending or in shale rock, while others are plainly locational, such as deposits on the seafloor. Many of these impediments may be solved with technology. Hydraulic fracturing of rock, for example (or fracking), is the primary engine of the United States’ comeback in oil output, as more and more shale formations release previously unreachable amounts of oil and gas.

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The Moving Profit Point

Because of advances in technology, variations in oil, and changes in deposit quality, there is no one profit point for oil corporations. The Brent oil price is often used as a benchmark for oil prices. It reflects an average light, sweet oil, thus nations base their prices on the Brent price, with a discount imposed based on how much their product deviates from the ideal light and sweet. As a result, some nations notice a reduced price per barrel immediately away since their oil is not light and sweet.

When you compare the expenses of extracting a barrel of oil at various firms and nations, the disparities become much more apparent. Companies will be enormously successful at a Brent crude price of, say, $80, since their cost per barrel may be $20. There will also be corporations that lose money because extraction costs $83 per barrel. In a perfectly rational economy, all the enterprises that are losing money would stop or reduce output as the price approached their break-even point, but this does not occur.

Uneconomic Production

Companies will drill on deposits and keep wells running even if prices are low since keeping property for exploration is costly, and drilling is frequently a requirement of the contract. Production, like any other resource-extraction enterprise, cannot be turned on a dime. Labor requirements, equipment expenditures, leases, and a variety of other expenses do not vanish when output is reduced. Even though certain expenditures, such as labor, may be avoided, they become a larger expense in the long term since the firm must rehire everyone when prices recover – with every other company also recruiting in the increasingly competitive labor market.

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Instead, oil corporations often look to higher future prices and will strive for a well to pay off over a period of years, so month-to-month price changes are not the key factor for them. Large oil businesses have robust financial sheets that allow them to weather downturns. They also have a mix of conventional and unconventional reserves in their wells. Smaller organizations are more likely to be geographically focused and have a less diverse portfolio. These are the businesses that suffer amid extended price decreases. Similarly, countries with mostly heavy oil reserves, such as Canada, see profits vanish with low oil prices since their cost per barrel needs a higher price per barrel than OPEC and other competitive nations in order to maintain producing.

From the discovery phase, with its seismic and land expenses, through the extraction phase, with its rig costs and personnel costs, the oil sector has just a few strategies to reduce costs. One approach is to combine upstream, midstream, and downstream output. This implies that a single corporation can handle it all, from exploration to extraction to refining. This may assist with cost containment in certain areas, but it also indicates that the organization is not specialized or focused on being outstanding at one thing. The second approach is to promote further technical improvement so that difficult deposits become less expensive to exploit. The latter seems to have the greatest long-term promise, yet corporations will continue to seek for vertical acquisitions as they await more technical advancements.

Supply and Oversupply

The last economic consideration—and it should actually be the first in most industries—is supply. There is no question that there is a lot of oil out there, but it is limited. Unfortunately, we will never have a precise number that will enable us to determine the appropriate price that will keep the planet adequately fuelled. Instead, the price of oil is determined by the current supply as well as the probable supply in the near future based on predicted output. As a result, when firms continue to produce during an oversupply phase, the price of oil falls more, and the companies with the most uneconomic resources begin to sink. Because all of that supply was previously unavailable to the market, increasing oil production in the United States, for example, has kept oil prices significantly lower.

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The Bottom Line

There is no question that oil extraction adheres to supply and demand principles. The problematic thing is that the cost of transporting one barrel of oil to market varies greatly. In addition, uneconomic items and oversupply are typical concerns for oil corporations and their investors. This, of course, is why investors are drawn to the industry. If you monitor a few fundamental parameters and determine the cost per barrel of some of the smaller enterprises, you may benefit from changes in benchmark oil prices when unprofitable resources become lucrative. After all, the overall economics of oil extraction speak to the reality that there is money to be made – for both extraction businesses and their investors.

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