The Economics of The Oil Industry

Basics of the Petroleum Industry IV: It costs a lot to produce oil

OK, so far, we’ve talked about how oil forms, how it accumulates in fields, and how scientists look for new oil fields. Everything we’ve looked at so far has been about science or technology, and how the nerdy guys and gals who work for oil companies use their high-tech toys to help find new fields. At one time, oil companies were the world’s leading users of technology; and they’re still close to the top. We’re talking about more than numbers of computers and amounts of memory and data storage; we’re also talking about software. One high-end software program widely used by large oil companies has a list price of a quarter of a million dollars – for every one-seat license – and the big multinationals have paid for hundreds of licenses and training so their staff can run these highly complex programs. And computers, software, and training are just a tiny part of the cost of finding new oil…

This time, let’s take a look at the economics of the petroleum industry. That gallon of gasoline you burned on your way to work this morning has had a long journey. Let’s ignore for now the minor miracle that had to happen for oil to accumulate in the first place and concentrate on what it costs along the way to get that stuff out of the ground and into your gas tank.

Step 1: Finding the oil

The business calls this “finding costs,” the expense of searching for oil fields. It might seem simpler to just take a drill and go out and stick a new hole in the ground every couple of miles, but the cost of doing that would be astronomical – not to mention that you might miss the good stuff (and you’d never be certain that you hadn’t stopped drilling a foot or two too soon). So companies work hard to reduce risk so they only have to drill one – or maybe two or three – exploration wells to find out if a prospective site has oil or not. To do this, highly-trained geoscientists make educated guesses about the area using data from nearby wells; and they also use seismic surveys. Now we’re talking about money: a seismic survey of an area will cost hundreds of thousands to several million dollars depending on the size of the survey and the difficulty of getting the data. Those billions of digital records must be processed and reprocessed with highly technical software, and then they’re loaded into high-end computers running expensive software. All that to just look for a prospective location…

We’ll skip the details and cut to the chase: an oil company has determined that there is a sufficient probability of a sufficient amount of oil that they’re willing to take the risk and drill. Before they can do that, however, they have to get permission to drill in the form of a lease. Companies pay for the right to lease land, either from individuals or governments, and also promise to pay part of the profits from any oil that’s produced from that property. Those payments are called royalties, and range from 10% of the sale price of oil up to more than half the proceeds in some foreign countries. The company must also pay to prepare the site if it’s on land, and usually pay for a permit to drill. The up-front investment to drill a well – including salaries for the exploration department – can be, shall we say, “substantial.” Exploration budgets for large companies are typically on the order of hundreds of millions to billions of dollars. Companies spend millions of dollars just picking a place to drill – and then the real money comes into play. Drilling a shallow well on land, perhaps 2500 feet deep, costs on the order of $75-100,000. Offshore exploration costs are far higher, and increase rapidly as the well gets deeper. A recent discovery in 4000 feet of water in the Gulf of Mexico is estimated to have cost a quarter of a billion dollars to drill!

Obviously, if oil sells for $50 per barrel and it costs $55 per barrel just to find it, the company is not going to make any money – that’s one reason why company projections of changing oil prices have to be taken into account just like company guesses at the size of the oilfield.

Step 2: Producing the oil

Let’s say you drilled yourself a gusher. Whoopee! But except for what returned to the surface from that one well, everything else is still deep underground. The physics of fluids like oil and water just don’t allow you to pump all the oil out of one hole, so you need to drill more wells to produce what’s down there. If you’re on land, you could just drive the drill rig to another spot and poke another hole, but if you’re in water, you will have to build an offshore platform and drill several wells to out at an angle. Each of those wells also costs a bundle, and the offshore platform could easily cost hundreds of millions of dollars. That’s all before you pump a single drop of oil into a tanker. If you’re on land, you still need to move the oil from all the individual wells (sometimes hundreds or even thousands of them) to central collection points so that the oil can be piped or trucked to market. There is a lot of money tied up in all the infrastructure, maintaining it, and the personnel needed to keep it operating. That’s a big part of “producing” or “lifting costs.”

But wait, there’s more: there’s also water produced along with the oil, more and more of it as the field ages. The water has to be separated from the oil and disposed of – usually by pumping it back into the reservoir, since it can’t just be poured out on the ground or dumped in a river because it’s salty. More expense…

Remember that we learned some time ago that oil doesn’t collect in underground streams and lakes, but is stored in the tiny pore spaces between grains of rock? That has an important side effect: most of the oil would rather stay clinging to its grains of sand than flow to a well. Companies use all sort of tricks to break that hold: pumping in lots of water, pumping in natural gas, even pumping in carbon dioxide in an effort to”re-energize” the oil and get it moving. Guess what: more expense! and there’s one truth that every oil company scientist and engineer knows: you can never get all the oil out of a field – you’re lucky when you can get half of it.

Step 3: Moving the oil to market

Though it’s not as expensive as finding or producing the oil, getting it to market also has its associated costs. You can’t drive a couple of tank trucks up to a field that produced hundreds of thousands of barrels of oil per day; that would eat up all your profits. So when a company finds a new field, transportation costs are another factor. Building a pipeline big enough to transport that volume of product costs hundreds of thousands of dollars for every mile of pipe. If you can’t get the oil to a refinery or a terminal to sell it, then producing it does you no good!

The bottom line:

Every drop of oil that a company like Shell or Conoco-Phillips sells has all of those costs, and more, associated with it. Just finding oil can cost a bundle, and that’s only the beginning: getting it out of the ground costs even more, and a company is still not done paying to produce oil until it finally reaches a buyer. It is possible – in fact happens frequently – to strike oil but determine that there isn’t enough in the reservoir or it’s not of good enough quality to pay for pumping it out of the ground. When this happens, the find is called “uneconomic.” Obviously, if prices increase faster than producing costs and transportation costs, a find can become economic sometime later.

A company will not drill a well unless they believe that there is enough oil at the site to pay back every one of the costs and have some left over for profit – without profit, they can’t drill the next well. This explains the so-called “obscene profits” that oil companies rake in when the price of oil hits $140 per barrel. Their experts forecast that they would make a reasonable profit at a price of $50 or $70 per barrel, and when the market started paying more, the extra dollars become pure profit. This is no different from a farmer who plants soybeans expecting to make $7 per bushel; except that if he gets $10 instead, no one talks about his “obscene profits.” Oil companies and farmers have the same downside as every commodity producer, because they don’t control the prices – their buyers do. So if our hypothetical farmer got paid $6 per bushel instead of the $7 he was expecting, he has a bad year, and the same with oil companies: if they’ve forecast $50 oil and the price drops to $35 (as it did in December, 2008) then they’re losing money.

So there you have it. That gallon of gasoline you bought today did not simply run out of the ground into a handy gas pump, it’s had a arduous journey from the reservoir to the pump – a journey that had costs at every step along the way.

This is the fourth of a series of minilectures on the petroleum industry from the ground up

1) Where Does Oil Come From?
2) Where Do Oil Companies Find Oil?
3) How Do Oil Companies Find Oil?
4) The Economics of Petroleum Exploration and Production <== You are here.  Future installments include:
5) Refining
6) The Economics of Big Oil
7) The Future of Oil