Future oil supply on world markets with regard to extraction profitability in different oil plays given falling oil prices

The estimates of various analytical teams as to how oil extraction will respond to current price developments differ widely. The breakeven cost is important for new projects (and for existing projects in the long run). Where the market price is not sufficiently high above the breakeven cost, and this situation lasts for an extended period of time, existing projects cease to be profitable and new investments cannot be justified. The estimates of individual institutions of the breakeven cost for different extraction methods and in different regions lie within a wide range (see Chart 1 Box and Table 1 Box). Many planned projects have already been shelved during the current oil price decline on the basis of this criterion. However, the currently observed decline in new investment will not limit oil extraction until the relatively distant future. Extraction will continue in existing projects at least as long as the oil price covers operating costs,¹ which are much lower than the total costs over the entire investment cycle. In addition, some projects will continue to extract temporarily even in a situation of operating loss (e.g. wells in the North Sea and oil sands extraction in Canada), as halting production would make renewal of extraction impossible or excessively costly. At the same time, many firms have hedged their production against sizeable price declines using financial derivatives, so they can continue to extract for some time regardless of the current price. In countries where budget funding and foreign exchange income are critically dependent on oil extraction, production is unlikely to be limited even when profitability is low.

Chart 1 (Box) Breakeven price of oil for fields in various regions of the world
Estimates of the breakeven price of oil differ widely depending on extraction technology and specific geological conditions
(USD/barrel; source: CNBC)

Table 1 (Box) Various institutions' estimates of the breakeven price of oil for shale extraction in the USA
The estimates of individual institutions of the breakeven price for new projects lie within a wide range, but the majority are above the current market price
(USD/barrel; source: Reuters, Bloomberg)

Shale extraction in North America has the largest potential for reduction, as the yields of these wells decline very quickly during the production cycle. In North Dakota, for example, the natural decrease in a well’s yield is 65% on average in the first year, 35% in the second year, 15% in the third year and 10% in the fourth year, while for conventional wells the yield decreases evenly at a pace of around 9% a year. Consequently, new wells must constantly be drilled to keep the extraction volume unchanged. However, rapid adjustment to market conditions cannot be expected here either. First of all, a decline in drilling permits can already be observed – with a lag of roughly three months since oil prices started to fall. The number of rigs actively being drilled (the “rig count”) begins to react with an even longer delay (4–6 months; see Chart 2 Box). After drilling, which at present is a matter of a few days, it usually takes another 1–6 months before the well is completed and ready to produce oil.

Chart 2 (Box) Rig count in the USA
The rig count in the USA started plummeting in December 2014
(source: Baker Hughes rig count)

It can be illustrated on detailed data from North Dakota (especially Bakken) that operators are now in no hurry to complete new wells so that they do not increase supply to the currently oversupplied oil market. The backlog of uncompleted wells is thus increasing (see Table 2 Box). The number of rigs drilled in North America peaked in mid-October 2014 and their high initial yields will therefore contribute to further rapid growth in US extraction at least in the first half of this year. This period is also characterised by the seasonally low global demand for oil, so the highest excess supply and the highest pressure on oil prices can be expected. Production growth in the USA should then start to slow as the well count falls. The largest numbers of wells will be closed in marginal areas of individual shale plays, but part of the conventional extraction from low-yield “stripper” wells, which produce less than 10 barrels a day and thus have high operating costs, will also be curtailed. Extraction is also likely to be cut back in the Bakken area, which is the furthest from the processing and transport infrastructure (and so actual wellhead prices there are significantly lower than the benchmark WTI price) and in the Permian Basin, where extraction costs are high because of complex geological conditions.

Table 2 (Box) Shale extraction in North Dakota
The numbers of permitted and drilling rigs are falling in response to the drop in the local oil price. Moreover, operators are delaying well completion, so the backlog of uncompleted wells is increasing
(source: North Dakota Department of Mineral Resources)

¹ A recent analysis by Wood Mackenzie states that wells accounting for a mere 0.2% of global extraction (i.e. 190,000 barrels a day) would post an operating loss in the event of Brent selling at USD 50 a barrel. The volume of loss-making production would rise to 400,000 barrels a day at USD 45 a barrel and to 1,500,000 barrels a day (1.6% of global extraction) at USD 40 a barrel. Some Canadian oil sands projects would get into trouble at this price. Shale extraction in the USA will start to experience bigger difficulties at Brent prices around USD 30 a barrel. However, loss-making extraction does not automatically mean that production will be halted immediately, as producers may increase their stocks for a while.