The gushing oil well at Spindletop Dome in Beaumont, Texas is one of the most iconic images in the history of oil. When the well hit paydirt, oil spewed 150 feet into the air at a staggering rate of 100,000 barrels per day. We’ve come a long way since that Spindletop gusher 112 years ago, and today’s industry faces greater challenges finding new sources that can be sold at a reasonable rate of return.
On a recent conference call, Core Laboratories N.V. (NYSE:CLB) CEO David Demshur stated that outside some of the best spots in the US, oil producers in the US will slow down exploration if oil prices are to remain below $90 for a sustained amount of time. Let’s look at a few factors that might give some credence to Mr. Demshur’s claim.
1. Higher resource costs. According to Chesapeake Energy Corporation (NYSE:CHK) the average shale well in the US is drilled to 7,800 feet vertically plus several thousand feet horizontally and is injected with over 5 million gallons of water, sand and chemicals to fracture the tight pores where oil is hidden. All of this effort is for an average initial production rate of about 450 barrels per day.
All of that extra work to tap a well translates into using resources, a lot of them. The list of requirements for a new well is so staggering, even the price of food products can affect how much it costs to drill a well. in Q2 of 2012, Halliburton Company (NYSE:HAL) took a big hit on earnings because the company overspent on guar gum, a thickening agent it needs for fracking fluids. When all of these kinds of costs are added up, the average well in the US today costs about $6 to $11 million dollars.
It’s plain and simple, money just doesn’t go as far as it used to. According to a report by Barclays, spending in the exploration and production sector increased 19% and 11% in 2011 and 2012, respectively. Over that time period, output only increased 0.1% in 2011 and 2.2% through first 10 months of 2012. The increased costs to get marginal results back will ultimately result in higher prices.
2. Location, location, location. To add insult to injury, these higher costs are compounded by the fact that the places where we are finding oil are remote, hard to reach locations. Whenever a company ventures off into one of these remote locations in search for oil, it is a higher risk situation that involves a lot of costs.
There are two great examples of these kinds of sources just North of the US: Alaskan offshore and Canadian oil sands. These two regions have been giving exploration and production companies headaches for years. Royal Dutch Shell plc (ADR) (NYSE:RDS.A) has spent $5 billion over the past 5 years trying to tap a potential source in the Chuckchi Sea off of Alaska, and so far they don’t have a drop to show for it. Also, because of high costs and slumping prices, several producers are shelving plans to build out Canadian oil sands, with French giant Total taking a $1.6 billion loss to completely walk away from the project.
What makes these projects unattractive? The break-even costs. A Wood Makenzie study recently showed that the break-even cost for a new Canadian oil sands project is between $65 and $100 per barrel, depending on the type of extraction. Add transportation and a rate of return, and these projects don’t make economic sense unless oil prices are high.