Royal Dutch Shell plc (ADR) (RDS.A): One Obscure Factor That Dictates the Future Price of Oil

Page 1 of 2

There’s no getting around it: The global oil market is complex. Prices can change because of the slightest disruption in the market, and sometimes because of an anticipated disruption where nothing has even happened yet.

Still, there are some simple truths that give us a general idea of where oil and gas prices are heading. One simple thing to look at is reserve replacement cost, or how much a company needs to spend to replace its current production levels. Let’s see what trends are emerging in this metric and what it means for the oil and gas industry

Keeping the shelves stocked
According to Ernst & Young’s annual U.S. Oil and Gas Reserves study, reserve replacement costs are some of the highest we’ve seen in several years. The average cost to replace a barrel of oil equivalent in 2012 was $32.72, almost double what it was in 2011. The closest comparable figure was in 2008, when reserve replacement costs were $39.34 per boe.

Royal Dutch Shell plc (ADR) (NYSE:RDS-A)

Reserve replacement costs can rise for two reasons. The most obvious one is that it becomes more difficult to find new resources, so the cost to find a new barrel of oil goes up. Most of the time, the cost of oil moves in tandem with reserve replacement costs. As prices for oil increase, companies are more willing to explore higher-cost, higher-risk regions, and they may not always find oil. One example is Royal Dutch Shell plc (ADR) (NYSE:RDS.A)‘s attempt to find oil offshore from Alaska. The company has spent $4.5 billion in the region but has yet to produce a barrel of oil from the region. The company can take such a chance on this region is because the price of oil gives it some flexibility.

The other reason reserve replacement costs might increase can make numbers go haywire. A company’s reserves are based on the amount of oil the company can economically extract based on current prices. If the price of oil goes down, though, a company needs to write down some of its reserves, because they can’t be feasibly produced at the lower price. So the replacement cost of what it has today goes up, since the company needs to replace both the oil and gas it’s currently producing, as well as the amount lost to these asset writedowns. According to Ernst & Young, the high reserve replacement costs in 2008 were largely related to writedowns, because oil prices dropped by almost $100 a barrel. Whenever oil prices take a big nosedive, as they did in 2008, you have to take reserve replacement costs with a small grain of salt.

In the case of 2012, reserve replacement cots went up in large part because of increased capital spending, but a drop in price played a small part as well. In 2012, capital expenditures for the top 50 E&P companies in the U.S. hit a five-year high, totaling $185.6 billion. Some companies have struggled more than others. In 2012, BP plc (ADR) (NYSE:BP) had a reserve replacement cost of about $72, which could become a large problem down the road as it tries to grow production in the future. While it’s technologically and economically feasible to access shale gas and tight oil today, the costs to access these sources is much higher. The average cost to complete a well in the Bakken formation in North Dakota costs about $11 million.

Page 1 of 2