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

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.

As the same time, though, the average price for a barrel of West Texas Intermediate crude, the U.S. benchmark, fell by about 10% over 2012, and natural gas prices hit 12-year lows in April 2012, which led to several asset writedowns. Companies with a gas-heavy profile suffered more than others. In 2012, Linn Energy LLC (NASDAQ:LINE) was forced to write off about $440 million worth of its reserves because of sliding gas prices.

With natural gas prices back on the upswing today, those same companies that had written down their assets in 2012 can start to put them back on the books. This is why Range Resources Corp. (NYSE:RRC) and Cabot Oil & Gas Corporation (NYSE:COG) both have reserve replacement costs below $6.25, one-fifth of the industry average. Both of these companies have very natural gas-heavy portfolios, so as gas prices go back up, they can put these assets back on their books without spending any money on further exploration or acquisitions.

What a Fool believes
In 2013, capital expenditures for E&P are expected to be higher than they were in 2012, but because we can’t exactly predict the movements of oil prices, it will be difficult to determine what 2013 reserve replacement costs will look like. One indicator that reserve replacement costs may remain high is that integrated majors such as BP plc (ADR) (NYSE:BP) and Royal Dutch Shell plc (ADR) (NYSE:RDS.A) are some of the biggest spenders when it comes to exploration and production. These two have reserve replacement costs well above the industry average, which will skew replacement costs higher for everyone.

The article 1 Obscure Factor That Dictates the Future Price of Oil originally appeared on and is written by Tyler Crowe.

Fool contributor Tyler Crowe owns shares of Linn Energy. You can follow Tyler at under the handle TMFDirtyBird, on Google +, or on Twitter @TylerCroweFool.The Motley Fool recommends Range Resources.

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