Oil and the Great Deception - Part Two

"It is getting much more expensive to find Oil these days."

While it is true that it is getting more expensive to find oil, one has to examine whether that increase is of a permanent nature as many argue. The reason that it is getting more expensive to find oil is mainly because service, drilling and other costs are sharply increasing. While this may seem like a circular argument at first, my intention is to demonstrate that the cost of finding oil is rising to a cyclical peak, and that it is not secular in nature.

All the data shows that the cost of finding Oil is rising sharply. Why? Very simply because of a self reinforcing boom in exploration and production, which led to a capacity shortage in oil services and drilling as demand for rigs and services increased faster than supply. Other costs, such as for steel, or the acquisition of existing producing properties has also increased for the same reason, a shortfall in capacity in various sectors, or an imbalance between supply and demand.

It is therefore, a cyclical increase in the cost of finding oil, not a secular or systemic one. If the exploration and production sector cuts drilling significantly, say 30-40%, then extra capacity will flood the oil services and drilling market leading to a plunge in prices and then the cost of finding and developing oil will decrease.

This argument is supported by data from many sources.

The Energy Information Administration (EIA) study entitled Oil and Gas Lease Equipment and Operating Costs, which has data from 1976 to 2006. The chart below demonstrates the cyclical nature of oil services.



Look at the green line back in the early 1980's when the cost index fell from 123.3 to 82.6 in just five years. This study does not include drilling and completion costs. If you included these, the cyclicality would be even more pronounced. Also, this data is only through 2006. The green line currently is significantly higher.

The same trend can be seen in the HS/Cambridge Energy Research Associates (CERA) Upstream Capital Costs Index. The latest monthly release from May 2008, shows that "the latest increase raised the index to 210 points from its previous high of 198. The values for the UCCI are indexed to the year 2000, meaning that a piece of equipment that cost $100 in 2000 would cost $210 today."



This index tracks "the construction of a geographically diversified portfolio of twenty eight onshore, offshore, pipeline and LNG projects."

As an example, five years ago, it may have cost $ 250,000 per day to lease a rig to explore deep offshore. Today, if you can find one it may cost you $800,000 per day. According to Cambridge Energy Research Associates (CERA), dayrates can be 30-40% of the cost of an offshore well.

So in a sense, it is getting more expensive to find oil, but people who say this are either ignorant of the reason why or being disingenuous to further their investment case. Bullish investors use this as an excuse to justify that oil prices have to stay higher because the cost to find oil is higher.

Please understand that I am not predicting that this these various cost indices will turn down soon, only stating for the record that they can turn down, and have turned down precipitously in the past once capacity catches up to demand.

If you argue that the cost of finding Oil is permanently higher, then you are accepting the argument that industries that have been intensely or even pathologically cyclical for 100 years are no longer subject to those conditions. This is a bold statement to make and you better be damn sure you are right.

Please read my earlier post of the fallacy of demand growth in emerging markets.