Economics of Petroleum Extraction

Although certain methods of producing alternative energy sources have improved, most parts of the world still use fossil fuels, of which petroleum is a typical example. Although it is disturbing to think that most of our infrastructure depends on dwindling resources, we still have a long way to go before we need to worry about a world without oil. In this article, we will study the economics of oil extraction and how to make decisions in terms of production.

The variability of oil

One of the most misunderstood aspects of oil is its variability-including its deposition methods and sediments. Oil is classified according to two characteristics. The first classification is light or heavy; this is based on API gravity and is a measure of density. The second category is sweet or sour, which is a measure of the sulfur content in the oil. Although light sweet oil still needs further processing, it is easier to convert into high-value final products, such as fuel. Heavy acid oil requires more intensive processing and refining. Oil extracted from the tar sands (heavy acid oil) of Alberta is more expensive to refine than light sweet oil from Texas.

In addition to oil, there is also the nature of sediments. There is still an alarming amount of oil in the world, but it is getting harder and harder to extract. Some of these are due to the physical formation of deposits-such as distortions or in shale-and some challenges are clearly location issues, such as deposits in the sea bed. Many of these obstacles can be overcome through technology. For example, hydraulic fracturing of rocks (also known as hydraulic fracturing) is the main driving force for the recovery of oil production in the United States, as more and more shale formations have previously produced inaccessible oil and gas deposits.

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Mobile profit point

Due to technological progress, changes in oil, and differences in the quality of mineral deposits, companies that extract oil do not have a single point of profit. The price of Brent crude oil is often used as the benchmark price of oil. It represents an average light sweet oil, so countries are priced according to the price of Brent crude oil and discounted according to the degree of deviation of its product from the ideal light sweet oil. Therefore, the most important thing is that some countries have lower prices per barrel because their products are neither light nor sweet.

When you look at the cost of extracting a barrel of oil for different companies and different countries, the variance increases. Assuming that the price of Brent crude oil is US$80, there will be some companies that are very profitable because their cost per barrel may be US$20. There will also be some companies that lose money because the mining cost is US$83 per barrel. In a perfectly rational economy, as prices approach the break-even point, all loss-making companies will stop or reduce production, but this will not happen.

Uneconomical production

Because holding land for exploration is expensive, and drilling is sometimes a condition of the contract, the company will drill the deposit and keep the oil well running even if the price is low. Like any resource extraction industry, production cannot get what you pay for. When you reduce production, labor requirements, equipment costs, leases, and many other expenses will not disappear. Even if some costs, such as labor, can be eliminated, they will become larger expenses in the long run, because when prices rise, the company must hire everyone again—all other companies are also hiring in the suddenly competitive labor market.

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Instead, oil companies usually expect higher prices in the future and hope to get a return from a well within a few years, so month-to-month price fluctuations are not their main consideration. Large oil companies have strong balance sheets that can help them tide over difficulties. They also own various wells, including conventional and unconventional deposits. Smaller companies tend to be regionally concentrated, and there is much less diversity in their portfolios. These companies have been struggling during a period of long-term price declines. Similarly, countries like Canada with large reserves of heavy oil will see profits disappear with low oil prices, because their cost per barrel requires a higher per barrel price than OPEC and other competing countries to continue production.

From the exploration phase, seismic and land costs, to the mining phase, drilling costs and labor costs, the oil industry has only a few methods to control costs. One is to integrate upstream, midstream and downstream production. This means that a company has the ability to do anything-from exploration to extraction to refining. This helps control costs in some ways, but it means that the company is not professional or focused on being good at something. Another way is to encourage more technological advances to make challenging deposits cheaper. In the long run, the latter seems to have the most potential, although the company will still consider vertical acquisitions while waiting for further technological breakthroughs.

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The last economic consideration—it should be the first in most industries—is the issue of supply. There is no doubt that there is a lot of oil there, but it is limited. Unfortunately, we will never have an exact number for us to find the right price for fuel that can keep the world fair. Instead, oil prices are based on current supply and possible supply in the near future, based on projected production. Therefore, when companies continue to produce during a period of oversupply, oil prices continue to weaken, and companies with the least economic deposits begin to fall into trouble. For example, the increase in oil production in the United States has made oil prices much lower because all previous supplies have not entered the market.

Bottom line

There is no doubt that oil extraction follows the law of supply and demand. The tricky part is that the cost of bringing a barrel of oil to market varies greatly. In addition, uneconomic products and oversupply are risks that oil companies and their investors often face. Of course, this is why investors are also attracted to this industry. If you follow some basic factors and calculate the cost per barrel of some smaller companies, it is possible to profit from fluctuations in benchmark oil prices because uneconomical deposits become profitable. After all, the overall economic fact of oil extraction is that there is money in it—whether for the mining companies or their investors.


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