Beginner’s Guide To Upstream Economics In The Crude Oil Industry

Upstream Fundamentals of the Oil Market

Understanding the fundamentals and economic nuances of the energy market and oil supply chain helps lay a firm, data-based foundation for an effective energy management strategy. Upstream market fundamentals refer to the entire process leading up to the production of crude oil and natural gas including exploration, drilling, and oil refining. This particular concept has a proven history of being the most profitable across all segments of the industry. In the coming sections, the regulatory and operational process of oil drilling, oil and gas formation, and some of the economic variables oil companies are cognizant of are discussed in greater detail.

Obtaining the Rights to Drill

Prior to physically establishing a drill site and beginning operations, oil companies first need to obtain mineral rights to the acreage, which are primarily owned by Federal governments. Mineral leasing, a more straightforward approach to legally extracting oil and natural gas, is a negotiated agreement that typically includes a cost per acre with a fixed royalty agreement. The second alternative to obtaining legal access to mineral development, which has recently become more prevalent in the industry, is a production sharing agreement (PSA). This method sets contractual terms that burden all financial risk associated with oil extraction on the driller, insulating the affiliated government. Under this approach, the cost of capital is covered by earnings achieved from the generated sales revenue and a percentage of remaining profits are then repaid to the mineral owner or government. This sort of agreement is often used in under-developed nations that lack the technology and infrastructure needed to facilitate similar industrial operations. Because the mineral owner has essentially nothing to lose and everything to gain financially, this method is attractive. A mineral lease is ultimately the first step for an oil producer to determine the financial structure of their upcoming operations.

Exploration

Estimated ultimately recoverable resources (EUR) is a metric used by oil producers to dictate the economic feasibility of establishing a potential drill site and plays a large role in determining optimal geographies to search for virgin oil territory. EUR predicts the total amount of natural gas and oil that will ever be recovered, produced, and therefore consumed further down the oil supply chain. EURs break down into multiple categories, including:

• Proven reserves: strong potential for earnings potential
• Probable reserves: greater than 50 percent chance for earnings potential
• Possible reserves: less than 50 percent chance for earnings potential
• Undiscoverable: “yet to find”

Within each category of EUR, oil companies calculate a recovery factor to determine the ratio of recoverable oil or natural gas relative to the estimated reserves in each region. Increasing the recovery factor is the primary objective for oil drillers, though this changes with time based on operating history, technological advancements, and overall drilling economics. When discussing the “yet to find” reserves, oil companies and petroleum engineers estimate the cost of developing a discovery operation and predicting how long it would take to drain a well of all its oil and natural gas resources. Like conventional business fundamentals, the substantial capital expenditure necessary to accelerate such operations is offset by the profits achieved from oil or natural gas sales.  This in mind, it is important to note that oil companies are not trying to get the last barrel of oil or natural gas out of the ground, but rather aiming to extract the last profitable barrel.

After targeting a potential well, drillers establish a discovery well to reach the heart of the oil-rich deposits where seven additional layers of protective sealant create a barrier to prevent oil-rich material from penetrating the water table. If successful, oil producers establish additional wells to discover the boundaries of the oil formation, with cost efficiency of key importance throughout the driller operation.

Oil and Gas Formation

The United States and OPEC leaders Saudi Arabia and Russia, the top three oil producing nations in the world are key actors driving the current global oil supply. To achieve such high levels of production, oil drillers in these geographies utilize similar drilling techniques to optimize drilling efficiency in a given region. In its simplest form, oil companies can drill either vertically or horizontally to find oil-rich source rocks that contain hydro-carbon molecules. In recent history, horizontal drilling predominates to maximize available surface area with a single oil rig. The deeper a well is drilled, the more the Earth’s core temperature increases, ultimately liquifying the hydro-carbon molecules that then escape out of the rock and converts into refinable crude oil. The pores, located between grains of sand and source rock, contain the oil and natural gas molecules that drillers target. Once drilled, the permeability of the material allows the natural gas and oil molecules to escape upward due to lighter density levels. If nothing blocks the molecules from ascending, they will eventually reach Earth’s surface.

Shale and Tight Oil

Technological advancements enable the efficient extraction of oil-rich shale material, increasing its production exponentially in recent years. Shale, located above the natural gas and oil layer, has low permeability. This means drillers are unable to access all the oil within a given deposit. Leveraging a process commonly known as fracking, drillers inject high-pressure liquids into oil/gas-rich material to create permeability within the shale for oil companies to maximize drilling yield. The chart below illustrates the disposition of US crude production since 2012, highlighting the emergence of shale output in recent years.

Economics of Drilling

Oil companies incur multiple costs when conducting drilling operations. Depth is the ultimate driver of total cost, and factors into the vertical and horizontal aspects of cost configuration. Simply put, depth of the well equates to drilling dollars, as the length of the well multiplied by the cost per foot results in the total cost to drill. When incorporating the horizontal dimension of horizontal wells, considering the length of the lateral well and the respective cost per additional foot is crucial. The sum of these two variables determines the total completion cost of drilling a well for an oil company.

When considering offshore wells, operating costs increase by a multiple of 3-4 because of the drastic increase in required drill depth and added complexities associated with offshore operations. Some offshore rigs, however, are eligible for lease and original rig operators charge fees based on a day rate. As oil prices rise in the market, so do day rates, further exemplifying the value of serviceable drilling infrastructure. Increasing production quantities and decreasing rig counts are evidence of the growing efficiency of technologically advanced rigs, requiring fewer rigs to satisfy demand. Moreover, as oil prices rise, more oil companies gain interest in establishing operations to take advantage of the higher price points of sellable crude oil. The chart below shows the relationship between rig counts and oil prices, revealing a strong correlation between the two metrics.

In today’s advanced drilling environment, horizontal drilling is usually the chosen means of extraction due to efficiency gains that offset the cost premium explained above. Moreover, shale layers that attract major oil companies require advanced means of extraction, primarily horizontal fracking, to create permeable shale that are later converted into sellable product.

The map below highlights the primary oil players in the United States, calling out their most current production quantities and breakeven prices.

Other economic variables that influence production costs and the total breakeven price of drilling projects include:

• Service sector cost deflation
• Project redesign
• Efficiency gains
• Improved capital allocation
• Currency devaluation
• Tax structures

Fortunately for drillers active in the shale and tight oil space, the North American shale breakeven price continues to trend downward as improved well performance and lower drilling and completion costs make the shale market an attractive option for oil majors in the United States.

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