Speculation is growing about how U.S. oil producers could react with oil trading around $40 per barrel. Various analysts and experts report daily about the challenges and options facing energy industry executives in a declining oil price environment. Some suggest large operators will be forced to cut dividends, while others suggest smaller companies will go bankrupt when oil price hedges roll off around October and banks cut credit lines. So the question remains, should oil producers simply stop producing and wait for oil prices to recover? The answer depends on the producer. (For more, see: Low Oil Prices Are Forcing Economies to Diversify.)

Big Oil Never Dies

Larger oil companies have more flexibility than smaller companies do, because economies of scale work in their favor. In a low oil price environment, large oil companies have the flexibility to postpone investment, redeploy resources to earn a higher return, sell assets, or buyout smaller competitors and increase market share. Rarely is it a strategy to simply close up shop and wait for better days. Large oil companies have multi-billion dollar projects that can span several decades to complete. They tend to employ an ultra long-term view of the market and publish price forecasts that span 20 years for a reason. Additionally, a certain level of production is necessary just to keep all the equipment operating properly.

Smaller companies, on the other hand, are often not able to ride through a complete price cycle for various reasons. Most often this is because they are too dependent on a high oil price to generate the cash flow needed for operating costs, investments, interest, taxes and so on. So for these guys, shutting down in a low oil price environment could make sense, but it depends on the cost structure of each company and where they sit on the cost curve

Shale’s Cost Curve

At the start of the shale revolution about five years ago, conventional thinking was that U.S. shale production would break even (costs = revenue) at around $80 per barrel. The chart below shows the International Energy Agency’s (IEA’s) global crude oil production cost curve. U.S. shale is clearly in the top quartile of production expense and significantly higher than the global average cost of production, which is a bit over $40 per barrel.

Rapid technological advances in shale production, however, are bringing costs down quickly. For example, CNBC reports that Eric Lee, Citigroup commodities strategist, claims shale oil muscled into the middle of the cost curve in the $30 to $70 cost level, but the price of producing a barrel of oil is still heading downward. They go onto report that in North Dakota's Bakken formation, the break-even cost has fallen into the $20 range in some counties, according to the state's Department of Mineral Resources. The Department also says that producing a barrel of oil would still be profitable at $24 in Dunn County, down from $29 last October. (For more, see: The Cost of Shale Oil Versus Conventional Oil.)

Reuters reports that costs vary from basin to basin, and shale’s average production cost across the U.S. is around $60 per barrel (on par with China or Kazakhstan), but is coming down according to Goldman Sachs (GS). Reuters goes on to say that the broker sees room for further cost declines in the three main shale basins in the United States: Eagle Ford, Bakken and Permian. If these materialize, shale could reach a $50 per barrel break even by 2020 (on par with conventional U.S. oil production).

Individual Company Cost Structure Matters

Elementary microeconomics theory says that firms operating in competitive environments such as the oil industry are price takers, where marginal revenue (MR) per barrel earned equals the price per barrel on the market. This same theory also says competitive firms will produce output at the specific level where marginal cost (MC) equals MR to maximize profit. The exact amount of profit is determined by the firm’s average cost (AC) to produce a barrel of oil, which itself is a function of economies of scale.

For example, in the diagram below we examine the profit level of an individual oil producer that can produce a barrel of oil for an average cost (AC) of $60 per barrel (the average cost of U.S. shale oil now) at a time when the price of oil is selling for $100. In this environment the company will increase production to the level (Q1) where marginal cost equals marginal revenue (MC=MR) to maximize profit. At this level of output the firm is earning a profit of $40 on each barrel produced. Total profit in the blue area is determined by multiplying the output volume in barrels (Q1) times the profit margin of $40 per barrel.

However, if oil prices collapse to $40 per barrel (the present price environment) then the picture is very different. The individual oil company is now operating at a loss, and is doing what is necessary to minimize losses rather than maximize profits. In this price environment, microeconomics theory says the company will still produce at a level (Q2) where MC=MR, but now the marginal revenue per barrel ($40) is below the average cost of production ($60), and the company is losing $20 on every barrel produced. Total losses in the orange area equal volume produced (Q2) multiplied by loss per barrel of $20. This is the smallest loss the company can have. Producing at any other output level (i.e. where MC does not equal MR) will only increase the area of the orange box and increase the total loss.

In this environment it could make sense for the oil company to shut down and wait for a better price environment, especially if production is not generating revenue to help cover fixed costs. In this scenario above, regardless of the production level, the company is losing money on every barrel produced. The best option would be to shut down and stop losing money. (For related reading, see: Will Shale Oil Companies Go Bankrupt?)

The other alternative is, of course, to reduce costs. If the oil company is able to drive down production costs through enhanced production techniques, greater efficiencies, or a combination of both, then this company can produce at a level of output (Q3) where MC=MR, allowing them to break even. As the diagram below shows, producing at a level other than Q3 will result in a loss per barrel of output because the average cost (AC) per barrel is always higher than the marginal revenue (MR) per barrel.

The Bottom Line

The U.S. shale industry is working hard to drive down production costs to avoid shutting down. Goldman Sachs says U.S. shale could reach a $50-per-barrel break even by 2020. In the current $40-per-barrel oil price environment this is still not good enough. In such circumstances, some operators are likely to scale back production or go bankrupt. This could be enough to get oil prices above the magic $50-per-barrel level and keep U.S. shale oil producers afloat.

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