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World economy

Relationship between oil prices and costs in the upstream industry

Extract from a research published on the VOXEU portal. Written by Alexander Naumov and Gerhard Toews (22 February 2016)
The recent dramatic decline in the price of oil runs counter to the argument that oil prices should be high because of the high costs. This column presents new evidence on this relationship. Using a representative global dataset, the authors find that upstream costs follow oil prices with a time lag. In particular, a sustained 10% increase in the price of oil leads to an increase in upstream activity of about 4%, and in this way triggers a sustained 3% increase in global upstream costs after a lag of one to two years.

Exploration and production (E&P) costs in the oil and gas industry increased by some 100% between 2000 and 2012 (IHS 2014). The higher cost of hydrocarbons production has previously been put forward in much of the economic literature as one of the primary reasons for structurally higher oil prices. However, the recent dramatic decline in the price of oil (the price of Dated Brent fell by over 50% between mid-July 2014 and early 2015) proved that the popular argument that oil prices could not fall because of high costs is incorrect.

Two questions about current oil price environment: New evidence

These developments raise two important questions relevant to the current oil price environment:

Q1. What is the true relationship between the price of oil and the cost of production per barrel?

Q2. And, what are the implications for the oil industry of the current price and cost environment?

On the supply side, when prices fall it is reasonable to expect that either more expensive production would be reduced to ensure profitability at new prices, or cost would fall, or some combination of the two. Indeed, cost inflation in the oil industry has stalled in the past few years and has started falling more recently as the industry adjusts to the new, lower oil price environment (see Figure 1). This holds implications for the industry as cost deflation could materially improve the profitability of projects. The prospects for a continuation of this trend are of particular relevance in an industry where project scales are typically large and long-term, and require considerable upfront capital investment.

Figure 1. Growth in three-year moving average of the real oil price and drilling costs (measured by the growth in the upstream capital cost index which is provided by IHS)

  
Continue reading on VOXEU: http://www.voxeu.org/article/oil-prices-and-costs-upstream-industry

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