Friday, 21 August 2015

A Capital-Driven Oil Glut?

Russell Gold of the Wall Street Journal reports today that even as oil prices sulk at $40 per barrel, oil producers just keep on pumping, even at what analysts believe to be losses. He doesn't mention it, but it is even worse in the oil sands (notice I did not say "tar sands") of Alberta, where their discounted price (because of the difficulty of transporting crude to market from Northern Alberta, and the reason for their desire to build Keystone XL) is more like $24 per barrel. Ouch, that hurts, eh?

A common explanation for the persistence in production, even at losses, is competition for market share. Saudi Arabia has actually increased production. Russell Gold, taking the same line as oil pundits, explains that this is Saudi Arabia trying to avoid losing Asian customers to competitors.

But there is another explanation. Saudi Arabia has always had low production costs -- somewhere in the neighborhood of $8-$10 per barrel. See the graphic below, from Agora Financial and Total S.A. It is true that most producers are now operating at a budget loss, but not a production loss.  The difference between the budget breakeven and the production breakeven is the difference between the orange blocks and the blue blocks below. As one can see, most producers are still selling their oil for more than the variable costs to produce it. The capital, most of the difference between orange and blue, is sunk. If you are a producer, you stop producing when your marginal price drops below your variable costs, not your total costs. Your capital is sunk; what are you going to do about it anyway?
Breakeven Costs For Selected Producers

This is the problem with a capital-intensive oil industry: that production continues even at loss levels. A heavy loading of capital makes the industry sluggish to change, and less responsive to price fluctuations. I guess that's a consequence of the capital-intensive oil industry. But that ignores the role that law and policy have played in contributing to this overcapitalization.

We have seen this before, actually. Fisheries have in the past been plagued by overcapitalization. Chronically poor fishers have gone out to fish out a depressed and overfished species just because they have a boat, and no other plausible use for it. It does not cost too much to pay the variable costs of fishing (gas, crew), so why not? What else are you going to do with that boat? That, in sum, as most ably researched by Jim Wilen, is an important cause of overfishing worldwide.

In the United States and Canada, we feed this overcapitalization, just as we fed, through fisheries policy, the overcapitalization of the fishing industry. The overcapitalization of oil and gas goes beyond the approximately $4 billion per year bestowed upon the oil and gas industry by the American taxpayer for over 100 years. All oil and gas exploration and drilling subsidies have to do is change the decision environment enough to convert an unprofitable situation to a profitable one. How inefficiently overcapitalized the oil and gas industries are, we do not know. Oil and gas subsidies are so old, there is no baseline.

So, oil continues to flow. And that's in significant part thanks to the American taxpayer.