How Far Can Costs Fall?

Back in February, I wrote about how I expected upstream capital costs to fall as the oil price collapsed,  and then in July, I wrote again with an update on how the IHS UCCI (Upstream Capital Costs Index) had actually fallen up to that time.

Well, this is a further update on that, mixed in with a bit of speculation on how far the fall in costs might go before we touch bottom. 

This is how the updated chart looks, I have left in the points I speculated might result from this oil price fall when I first looked at the numbers back in February and I have also highlighted in red the new data since then. Costs have come down quicker than I thought but then prices went lower than I hoped and stayed down longer than I feared. Some might say prices have been lower for longer, to which I say: enough already.

IHS UCCI Index, deflated by US BLS CPI & Brent Oil Price

IHS UCCI Index, deflated by US BLS CPI & Brent Oil Price

The index is not the raw index that IHS publishes, you can find that data here, I have deflated it by US CPI to take the background inflation rate out of the system. The virtue of doing that is that you can clearly see that there is a real hard floor to how far this index could possibly fall. We are down by about 20% relative to the average costs oil companies were paying back in 2014, the total fall can't be more than 40%, or we will have costs that are lower than we have seen for nearly twenty years, and to get that low it seems oil prices would need to be in the $30's.

The ramp up in costs that started in 2006 was driven by the need for more contracting capacity, people, rigs and vessels. A 70% jump in the cost of doing business in about two years was enough to drive investment into the oil service sector in a way we hadn't seen in years. Count all the brand new rigs, from super heavy duty jack-ups to sixth generation semisubmersibles that can drill in literally thousands of metres of water to the multitude of land rigs manufactured to drive forward the US Shale oil boom. Well, they are all built now and with projects being cancelled left right and centre the drilling contractors are hungry enough to rent them to you or me at a modest margin above the operating day rates

This is the oil service cycle and the capital destruction in this sector has only just begun, contractors with too much debt will go bankrupt, the more prudent ones will survive to reap the rewards when the cycle turns in their favour again. Check the balance sheet before investing, and be cautious about what the actual value of the tangible assets are.  Just because someone has spent $600 million on a heavy duty jack-up doesn't mean it is worth that value today.

So, we are probably two thirds of the way through the cycle, costs are down 20%, if prices stay "lower for longer" at about $50/bbl, there is maybe another 10% reduction to come, but much sooner than I had thought before – probably by 1Q 2016. This will cause consternation amongst oil service companies, however we are definitely in the phase of the cycle where oil companies with the nerve and the capital to commit to development projects will get their projects constructed and wells drilled for a bargain price.