A Double Bubble Drives Rising Oil Production Costs

The dramatic run-up in oil prices in recent years has been the subject of much attention and many headlines. What has received far less attention is another increase: the parallel rise in the costs of drilling for oil and building the infrastructure necessary to pump it out of the ground.

This surge in costs has a significant impact on the oil industry's ability to meet growing global demand for oil and the timing of developments. These rising prices figure directly into the price of crude oil, gasoline and other products.

Among investors and within the industry, this rise is a major preoccupation, and with good reason. For the increase is substantial. Project costs are up 68 percent on average since 2000. That is the conclusion of our new IHS/CERA Capital Cost Index. And most of the real increase has been in the last two years.
What's driving these cost increases? We call it the "double bubble."

Two kinds of goods and services are needed to transform an initial discovery into a producing oil field. The first are commodities like steel and general-purpose equipment such as generators that provide electricity in remote locations. The second kind is equipment specific to the oil industry, such as drilling rigs, along with the experienced workers who can run them. Both kinds of costs have taken big leaps in recent years. That's what we mean by the "double bubble."

The major oil price spikes of the mid-1970s and early 1980s were accompanied by global economic slowdowns. Not this time. The costs of raw materials and general-purpose equipment have risen sharply because of the strong global economy, led by Asia's expansion. As a result, the oil industry is competing with many others for raw materials.

Simple goods such as large-sized truck tires are in short supply. So are long-lead-time, complex goods like ship hulls. For example, hulls needed for oil tankers are in short supply in part because of high demand for container ships in Asia.

The costs of oil field equipment and labor are also up sharply. Higher oil prices mean producers have strong incentives to do more drilling. But the equipment required to drill is complex and expensive.

It isn't possible to increase the number of hundred-million-dollar drilling rigs or billion-dollar offshore platforms available for use overnight. As a result, oil producers are competing with each other for the same scarce pieces of equipment to develop their fields. Costs have naturally spiraled as a result.

Over the past four years alone, drilling rig rental rates have more than quadrupled on a global basis, with salaries for expert personnel experiencing 50 to 100 percent increases. Since drilling equipment and labor represent between 30 and 50 percent of overall costs, it is easy to see why project costs have risen so rapidly.

The service industry-the contractors that do much of the work for the oil producers-has gone through a major contraction over the last two decades. When oil prices ran up in the mid-1970s and early 1980s, oil-service companies expanded rapidly.

When prices then fell in the mid 1980s, these companies were stuck with a vast overhang of equipment that depressed the rates they could charge throughout the ensuring two decades. They were hit again with the oil price collapse at the end of the 1990s.

In the face of these two collapses, capacity in the service industry went through a substantial shrinking.
Adding to the constraints is a worldwide shortage of experienced people to run oil field equipment. It's almost as though a middle generation has disappeared from the service industry, a loss that will take years to overcome.

To quantify the impact of this double-bubble, CERA, in partnership with its parent company, IHS, tracks changes in the costs of oil and gas field project development in its Upstream Capital Cost Index, or UCCI. This IHS/CERA index demonstrates the aforementioned 68 percent leap in real costs since January 2000.

Escalating costs have the effect you would expect-they reduce drilling activity. Most oil companies fix their capital budgets one or two years in advance. When the money's spent, it's spent. In 2006, rising costs forced several small firms to terminate their drilling campaigns before year's end.

Cost pressures have led other companies to reduce the number and scope of projects that they undertake. In addition, higher costs have forced oil companies to reevaluate the projected profitability of projects they approved during the 2000 to 2004 period, to take into account the new price-cost tradeoff that is in place today.

In some cases, unplanned cost overruns encountered during early project phases have pushed some projects into the "no-longer-economic" column, and caused their backers to pull the plug.

Markets sort themselves out. A continuation of high oil prices will eventually bring more oil equipment and personnel on line. Some of it will come from non-traditional sources, like China and India. But lead times are inescapable.

Signals sent by higher oil prices take several years to register fully, since the response involves mobilizing equipment with price tags that can extend into billions of dollars.

Moreover, it takes time to attract skilled workers who require long periods of training. Expectations are important in the decisions that people make, whether in terms of a major commitment by an oil service company or the decision by a younger, technically trained person to go into the oil industry.

People do have more confidence today. However, even with relief on one of the bubbles, the other one will continue to have its impact.

Strong economic growth will keep the costs of raw materials and general-purpose equipment high. And that translates into higher oil field development costs.
About the IHS/CERA Upstream Capital Costs Index (UCCI)
The IHS/CERA Upstream Capital Costs Index is similar in concept to the Consumer Price Index (CPI) used to track the cost of a fixed basket of goods and services.

In the case of the UCCI, the items tracked are the equipment and services required to construct a fixed basket of oil and gas projects. The UCCI helps to track and to provide a better understanding of rapidly escalating costs in the energy industry.