Thanks. Unfortunately, in re-reading what I wrote, I realized that I made dozens of typos.
The energy industry is incredibly complex on one hand and simple on another. I came into it with a finance background and highly respect the geologists, engineers, and others with technical backgrounds that bring the real value to the industry. I am most knowledgable about the domestic E&P industry with a major focus on the small and medium sized public and private companies. I do spend a decent amount of time in private research on the other areas that are not my primary job focus.
However, to clarify, most of the costs of oil are up-front costs. If the government is clever, it will charge royalites that hike significantly with the price of a barrel of oil. But yes, most of the money made selling that barrel of oil noadays from a simple oil well is earnings. I can’t say profit because if the oil company wants to be around in 20 years, they have to spend some of that.
If the oil well was drilled 30 years ago and still producing, that’s just gravy. Sorry, but production, transport and support costs have NOT gone up (or down) as wildly as the price of oil. It certainly does not double or cut in half in a few months.
The problem is this (just ask BP!) - to replace the oil they get “for free” the oil companies have to find new oil. Think of oil as like movie-making. Once that film is in the can (or whatever they do nowadays) it just makes money. All the major costs were before it was finished and in theatres. But if you want to make close to the same amount of money next year, you have to invest in another one. Same with oil wells; explore to figure out where the oil should be, drill to see if it’s there, hope an accident does not cost you a few billion or more… Drilling may ahve been a matter of driving a drill onto a field 30 years ago, but now the big wells are a thousand feet underwater, you start with a rig that is one of the more expensive"boats" in the world, and you have to pay enormous slaries and support costs, helicopter people on and off the rig, and I bet now, pay pretty good insurance premiums. That’s where the majority of their “profits” go to now.
because the price of oil bounes up and down, the oil companies have to be careful. If there’s a good possibility that oil will sell for $70 in the next year, don’t go hog-wild on drilling wells that need to make $100/bbl to pay back the construction costs. So then, if oil does hit $110, then these are good times for the oil companies. If it looks like the price is here to stay - they will spend more of it on those extra-expensive wells. It’s a gamble and a guess.
And “why should the oil company sell it for $90 a barrel if they get it for free”? It’s called “the market”. If all it cost me was $500 in cattle feed, why should I sell my cow to you for $600 when the steakhouse across town is offering $2,000? If you don’t buy the oil at $90/bbl, some Indian or Chinese guy will. And what that means, is that the oil coming from a mile under the Gulf of Mexico, that DOES cost $90/bbl when you spread the drilling cost over the well production for the next 10 years - that oil will make a profit too. If for some reason they cannot make enough to pay for floating deep-sea drills, then a few years from now, they will be running out of oil and the price will go back up. Supply and demand.
There was a very similar thread just recently. I’m not going to rehash it.
Just ask: if oil companies decided to simply sell oil for $50 a barrel (or whatever their lowest, barely-profitable price is), are you confident that you’ll be able to buy gasoline tomorrow? How about next week? How about in a month?
Prices move on it in much the same way that stocks go up and down in price - that is, based on how many people are buying and selling, and at what prcies they are placing their bids and offers in.
There are 2 types of players in commodities markets: hedgers and speculators. Hedgers are buying or selling to lock in price or volume (well, both really), while speculators are trying to make a buck.
So oil prices tend to go up when supply decreases or demand increases. Demand tends to increase when the economy improves (more industrial work, shipping, etc). Supply is actually more about perceived risk and reserves. So when reserve estimates are adjusted, it’s like a supply spike. Supply can also be affected by things like rig-switching, where big exploration companies may actually switch rigs back and forth from natural gas to oil or vice versa depending on the relative profitability of either operation. Finally (for this post at least) when traders see increased risk around the supply (like political instability in the Middle East) they treat it like a decrease in supply, because if you think of supply as the expected value of a probabilistic array of potential supply possibilities, then current events can change the calculus, increasing the probability of a low supply future and thetrefore reducing the expected value of future supply levels.
Fear. The price had been driven up by speculation on the future price, and increasing unrest in the Middle East created concern that the future price would rise even higher. Investors threw huge piles of money at the idea of “what it’ll take to fill the tanks next time.” But as US elections neared, speculators began to pull out, sensing that the good times would soon end (this is the “fear” part). By November, the Texas oilman had left the White House, and things almost became normal again. Of course, right about then Middle Eastern suppliers, seeking to protect their interests, decided to cut output again, restricting the supply and forcing the price per barrel upward again, toppling the first domino to lead us to where we are today.
Yes, my one-line answer was not very specific, and was more of an attempt to make a funny. I hope this is more satisfactory.
It would be instructive to take a look at the annual report from a company like Exxon Mobil
warning pdf http://www.exxonmobil.com/Corporate/Files/news_pubs_fo_2010.pdf
A few things should be noted -
As Longhorn dave pointed out the company is divided into upstream (oil exploration and production) and downstream (refining and gasoline sales)
Exxon as a whole had sales of 370 billion net income of 30 billion
The upstream side sold 86 billion dollars worth of oil and natural gas.
To do that they had to spend 13.2 billion in production expenses (15%)
2.2 billion in exploration expenses.
Then a further 11.6 billion in depreciation and depletion. This depreciation can be thought of as a long tern loan payment for all of those expensive production facilities. So whilst the drilling and production facilities are an up front cost - they get depreciated out over the useable life of the asset (basically a loan) and so the on going production has to cover those loan payments. That chews up another 13%. (lets pretend depletion is a form of depreciation for the moment to keep things simple)
The next 35 billion (40%) is taken up in royalties and taxes.
So no we have about 62billion of the 86 billion revenue being taken up in ongoing expenses associated with the ongoing production so I don’t think it is reasonable to say once the initial costs of drilling are done with, everything is free money after that.
Sure when you finally fully depreciate the production assets and the wells are still producing you get maybe 10% boost to revenue. However the upstream made 24billion profit, which isn’t too bad
Now on the Downstream side they have earnings of 3.5 billion (chemicals made a further 5 billion) To make that 3.5 billion profit, in addition to the refining expenses and depreciation they had to purchase 198 billion dollars of crude.
Obviously that is far more than their downstream segment produced, so they had to go to the market and buy a lot of crude oil at what ever price they could negotiate (spot , futures, auction plenty of places to buy crude but it will be closely linked to the spot price)
So the downstream side has significant fixed costs, the oil isn’t free once the well is drilled and the downstream side sells to anyone at the market rate.
The upstream side has to buy a lot more oil than downstream division can produce, and may not buy it from their downstream division and have to buy at the market rate.
You could ask the downstream to sell to upstream at a reduced price so upstream can sell cheaper gasoline, however upstream will sell at market rate and so you simple move the profit from downstream to upstream.
Yes, very little in business is “seat of the pants”. A resource like an oilfield or gold mine is carefully studied and calculated by anal bean-counters.
First, geological surveys (gelogical sonar soundings, etc.) try to estimate the exact extent of the deposit; then exploratory holes tell you how good the geologists’ guesses were. Then they model out the cost of building the infrastructure to extract the oil. Then, based on industry expert guesses of the selling price of the product over the life of the resource, they can say whether they can even make a profit.
If it looks profitable, they go ahead and build the oil field, pipelines, roads, rigs, etc. required. This costs money before much oil is even flowing. Think of this as like a mortgage on a house. They will spend X million dollars to recover Y billion barrels over Z years; if (price of oil) times (Y) is high enough, they make X. If the price is higher, the rest is profit. If not, well, better hope you have other cheaper wells that help pay off the debt.
TO “write off costs” (depreciation) of developing a well, it has to be matched up to money from the product sold from there unless you are taking an “extraordinary write down”, accountant speak for “someone screwed up big-time”.
So yes, if they estimated the ongoing selling price was $70/bbl and it’s $110, a lot of that is gravy. But if the world selling price is $110, it means that’s because nobody can find enough oil any more at $70. The next wells you have to drill if you are lucky, will only cost $110 a barrel. If the price falls, put those $110 plans on hold, and there is less oil on the market. It’s a matter of balance.
Thanks LonghornDave. Good explanation. But I’m still not thrilled about gas going up because someone wants to make more money and damn the economy. I miss the old days when there were a lot less greedy people. Sigh.
At the margins it does because the suppliers of oil-rig equipment and oilfield services also get to enjoy speculation-driven price hikes, which costs the oil co. more for each incremental barrel.