(John Kemp is a Reuters market analyst. The views expressed are
* Chart 1: tmsnrt.rs/2midNVb
* Chart 2: tmsnrt.rs/2n1VQIz
* Chart 3: tmsnrt.rs/2n1yfb8
* Chart 4: tmsnrt.rs/2mi66hG
By John Kemp
LONDON, March 7 Oil industry costs are
notoriously pro-cyclical, which is one of the main reasons for
the pattern of boom and bust that has afflicted in the industry
from the beginning.
The cost of everything from skilled and unskilled labour to
engineering contracts, field services, raw materials, equipment,
spare parts and rig hire tends to rise and fall with price of
During a boom, prices for labour and equipment escalate
rapidly, pushing up the breakeven cost of finding and developing
new deposits, and driving the market-clearing price of oil even
In a bust, labour and equipment prices fall sharply, pushing
down breakeven costs and helping sustain production at an
unexpectedly high level despite the plunge in oil prices.
Pro-cyclical costs include everything from skilled petroleum
engineers and unskilled labour, to fuel, rig hire and drill
Pro-cyclical costs apply to a host of other services in the
supply chain including catering, accommodation and
And in the broadest sense, pro-cyclical costs include taxes,
royalties and other government charges on exploration and
In a downturn, governments cut tax and royalty rates, and
offer regulatory relief, to attract investment, only to increase
them again during a boom to capture windfall gains.
The pro-cyclical behaviour of costs is a classic example of
positive feedback which amplifies the boom-bust cycle in oil
prices and delays the process of adjustment following a supply
or demand shock.
Pro-cyclical costs ensure crude supply tends to respond
sluggishly to even a big change in oil prices ("Oil prices:
volatility and prediction", Reuters, 2016).
Rising costs hampered efforts to boost oil production during
the 2004-2014 boom; more recently falling costs have hampered
efforts to cut output and rebalance the market during the slump.
The best symbol of the industry's cost cycle is the
provision of free fruit to employees at BP's giant
Sunbury campus near London ("Operational excellence becomes oil
industry watchword (again)", Reuters, 2015).
Free fruit tends to be axed when oil prices fall, only to
return when prices rise, as the company's priority switches
between cost control and employee morale.
Free fruit is a trivial example but multiplied up by
thousands of items in the supply chain it shows how the entire
cost structure can rise and fall by tens of billions of dollars
STRUCTURAL v CYCLICAL
The recent slump in oil prices has been accompanied by
brutal cost-cutting across the entire oil and gas industry.
U.S. drilling companies cut their prices by a third between
March 2014 and January 2017, according to the U.S. Bureau of
Labor Statistics (tmsnrt.rs/2midNVb).
Cheaper prices for everything from drilling contracts to
labour, fracking sand, pressure pumping and freight have helped
lower breakeven prices for U.S. shale producers.
Similar cost reduction strategies have been implemented by
state-owned oil companies such as Saudi Aramco as well as major
privately-owned companies such as Exxon, Shell
As a result, breakeven prices for the entire oil industry
from OPEC to shale and offshore producers have tumbled since
The critical question is how much of this reduction is
structural and permanent versus how much is cyclical and will be
reversed as oil prices start to recover.
Oil industry leaders insist this time will be different and
that they will maintain tight control over expenses even as oil
Some of the efficiency improvements wrung from the supply
chain during the slump are likely to prove enduring.
Standardisation of equipment and procedures, as well as
better targeting of production zones, longer lateral sections in
wells, and multilayer wells are improvements that will not be
Past experience indicates, however, that costs have a large
cyclical component and will start to increase as producers shift
from contraction to expansion.
Changes in drilling costs, for example, have been closely
associated with changes in the number of rigs drilling for oil
U.S. drilling prices were down 7 percent in January 2017
compared with January 2016, according to preliminary data from
the Bureau of Labor Statistics.
But the year-on-year decline has progressively slowed from
as much as 24 percent in November 2015, in an indication
drilling costs are stabilising (tmsnrt.rs/2n1VQIz).
By early March 2017, the number of rigs drilling for oil and
gas in the United States had risen by almost 60 percent compared
with the same period a year ago (tmsnrt.rs/2n1yfb8).
As the rig count continues to climb, drilling prices should
stabilise, then begin to rise, based on past experience (tmsnrt.rs/2mi66hG).
Fracking sand prices have already surged, owing to a
combination of poor weather, supply problems and a big increase
Oilfield service company leaders have warned contract prices
have been cut to unsustainably low levels and must increase, at
least in the United States.
For the time being, oil industry buyers will continue to
hold the upper hand in negotiations, but the balance will shift
as the industry returns to expansion mode.
And as the balance of pricing power shifts, costs will begin
to escalate, and the industry's estimated breakevens are also
likely to increase.
Pro-cyclical costs are a fundamental rather than incidental
feature of the supply chain and there is no reason to believe
that will change.
Appeals for cost discipline may work in the short term, but
in the medium term they are no more likely to be successful than
in the past.
(Editing by David Evans)