Oil investors are behind the curve. Many assume that the cost of pulling oil out of the ground is relatively static – or at least changes slowly. Reality is slipperier. Rethinking the way the “cost curve” works may help explain recent gyrations in oil and other commodity markets.
Miners, drillers and investors love cost curves because of their attractive simplicity. Draw a chart with the various producers lined up on the horizontal, in order of how cheaply they can get supply out. In the case of oil, to the far left are the cheapest Middle Eastern fields; on the right, the most expensive deepwater and oil sands. On the vertical is the cost of production.
The result is an upward-sloping curve. As the price rises or falls, suppliers become economical, or not. Analysts then guess how supply will pan out. Trouble is, the cost curve used to be seen as mostly fixed over the short to medium term. The recent surge in U.S. shale oil production means the old rules may no longer apply.
Production of U.S. crude has jumped 50 percent since 2008, driven by a dramatic increase in the volume of oil produced from shale rock. Breakeven prices are also falling rapidly as drillers grow more experienced with new production methods. Four years ago, it took EOG Resources, one of the more efficient drillers, an average of 22 days to complete a new well in the Eagle Ford shale in Texas. Today it takes about a week.
Shale drilling, in which producers dig thousands of small wells in quick succession, offers more opportunities for improvement than conventional oil. Traditional cost-curve analysis says that when prices make a producer uneconomical, they will stop drilling. Instead, it is as if they keep going so that practice makes them cheap enough to stay in business. Meanwhile, labour costs have fallen and producers have found new ways to squeeze their own suppliers.
The disconnect between analysts’ rigid cost curves and more fluid reality may explain why markets were caught badly off guard by oil’s collapse. Copper and iron ore are other markets where analysts have had to accept that producers don’t always behave as the curve predicts. Until a new model appears, the commodity markets will keep serving up new surprises.