Reserves don’t matter as much as the cost of getting the oil out the ground

Oil and gas reserves don’t much matter any more. You arrive at that conclusion after listening to Royal Dutch Shell’s strategy presentation in which the company this week finally allowed investors to have a look at the gauge on its fuel tank.

Reserves on their own don’t matter. What matters is the cost of getting the reserves. Shell’s investment per barrel of oil and gas has increased fourfold in just three years, a period during which the oil multinational’s output has not increased. The company displayed another chart showing the average spending of the big oil companies. Per barrel of hydrocarbons, spending rates were pretty static during the 1990s at between $5 (U.S.) and $6 a barrel. In 2003, the rate of investment began to escalate and is now shooting higher, rising at an alarming pace. Last year, the average investment per barrel was just shy of $15.
On top of that, you must load the daily cost of operating wells and pipelines and the colossal overhead of running a big oil company. Moreover, we know that the $14-to-$15-a-barrel average investment is just an average and it is rising. Every new barrel is a more expensive barrel because in order to get the oil, Western oil companies must push the technology envelope even further, into deeper water and more heavy oil, such as Alberta’s oil sands. The only giant discovery of the past decade has been Tupi, the eight-billion-barrel oil field discovered offshore of Brazil in water depths of two kilometres.

Technology is expensive, but it is the materials, manpower and energy cost that hurts. Shell estimates that the operating cost per barrel of the Athabasca project is between $20 and $25, of which a third is energy – the cost of natural gas used to heat water to extract bitumen from sand. Shell won’t reveal the capital cost of an Alberta oil sands barrel, but it is certainly a lot higher than its average of $7 and likely near the top rate of $15 to $20.

The point of all this is that it helps to explain the current $105-a-barrel oil price and its extraordinary resilience to weakening demand signals. Oil price speculators know that the U.S. is heading into recession and they can see the signs of weakening gasoline consumption, but they are maintaining long positions in West Texas Intermediate and Brent, the benchmark futures contracts. If they remain bullish, it is not because they believe oil is running out but because they believe the cost of producing the marginal barrel will remain high and will continue to rise, regardless of a U.S. recession.

That doesn’t mean the oil price won’t dip or suffer a short-term plunge. There will be temporary gluts of gasoline as America works through its credit crunch, but it is the cost of producing extra barrels and the price of alternatives such as biofuels that will determine what we pay for oil in 2012.

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