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Oil prices in 2014-16 are $40-$50, which is lower than shale’s “all-in” cost ($60-$70), because of another basic economic concept: sunk costs.

If you expect your well will cost more than you’ll get per barrel, you don’t drill. More importantly, investors don’t fund it. However, in 2012-2014, shale wells were financed assuming prices won’t fall below $85 (more on the source of this number in the next section).
A year or two later, we have more wells ready to produce oil than the market can handle. The catch is that about a third of the cost of shale oil production is in drilling the well. This is a fixed (or sunk) cost. You pay it even if you won’t pump out a single barrel. In the short run, shale oil producers have a difficult choice: pump expecting a loss or don’t pump at all and lose even more. The choice depends of course on the price. Eventually, the price drops so that enough producers are convinced to give up (or just can’t pay their bills and go bankrupt).
Some of the high-cost producers are in the same boat. They already paid very high fixed costs, and now they can either produce oil and cut their losses, or stop producing and lose even more.

In practice, many considerations, such as financial structure, salvage value, firm structure, etc. also affect each producer’s decision. The market is in correction mode, and the details are too specific to model or predict. Roughly speaking, most producers with a drilled well will sell as long as the price is above their variable cost — that is, act as if they got the well for free. Because the variable cost for most shale and some high-cost wells is between $30 to $50, the following figure illustrates the last two years’ situation with too many drilled wells. The additional shift at low prices is for accuracy and explained in the next section.

Equilibrium2015

Supply essentially depends only on variable cost and price drops accordingly. Demand increases but just barely. Most shale suppliers still sell. They won’t cover their entire drilling costs, and definitely not make any profit, but they are doing the best they can in a difficult situation. Some suppliers just close their wells, completely defaulting on any debt. Some have deep enough pockets to wait in hope that prices will bounce back.
In the long run, the drilled wells will dry out, and new ones won’t be drilled unless price will rise above their all-in cost per barrel, returning to the figure in the previous section.

To summarize this part: With too much shale oil wells already drilled, the price drops below the “all-in” cost per barrel and, roughly, reflects only the cost of production from a well that was already drilled, which seems to be around $45.

Next:
Oil 2016 Where’s OPEC?
Oil 2016 Expectations

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Oil 2016 Overview
Why $65-$70 should be the new normal

One Response to “Oil Prices 2016: Sunk costs explain current prices”

  1. Oil 2016: $50-$60/barrel will be the new normal ? | Guy Arie

    […] next parts discuss: Why is price today lower than shale’s “all-in” cost? Why isn’t OPEC raising prices? What I think will happen […]

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