Thursday, April 30, 2009 2 comments ++[ CLICK TO COMMENT ]++

Commodity marginal cost of production tends to decline decline

I guess this blog is more about quantity rather than quality :) On a blogging roll in the last few days... Anyway...

One of the difficulties for commodity investors—a point often ignored during bullish times—is that the marginal cost of production can decline over time. In fact, this is what tends to happen for most commodities. The vast majority of commodities seem to deflate over time (I need to check this but that's my impression). I want to illustrate this point by referring to what Talisman (TLM), one of Canada's largest oil & gas E&P companies, is saying about natural gas:

Until recently, energy producers have found it too expensive to tap into the huge reserves of natural gas trapped in various shale formations. But as technology has improved, Talisman and several Canadian and U.S. firms have been flocking to the regions.

"The gas price at which our unconventional business remains profitable is coming down all the time. We can see ways to ensure profitability down to $4 gas prices, but we're not going to stop there," Mr. Manzoni [CEO] said.

CEOs are often wildly bullish about future prospects so who knows how correct this will turn out to be. Nevertheless, it is quite remarkable that Talisman thinks it can be profitable at $4/MMBtu with shale gas. Not many would have imagined a few years ago that you can be profitable at $4 with unconventional natgas (for those unfamiliar, unconventional natural gas, such as shale gas, is one of the most expensive sources on the planet.)

This post isn't predicting $4 natgas; rather, the point is that technological advances, efficiency improvements, government incentives, and the like, can bring down the marginal cost of production. If you are betting on a commodity business—by definition, a price-taker and hence only minor control over profitability—you better discount the marginal cost of production to account for technological and other changes.

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2 Response to Commodity marginal cost of production tends to decline decline

May 3, 2009 at 7:44 PM

I suppose it's difficult that oil  price goes below the cost of oil from tar sands.
I read that Canadian Oil Sands Trust has an operating cost of 38,76 canadian dolar in one location and expect 33,50 for this year. Can you give me an idea what are the total cost aproximately? what´s the cost of taxes on one barrel oil from tar sands?

May 4, 2009 at 1:04 PM

I don't follow the oil market much anymore so I can't give concrete answers. However, you may get some idea from this article which says that costs are falling because material and labour costs have fallen. The situation is complicated right now because everything--material, labour, energy, taxes, C$ fluctuation--are in flux.
According to the article:
"The extent of the savings has come to light in the recent weeks, as the oil patch began its round of first-quarter results. Suncor Energy Inc. SU-T is targeting a drop in operational expenses of 10 to 15 per cent over the next 12 months. Petro-Canada PCA-T has crunched new numbers for its proposed Fort Hills oil sands mine, and came up with a drop of more than 30 per cent - from more than $14-billion to under $10-billion. The price tag on Husky Energy Inc.'s HSE-T Sunrise project has nearly fallen in half, from $4.5-billion to $2.5-billion. Royal Dutch Shell PLC RDS.A-N expects oil project development costs worldwide to fall by 50 per cent.Huge escalations in the price of labour and material had nearly quadrupled the cost to design and build an oil sands project early in the past decade. Operating costs substantially increased, too. Now the oil patch is striking back....Thanks also in part to reliability gains, Suncor's cost to produce a barrel of oil has declined from $41 in the fourth quarter to just over $33 now, and the company is targeting a further 10- to 15-per-cent improvement in the coming year." 
Having said all that, you need to look in detail at the specific companies in question. The vast majority of the cost of oil sands is the initial capital expenditures needed to start the project. Once the project has started, finding costs are close to zero. In contrast, conventional oil has lower initial capex but has sizeable finding cost. I suspect that the companies that have already built out most of their infrastructure or have completed all of it, will have low cost of production; whereas there are many start-ups and juniors who just started building stuff in the last two years and they may have problems with high cost. 

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