God is a Capitalist

Thursday, January 22, 2015

Crude shutdown price - lower than you think

When the Saudis allowed the price of their crude oil to fall, it was reported that the Saudis expected the price to fall no lower than $60 per barrel. The Saudis assumed that the average cost of production in the US shale oil fields was somewhere around $70 and that producers there would not operate for long at a loss. Insiders have said that the Saudis want to reduce competition from high cost US producers and retain their share of the US market, which came to 13% of imports in 2013, the latest figures from the US Energy Information Agency.

But the Saudis have made the same mistake as most analysts who have tried to predict when high cost oil producers, such as US shale oil producers, will shut down their wells and reduce the worldwide glut in oil supply: they use the break-even price. Had they paid attention in Econ 101 classes, they would have known that the shutdown price for rational producers is the average variable cost, not the break-even price. The graph below will help illustrate the concepts.

Profit maximizing firms will operate at the output level directly below the point where the marginal cost curve (MC) crosses the marginal revenue curve (MR). The break-even point is the average total cost curve (ATC). The shutdown point is on the average variable cost curve (AVC). In the graph above, the shutdown price is P and the quantity produced is Q. BTW, the MC curve above the shutdown price is also the firm's supply curve.

Why would a producer not shut down when the price fell below the ATC, or the break-even price? The producer won't because the process of shutting down can be costly. And the producer may think prices will recover to a level that will generate a profit again, in which case he will incur additional start-up costs if he has shut down. Shutdown and start-up costs are greater in capital intensive industries like oil production. The oil industry ran into start-up costs in the early 2000's when the price of oil spiked to almost $150. Congress held hearings and demanded oil executives explain why they weren't drilling for more oil. The executives responded that they would drill more if they could get the rigs and experienced workers, but the price of oil had remained so low during the 1990's that the supply of both had dried up.

Firms can operate between the break-even and shutdown prices only in the short run because they are still losing money. Prices at the average variable cost of the firm contribute only enough money to pay the variable costs such as utilities, labor and interest on debt. The firm can't pay for overhead expenses or pay down the principle on debt.

Saudi Arabia's shutdown price is around $10, so it can last longer than most US producers. But the Saudi's have a political problem: it will have to spend foreign reserves to make up for the lower price of oil and when those run out it will have to borrow to finance government expenses. Eventually, enough production will stop to cause the glut of oil to subside and prices rise again. But keep in mind that a similar situation occurred in 1986 and prices didn't begin to recover until 2000.

Oil as a commodity and oil stocks will eventually become excellent investments, but that will take longer than most analysts think because oil prices will fall farther and stay down longer than most analysts think.

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