A rigger explains why oil is tanking

A friend told me the world’s storage tanks are almost completely full. This should cause the oil price to drop. But how much farther can it possibly fall?

Back in Limerick recently, I met up with an old friend at the Saturday farmers’ market. It was freezing cold out and, to nobody’s surprise, it started raining. So we took shelter by the fire at Nancy Blake’s pub, and with one eye on the Munster rugby match, caught up over hot whiskeys.

John works as a driller on offshore oil rigs. His job is to guide the drill bit into the sea floor using joysticks and underwater cameras and such. He works on one or two-year contracts all over the world – he’s drilled off the coast of Norway, Brazil, Angola, Nigeria and Korea.

As you can imagine, it’s not a great time to be a deep sea oil explorer. Over a couple of hot whiskeys he talked me through what’s happening in the industry.

It’s ugly out there…

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Why they keep on pumping

At the moment, John’s preparing to spud a well off the coast of Uruguay (in water depth of over 11,000ft by the way – the deepest water ever drilled in).

“What gives?”, I asked him. “How can a deep sea field in the South Atlantic be economical with oil at $30 a barrel?”

John patiently explained to me how oil exploration works: companies buy “concessions” to drill for oil (from the Uruguayan government in this case). That gives them the right to extract whatever oil they find, provided they sink a certain number of exploration wells within a certain time. If they don’t sink the exploration wells, they lose the right to the oil.

So, John only has a job at the moment because the Uruguayan government is forcing his company to drill. That work will dry up next year.

The oil companies are still operating a bunch of other deep sea wells. Over their lifespans, those wells will end up losing a tonne of money. That’s because, when it comes to offshore oil, most costs are front loaded: the cost of finding the oil, setting up the rig and the refineries, and drilling the wells.

Once a rig is up and running though, its costs are fairly low. That’s why they’re still extracting oil, even with the price at $30/barrel. The average cost of a barrel of oil from the well, which includes all the setup costs, is a lot higher than the marginal cost of a barrel of oil when the well is already set up. That’s crucial for understanding what’s happening with the oil price.

John told me that at $30/barrel, 94% of world production can cover its marginal costs.

In other words, don’t expect the supply of oil to dry up any time soon. There might not be any exploration at $30/barrel. But production will keep chugging along for another year or two until the existing wells have run their course.

So there’s one good reason for a driller to be worried. Then John drained his glass and gave me another one.

The glut

Normally the oil price does a reasonably good job of matching supply and demand, so that oil inventories (in other words, giant storage tanks) are neither full nor empty. But that’s not happening at the moment. John told me that the world’s storage tanks are almost completely full. Apparently, they’re at all-time record levels.

They’re literally running out of places to keep the stuff. Off the coast of Iran right now, there’re six huge tankers carrying up to 50m barrels of oil, just bobbing along on the tide. The International Energy Agency reckons the glut’s going to get a lot worse before it gets better.

The oil glut

crude brent

Source: IEA

The obvious way to empty those tanks is for the price of oil to drop. But how much farther can it possibly fall?

John didn’t have an answer for that. But he’s looking around for other work.

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