The price of gas in Red Lodge, January 9, 2015

The price of oil has collapsed since fall. One result is the steep decline of the price of gas at the pump. When I first looked at falling prices on November 10, the pump price was $2.97 in Red Lodge and $2.99 in Columbus. On December 3  when I discussed the reasons for the price decline, the pump price had dropped to $2.77. By last Friday, as you can see from the graphic at right, the price was down to $2.04, the lowest level since May, 2009.

Falling fuel prices are of course driven by the plummeting price of oil. Last June it was $105 a barrel. In November it was $77 a barrel. In December, just after a pivotal OPEC meeting, it was down to $62. As of Friday, the price had collapsed to $48.79, a drop of about 54% since June, and roughly equivalent to the price a decade ago when the hydraulic fracturing boom was in its infancy.

Not surprisingly, we’ve recently seen Energy Corporation of America decide to walk away from the well in Belfry “for now.” (You can read the letter from ECA to the Carbon County Commissioners here.) This decision is undoubtedly related to the economics of oil production, which are worth looking at in some detail.

Components of the cost of oil production
There are two components of cost in producing oil from a well: the fixed cost of finding the oil, drilling, and generating the initial output, and then the variable cost of keeping the well going over time. Fixed costs include primarily equipment costs and labor, and variable costs are mostly labor and electricity.

When an operator is making a decision in advance about whether to drill a well or not, he looks at the total of both fixed and variable costs to determine whether it is going to be profitable to drill the well. Profit over time is the difference between expected revenues and the total of fixed and variable costs.

Photo credit: Getty Images

But once the decision is made to drill a well and the well starts producing, the fixed cost is spent. From that point on, the decision about whether to keep operating the well is based on whether the revenues are greater than the variable cost of production.

According to Shawn Tully of Fortune Magazine, with conventional wells, production declines by only about 2-5% per year, so they can produce for 20 years or longer. After several years, the variable cost can be as low as $20-$30 per barrel, so in the case of the kind of price drop we see today, these wells can go on pumping. Operators will only stop drilling when the sales price goes below the variable cost, which rarely happens.

“What drives the business is the marginal (variable) cost, not the total cost,” says Ronald Ripple, a finance and energy business professor at the University of Tulsa. “Even at low prices, the production is still contributing something to cover the upfront investment.”

How fracking cost differs from conventional well costs
But the equation for unconventional wells is different. Unlike conventional wells, the production from fracked wells drops off very quickly and the wells have a relatively short life. In the Bakken, production declines by 72% in the first year of production. By the end of the second year, the well’s reserves are 50% depleted, and the annual production is very small. To keep increasing revenue, producers need to keep drilling new wells because existing wells have such a short life.

That poses a problem for the fracking industry, because new wells require additional fixed costs. And the decision to drill a new well means a higher breakeven cost.

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According to a study by Rystad Energy, the total (fixed plus variable) breakeven oil price for a new well in the Bakken is $53 in North Dakota and $65 on the Montana side. It’s important to note that these breakeven prices are just averages, since companies with an established presence will be able to leverage their initial investments to reduce the breakeven price.

What we are now seeing in the field is that the number of wells is declining quickly in the face of these price declines.

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According to Baker-Hughes, the number of active rotary rigs in the United States, after increasing dramatically throughout 2014, has taken a precipitous drop of about 8% since December (click on chart at left).

However, we shouldn’t expect huge declines to continue. The bottom line here is that, even with the very large drop in oil prices, most existing wells will continue to operate, at least in the short term, because their variable costs are covered. However, if the price continues to stay low for an extended period, we may see a significant decline in production in shale plays because of the constant need for new wells.

All of this is extremely volatile. Last June, the oil industry was on top of the world, and we were looking at wells being drilled in Belfry and Dean. Factors that we don’t anticipate, such as increased demand in China and India, or a decision by OPEC to reduce production, could change everything again in a few months.

We need to focus on our long-term future
Along the Beartooth Front, it is important for us to keep our eye on ensuring the long-term viability of our community. Oil booms will come and go, and producers will find us more or less attractive depending on the price of oil and the cost of extraction.

What we need to focus on is making sure that drilling is done in a way that preserves our rights, our water, and our way of life. Even as market volatility changes the short-term outlook, we need to stay busy working on our long-term future.