Slugcatcher: Economics Class 101

Economics 101: Welcome to the class boys and girls. The first question today is what happens to a business which spends $8 making product A, but sells it for $4? Answers, in writing, should be sent to Slugcatcher by Friday. No cheating, but use of reference books permitted.
Slugcatcher: Economics Class 101 Slugcatcher: Economics Class 101 Slugcatcher: Economics Class 101 Slugcatcher: Economics Class 101 Slugcatcher: Economics Class 101

If his faith in readers is sustained, most of you will get it right. The business goes broke. Sadly, he suspects some of you will miss the point – which is that no-one can sell a product for less than it costs to make.

And all of you will say: “what’s this silly example got to do with the oil patch when crude is selling for $US50 a barrel?”

The answer is a little complex, but totally focused on the long-term prospects for oil because the example comes directly from the latest study of the economics of oil exploration by the highly-respected research consultancy, Wood Mackenzie.

According to what Slugcatcher has read of the WoodMac survey of exploration economics released in London over the weekend oil explorers are having a pretty dismal time. It’s not that they have failed to make discoveries, it’s just that the discoveries are costing more to make than the value of the oil in them.

This is the central point being made by Slugcatcher. The oil price is good news for today’s production. The future is lot more uncertain as shown in a WoodMac analysis of the discoveries made last year by the world’s top 10 oil groups.

For an outlay of $US8 billion, discoveries made have a net present value of $US4 billion.

More disturbing, this was nothing new because the results of the previous two years had also produced a negative result with the value of oil discovered being less than the amount spent to discover it. In the words of Robert Plummer, a senior WoodMac adviser: “The problem is exploration has not been generating returns.”

Slugcatcher can think of all sorts of reasons as to why exploration has turned negative. The most obvious is that the best oil and gas accumulations have already been found. Another is that exploration was not aggressive over the past few years because of the lingering effects of oil at $US10 a barrel in the mid-90s.

Whatever the reason, the WoodMac study makes for sobering reading because of its long-term implications. One of those is that the price of oil must continue rising to justify continued high levels of new investment. This is the one that Slugcatcher likes – and it is the one which he suspects will be delivered with high oil prices generating increased exploration, which delivers smaller-and-smaller discoveries, which pushes oil prices higher etc etc etc.

There is, however, a reverse theory which cuts a bit deeper into the business case for oil, and which is left for debate.

If WoodMac is right, and it is costing twice as much to find oil as the value it represents, is there not a case for curtailing exploration because it is not a profitable use of shareholders funds?

Obviously, this is a totally theoretical question, but it is one which may become valid in the future as investors look at a business and ask that very direct question: “what happens to a business which spends $8 making product A, but sells it for $4?”

In time, and that’s the key here, it must go broke.