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One of the Biggest Challenges Facing Oil Companies

In the world of energy, an unsettling trend has emerged over the past few years. The world's largest oil companies are spending massive amounts of money on new oil and gas projects each year, yet their production continues to stagnate or decline.

For instance, ExxonMobil (NYSE: XOM  ) , the world's largest publicly traded oil company, reported a 3.5% first-quarter decline in its total oil and natural gas production from the same quarter a year ago, while French oil major Total SA (NYSE: TOT  ) said its production fell 2% in the first quarter from year-ago levels.

What's going on?

Why oil is becoming more expensive to extract
In a nutshell, new investments by the oil majors simply haven't resulted in enough output growth to offset declining production from maturing fields. It has to do with where the marginal barrel of oil is coming from.

With the era of "easy oil" a distant relic, energy companies are being forced to explore for and produce oil in harder to reach unconventional locations. Some of these include U.S. shale, Canadian oil sands, and deepwater sites off the coasts of Africa and Brazil.

While these sources have contributed substantially to global supplies, their costs of production are exorbitantly high due to the sophisticated equipment and highly skilled personnel they require. In fact, according to some estimates, oil prices need to stay above $85-$90 per barrel for many of these projects to warrant investment.

As the sources of marginal supply have shifted from conventional fields toward unconventional ones, the industry's marginal costs of production – the expenses associated with producing the last barrel of oil – have soared. According to Bernstein Research, marginal production costs among the world's 50 largest public oil companies increased 229% between 2001 and 2010. 

Not surprisingly, the industry's annual capital spending has more than tripled over the past decade, coming in at $550 billion in 2011, according to oil-field services firm Schlumberger (NYSE: SLB  ) . Yet despite shelling out all that money, the industry as a whole has been unable to secure enough new reserves to offset production.

According to Bernstein Research, the reserve replacement ratio among European oil majors last year was just 92%. The ratio is an important metric that gauges the extent to which companies are replacing the oil they produce with new reserves. If the ratio is consistently under 100%, it generally indicates trouble further down the line.  

In this respect, ExxonMobil fares quite well, having reported a reserve replacement ratio of 115% last year, while Chevron's was an impressive 112%. Total's however, came in at 93%, while Royal Dutch Shell's was a worrisome 85%.

The bottom line
As these developments highlight, the marginal barrel of oil has become – and will continue to become – more complicated and more expensive to extract. Already, this trend is evident in the diminishing returns from upstream capital expenditures.

In the period from 1995 to 2004, the upstream industry spent $2.4 trillion to produce 12.3 million barrels per day of additional oil output, while in the period from 2005 to 2010, the same expenditures yielded a decline of 0.2 million barrels per day, according to energy research and consulting firm Douglas-Westwood.

This suggests that further increases in capital expenditures will fail to yield commensurate increases in oil production, meaning the oil majors will need to find other ways to get more bang for their buck.

Though the supermajors are having difficulty boosting production, companies focused exclusively on exploration and production are having better luck. Chesapeake Energy, for instance, has reported nearly 40% year-over-year growth in liquids production. As the company transitions away from natural gas, will it manage to meet its oil production target and boost cash flow? Or will it languish under the weight of its heavy debt load? To answer that question and to learn more about Chesapeake and its enormous potential, you're invited to check out The Motley Fool's brand-new premium report on the company. Simply click here now to access your copy, and as an added bonus, you'll receive a full year of key updates and expert guidance as news continues to develop.

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9/23/2016 4:00 PM
SLB $75.92 Down -1.09 -1.42%
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