Comment: Beware of break-even and marginal-cost analyses

Leonardo Maugeri,
Harvard Kennedy School's Belfer Center for Science and International Affairs

Shale oil and gas productivity and costs vary dramatically among the different areas of a shale formation, and the difference between owning the best acreage or the worst is what makes winners and losers.

Clearly, the difference in productivity of each area of a shale formation reveals striking break-even differences across the same formation (on a micro-level, it also implies that wells drilled in a certain area have a bigger productivity than others).

Thus, to have a sound assessment of how unprofitable a shale formation could become below a given price level, it is essential to have a clear understanding of the break-even point of each area and to weigh it against the production of that specific area.

This kind of evaluation is also necessary to obtain a correct view of the marginal costs of a given formation.

For example, McKenzie County, ND, is the most prolific production area of the Bakken-Three Forks formation, with an average output of almost 350,000 b/d, more than one third of total Bakken production as of August 2014.

The McKenzie break-even point, including a 10% internal rate of return, is $28/bbl. Conversely, in August, Divide County, ND, produced slightly more than 35,000 b/d in August, but with a break-even point of $85/bbl.

Overall, 80% of Bakken oil now has a break-even point below $42/bbl.1

Finding these numbers is hard, so most analysts resort to oversimplified models and use input data that do not weigh specific break-even points against specific production levels. This creates misleading indications about both.

I do not understand, for example, how those claiming that the average break-even point of Bakken oil is higher than $70/bbl have calculated that number. In any case, the notion of average may be highly misleading when referred to shale.

What's more, falling oil prices are prompting oil companies to ask service companies (those making fracking jobs and other related services) to review downward their tariffs, adding the threat of slashing their demand for services.

From early insights, these kinds of requests seem to be destined to succeed, implying a general decrease of cost for shale activity in the near future.

As to marginal costs, while it is perhaps formally correct to say that the marginal cost of production in the Bakken has a break-even point of $85/bbl, it is very misleading not to point out that this number refers to less than 3% of overall Bakken oil production.

Editor's Note: This is an excerpt from Leonard Maugeri's Global Energy Trends No. 2, Nov. 19, 2014.

References

1. Maugeri calculated this using August 2014 statistics from North Dakota Department of Mineral Resources.

The author
Leonardo Maugeri is former Eni SPA's group senior vice-president (director) of corporate strategies and international relations. He began his career at Eni as a business analyst and shortly thereafter was named executive assistant to the CEO. He also has held positions as head of strategic analysis and group senior vice-president of strategic studies, public affairs, and international relations. He is a member of Eni's executive committee and the head of the company's strategy committee; he also serves on the boards of Eni petrochemical subsidiary Polimeri Europa and of Eni Corporate University. Maugeri also serves as senior fellow at the World Economic Laboratory of the Massachusetts Institute of Technology in Boston, a senior fellow at the Foreign Policy Association in New York, and a member of the executive council of the Center for Social Investment Studies. He has written books and several articles on the oil industry. Maugeri has a degree in petroleum economics and a PhD in international political economy.