Do Costs Determine Prices?

Conventional wisdom generally suggests that when costs rise, price increases follow.  Most of the time, this may be accurate.  However, investors should investigate carefully before jumping to a conclusion.  Sometimes costs adjust to reflect prices rather than the other way around.

An interesting case in point is the oil industry’s reaction to a major decrease in prices, when, over the last several years the price of oil went from approximately $100/bbl. to the current price of about $50/bbl.

As the price of oil dropped, “experts” suggested that U.S. shale production would decline precipitously as lower prices were faced with high costs.  However, U.S. shale production remains robust and is increasing.  What happened?  The short story is, costs decreased.

Now we are seeing the same thing happen in the North Sea.  For more than a decade, the once booming North Sea oil sector has been mired in a decline.  At its peak, early this century, North Sea oil volume was similar to Saudi Arabia’s, but then declined some 34%.  Things change.   Investors have recently committed more than $16 billion into European projects, primarily in the North Sea.  What happened?

Costs declined significantly.  BP has cut its average production costs in the North Sea from a peak of more than $30/bbl. in 2014, to less than $15/bbl. currently and expects a further decrease to $12/bbl.  Shell’s costs have fallen by 60%, an achievement matched by major competitors, putting North Sea costs in line with prices.

All comments and suggestions are welcome.

Walter J. Kirchberger, CFA®