M 115 &U W>*J LOW OIL PRICES AND THE ILLINOIS OIL INDUSTRY Effects, Outlook, and Policy Recommendations Subhash B. Bhagwat <«* 6^ )^ v \V- ILLINOIS MINERALS 115 1995 Department of Natural Resources ILLINOIS STATE GEOLOGICAL SURVEY ILLINOIS STATE GEOLOGICAL SURVEY 3 3051 00006 0347 LOW OIL PRICES AND THE ILLINOIS OIL INDUSTRY Effects, Outlook, and Policy Recommendations Subhash B. Bhagwat ILLINOIS MINERALS 115 1 995 ILLINOIS STATE GEOLOGICAL SURVEY William W. Shilts, Chief Natural Resources Building 615 East Peabody Drive Champaign, IL 61820-6964 ^ Printed by authority of the State of Illinois/1 995/550 w printed with soybean ink on recycled paper CONTENTS ABSTRACT 1 INTRODUCTION 1 History of Oil Prices 2 Oil Reserves 2 Oil Production, Prices, and Imports 3 Import Spending and the Gross Domestic Product 4 Effects of Low Oil Prices on the Oil Industry 5 ILLINOIS OIL INDUSTRY 6 Production Economics of Illinois Oil Fields 7 Production Economics of Typical Illinois Oil Fields 8 Economic Impact of Low Oil Prices in Illinois 10 SUMMARY, OUTLOOK, AND POLICY RECOMMENDATIONS 1 1 Effects of Price Changes 1 1 Illinois Outlook 12 Economic Costs 13 Policy Recommendations 13 REFERENCES 13 Related Bibliography 14 FIGURES 1 Oil prices in actual and 1993 dollars 2 2 World oil reserves 2 3 U.S. oil reserves 3 4 Illinois oil reserves 3 5 U.S. production and imports of crude oil 3 6 U.S. production and net imports of crude oil and natural gas liquids 4 7 U.S. gross and net imports of petroleum products 4 8 U.S. import dependence for crude and petroleum products 5 9 U.S. imports and the GDP 5 10 Transportation as percentage of U.S. GDP 5 1 1 U.S. well drilling by company size 6 12 Capital and exploration expenditure 6 13 Average number of rigs operating in Illinois 7 14 Well completions in Illinois 7 15 Stripper wells as percentage of total producing wells 7 16 Stripper well production as percentage of total 7 17 Number of producing oil fields discovered in Illinois since 1980 8 18 First-year production from oil fields discovered since 1980 8 19 Second-year production from oil fields discovered since 1980 8 20 1993 production from oil fields discovered since 1980 8 21 Break-even production for a five-well Illinois oil field discovered in 1980 9 22 Break-even production for a five-well Illinois oil field discovered in 1994 10 23 Break-even price for a five-well, 10,000 bbls/yr Illinois oil field discovered in 1994 10 24 Illinois oil production, 1973-93 11 25 Illinois oil industry employment, 1973-89 11 26 Illinois oil consumption, 1973-93 11 TABLE 1 Input parameters for model break-even analysis of a five-well Illinois oil field 9 Digitized by the Internet Archive in 2012 with funding from University of Illinois Urbana-Champaign http://archive.org/details/lowoilpricesilli115bhag ABSTRACT The fall in oil prices between 1981 and 1986 has had both good and bad economic conse- quences, which vary at national, state, and county levels and between major oil producers and independent producers. The overall economy benefited from low oil prices as the cost of energy input in manufactur- ing and transport of goods declined. In 1993, the United States spent less than half as much on oil imports as it did in 1980, both in terms of dollars and in percentage of gross domestic product. Declining oil prices in the 1980s have had a negative effect on oil production in Illinois and the United States. Although all states were affected, the negative impact of low oil prices has been borne more heavily by states such as Illinois and counties within the states that produce oil from stripper wells operated by small independent producers. The unfavorable economics of stripper wells, exacerbated by the financial weakness of the independents, has led to decreased exploration and development efforts as a result of low oil prices. Because major oil producers can shift investment away from crude oil production to refining and other downstream sectors and from the United States to other oil producing regions, explora- tion for new fields and exploitation of an increasing number of domestic fields are being left to independents. In addition to the decreasing value of the oil produced, declining domestic production led to direct and indirect job losses, increased expenditure on social welfare, and lost tax revenue. In Illinois, the estimated impact of low oil prices includes lost production value of more than $500 mil- lion per year, a direct loss of 4,100 jobs in the oil industry, indirect loss of 8,000 to 12,000 jobs, lost royalties of $88 million annually, reduced tax revenues, property devaluations due to eco- nomic slump in certain counties, and increased welfare costs to the state. Although the state's economy benefited by $2.8 billion due to lower oil prices, the negative impact was borne by a few counties, which added a degree of severity to the effects of low prices. In the absence of higher oil prices, the key to an improved economic environment for inde- pendent operators in Illinois is to direct research efforts toward expanding technological and geo- logic knowledge that increases efficiency of oil exploration and development and lowers the cost of production. INTRODUCTION Although international oil prices have risen and fallen dramatically since 1973, only the impacts of high oil prices have usually been studied. Especially from state and local perspectives, the effects of low or falling oil prices have largely escaped attention because of the positive influence they have on gasoline prices. Low prices, however, have both good and bad consequences, and what may be bad for the oil industry is good for the country, and vice versa. Some of the misconcep- tions about low oil prices, and especially their effect on Illinois, will be considered in this report. The effect of low oil prices on U.S. oil production was summarized by the congressional Office of Technology Assessment in 1987 (U.S. OTA 1987). When crude oil prices decline, low productivity wells are abandoned and production declines. A reduction in expenditures on explora- tion and development may be accompanied by a shift away from domestic to foreign oil invest- ment and an increase in oil imports. Although profits from foreign investments flow back to U.S. interests, such a shift in investment leads to a loss of domestic jobs. Not all the effects of low oil prices are negative, however, nor are they uniform across the oil industry and national economy. To a certain extent, lower oil prices offset the impact of greater non-oil imports on the foreign trade deficit. Because transportation costs represent a significant portion of the nation's economy and oil is a vital cost factor in transportation, lower oil prices reduce transportation costs, create new jobs, and invigorate the economy. Illinois is a major indus- trial and agricultural state that produces only a small fraction of the crude oil needed in its econ- omy. Lower oil prices therefore mean less money spent to import an essential ingredient of the economy and consequently a lower overall cost of doing business in the state. Different segments of the oil industry are affected in different ways by low oil prices. When crude oil prices fall, major oil companies can emphasize investments in the refining business in order to benefit from the low refinery feedstock prices. Smaller and independent oil producers may not have the same options and may suffer severely from a drop in oil prices. The impact of declining oil prices may differ regionally because of the characteristics of the local oil industry. The oil industry in Illinois, for example, is dominated by small, independent producers and there- fore is more severely affected by low oil prices than it is in some other states with fewer small producers. This study reviews the development of oil prices, reserves, production, and imports and pre- sents a comprehensive view of the positive and negative impacts of low oil prices on the economy, as well as the oil industry, to aid policy makers in setting long-term goals for Illinois. Specific con- ditions in Illinois oil fields are studied, and suggestions for Illinois oil policy are offered. History of Oil Prices Oil prices in the United States have fluctuated widely since 1970, for both domestic and interna- tional reasons. In 1973-74 and again in 1979-81 , oil price increases were triggered by interna- tional crises in West Asia. However, because prices of domestically produced oil in the United States were regulated, the full impact of international price increases was not felt by U.S. consum- ers until the deregulation of U.S. domestic oil prices was completed in 1981. The price of a barrel of crude oil (in 1993 dollars) increased from about $13 in 1973 to about $26 in 1975, and from $26 in 1978 to $55 in 1981. Prices fell sharply between 1981 and 1986 as a result of price-induced conservation, increased worldwide supply, and an economic recession in 1982. Since 1986, prices have fluctuated between $15 and $25 per barrel (fig. 1). The price of oil is the most signifi- cant variable in determining exploration activity, discovery, and development of new reserves because, other factors remaining unchanged, a higher price is generally associated with a higher profit margin. Oil Reserves A time-lagged correlation is expected between oil prices and oil reserves because high oil prices are an incentive to exploration, and low prices discourage exploration. Figure 2 shows that a sharp upward revision of world oil reserves came in 1 988 and 1 990, or 7 to 9 years after oil prices peaked in 1981. This time lag may indicate the effort required for successful exploration but could also have nontechnical reasons because most new reserves came from the traditional oil- producing countries in West Asia. The increase in world oil reserves preceding the 1973-74 price increase obviously cannot be attributed to the price increase. Furthermore, U.S. oil reserves have declined by about one-third since reaching a high in 1972, despite price increases in following years (fig. 3). Similarly, in 60 50 £ 40 t_ CD jQ q. 30 Q. JQ CD ^ 4 (0 * 1970 Production I Imports i, 1 1975 1980 1 1985 1990 Figure 6 U.S. production of crude oil and natural gas liquids, and net imports of crude and petroleum products. Source of data: Monthly Energy Review, U.S. Dept. of Energy, DOE/EIA-0035; Basic Petro- leum Data Book (1993). Crude oil constitutes only a part of the oil scenario; the other part is refined products. The refining industry in the United States benefits from low crude oil prices. Figure 6 shows that com- bined net imports of crude oil and petroleum products reached high points in 1977 and 1993 but never equaled the level of domestic production of crude oil and natural gas liquids for two main reasons. First, production data include natural gas liquids, which are reported independently by the oil industry. Second, net imports of petroleum products have decreased because of greater exports of products by U.S. refineries (fig. 7), which suggests technological and cost advantages of U.S. refiners over their international competitors. United States dependence on imported crude and refined products increased from 22% to 47% in 1970-77, despite the price increases of 1973-74. The second round of price increases in 1979-81 initiated a fall in import dependence that continued until 1985. The low prices that pre- vailed since 1985 have led to increased imports and a rise in import dependency from 28% in 1985 to 44% in 1992 (fig. 8). 3 Import Spending and Gross Domestic Product Are increased oil imports and in- creased dependence on imports for consumption bad for the econ- omy? Figures 8 and 9 indicate that the price decline in recent years has permitted the United States to import increasing quanti- ties of oil without spending a higher share of gross domestic product (GDP) for the imports. In comparison with oil imports, non- oil imports have posed a greater problem. Until 1980, the United States earned up to 2% of GDP as a result of net exports of non-oil 2.4 1.8 >> ■D CD Q. J2 a> aj CD 1.2 0.6 I Exports | Net imports ll I ill Gross imports 1970 1975 1980 1985 1990 Figure 7 U.S. gross and net imports of petroleum products. Source of data: Monthly Energy Review, U.S. Dept. of Energy, DOE/EIA-0035. 1970 ~1 1 1 1 - 1980 1 1 1 - 1985 1 1 1 1 1 1 - 1990 Figure 8 U.S. import dependence for crude and petroleum products. Source of data: Monthly Energy Review, U.S. Dept. of Energy, DOE/EIA-0035. goods. These earnings helped nearly balance the foreign trade account. In the first half of the 1980s, the non-oil balance of trade dramatically worsened while spending on oil imports as per- centage of GDP actually declined. Although net imports of non-oil goods have declined since 1985, they rose substantially in 1992 and 1993, surpassing the oil trade deficit by $25 billion in 1993. A total of about 1 .8% of U.S. GDP was spent on net imports of oil and non-oil goods in 1993 (fig. 9). Oil and petroleum products are consumer items for industry and business. Therefore, the effects of oil price changes should be manifest within only several weeks. The data in figure 9 indicate, however, no apparent negative impact on U.S. non-oil exports as a result of oil price increases in 1974-75 or 1979-81. Likewise, the falling oil prices in real dollars since 1982 Oil imports -3 ' ' I ' I I ' ' l~" 1970 1975 t — i — i — i — r— i — i — i — i — i — i — i — i — i — r 1980 1985 1990 Figure 9 U.S. imports and the GDP. Source of data: Monthly Energy Review, U.S. Dept. of Energy, DOE/EIA-0035. 1970 1975 1980 1985 1990 Figure 10 Transportation as percentage of U.S. GDP. Source of data: Survey of Current Business, U.S. Dept. of Commerce. had no positive effect on non-oil exports until the prices stabilized in the latter half of the 1980s. The U.S. economy in general, and the transportation sector in particular, did respond to the crises in the international oil markets by resorting to cost-saving measures. As indicated in figure 10, the share of the transportation sector in the national GDP declined from about 4% before the 1973-74 oil crisis to slightly more than 3.1% in 1992. Most of this improvement took place in the 1980s. The foreign trade imbalance in the non-oil sectors would have been larger without the cost savings in the transportation area. Effects of Low Oil Prices on the Oil Industry While non-oil sectors of the U.S. economy benefitted from the falling oil prices after 1986, the oil industry itself was adversely affected. The oil industry, contrary to widely held public opinion, is neither monolithic nor identical with large international oil firms. The three major segments of the oil industry are exploration, production, and refining, which also support a large and varied group of service companies. The biggest companies can operate in all three areas, whereas small com- panies may specialize in only one area. Additionally, each operating segment has different char- acteristics and operating philosophies. 100 80 ■D 60 = ■c T3 CO =5 40 20 *ln 1 990, OGJ began reporting only 300 firms Other firms OGJ 400/*300 firms. 100 1983 1985 1990* 1983 84 90* 91* 1992* Figure 11 U.S. well drilling by company size. Source of data: Oil and Gas Journal. Figure 12 Capital and exploration expenditure (OGJ 4007*300 firms). Source of data: Oil and Gas Journal. The Oil and Gas Journal ranks the top 400 or 300 companies by the dollar value of their assets and provides information on their production, drilling, and overall expenditures on explora- tion and investments. (Beginning in 1990, the journal ranked only 300 companies.) Since 1982, the OGJ 400/300 companies have been responsible for nearly 75% of annual U.S. oil production. According to the definition used by the Independent Petroleum Association of America (IPAA), com- panies with 1994 sales of more than $5 million per year, or reserves of at least 1 billion barrels, or refining capacity of more than 50,000 barrels per day are considered "major" companies. Accord- ing to this definition, about 30 of the OGJ 300 companies listed in 1992 were major companies. The top 10 listed companies accounted for about 60% of U.S. oil production in 1992. Using statis- tical sampling techniques, the IPAA estimates that nearly all the remaining 40% of U.S. oil produc- tion comes from independent producers (IPAA 1993). Despite incomplete statistics and sampling errors, a significant amount of oil is obviously produced by independents. Independents play an even greater role in drilling activity. In 1992, the top 10 listed firms drilled only about 10% of all wells in the United States, although they produced 60% of the oil. The entire list of OGJ 300 companies drilled some 31% of all wells (fig. 11), although this percent- age has increased from only 20 in 1983. Figure 1 1 indicates that while the OGJ 300 firms pro- duced 75% of U.S. oil, the smaller companies drilled 69% of the wells and discovered most of the new oil fields. The capital and exploration expenditures of the OGJ 400/300 companies in the United States in constant 1993 dollars declined by nearly a half in the past decade (fig. 12). ILLINOIS OIL INDUSTRY Because most Illinois oil companies are independent producers, nearly all the drilling in Illinois depends upon the response of the independents to oil price changes. Figure 13 shows the aver- age number of drilling rigs operating in Illinois since 1970. The number of rigs doubled from 10 to about 20 in response to the first major oil price increase in 1974-75. The oil price increase in 1979-81 was significantly more stimulating in Illinois, raising the number of rigs to about 75 in 1982. The subsequent fall in oil prices dampened the Illinois oil industry's optimism. Decreased drilling incentive produced a precipitous drop in the rig count to an average of five in the years since 1986, or about half the number operating in the pre-1973 years. Well completions in Illinois indicate a similar pattern (fig. 14). Independents rely, in part, on savings to fund exploration. Prof- its from infill and offset development wells drilled in times of high oil prices (1974-78) enable operators to generate savings needed for exploration drilling (1979-85). Furthermore, an increase in oil prices (1978-85) significantly increased both exploration and development drilling in the 1979-85 period. Well completions fell back to the 1970s levels by the early 1990s as a result of the oil price decline. Figure 13 Average number of rigs operating in Illinois. Source of data: Basic Petroleum Data Book (1 993). Figure 14 Well completions in Illinois. Source of data: Basic Petroleum Data Book (1993). 100 1970 1975 1980 1985 1990 Figure 15 Stripper wells as percentage of total producing wells. Source of data: Basic Petroleum Data Book (1993). ~i — i — i — i — i — r 1970 1975 Figure 16 Stripper well production as percentage of total. Source of data: Basic Petroleum Data Book (1993). Although the effect of price changes on the entire U.S. oil industry was similar to that in Illi- nois, its consequences in Illinois were more serious and long term because of lower Illinois well productivity. Well productivity is measured in barrels of oil produced per day, and wells producing less than 10 barrels daily are called "stripper" wells. Figure 15 shows that more than 95% of pro- ducing wells in Illinois are stripper wells, compared with 70% to 78% of all U.S. wells. Figure 16 shows that more than 90% of Illinois oil is produced from stripper wells, as against less than 15% nationwide. In 1993, the average Illinois well produced about 1.6 barrels of oil per day compared with the U.S. average of about 1 1 .8 barrels. The national well productivity average is highly skewed by the fact that about one-fourth of all U.S. wells produce over 85% of total U.S. oil, whereas the remaining three-fourths of the wells produce less than 15% of U.S. oil. As a result of the productiv- ity decline of U.S. wells, major oil companies have been shifting investment away from the United States, leaving domestic production increasingly to the financially weaker independents. Production Economics of Illinois Oil Fields Since 1980, 36 oil fields were discovered in Illinois (fig. 17). About 80% of these were discovered in 1980-84 (i.e., in the years of the highest oil prices). First- and second-year production by field s CD .Q E 4 u 36 fields L i i i i i i i i i i i i i 1980 81 82 83 84 85 86 87 88 89 90 91 92 1993 Year of discovery Figure 17 Number of producing oil fields discovered in Illinois since 1980. Source of data: Illinois State Geological Survey, Oil and Gas Section. 15-20 25-30 70-75 Barrels per year (thousands) 130-135 Figure 18 First-year production from oil fields discovered since 1980. Source of data: Illinois State Geological Survey, Oil and Gas Section. 0-5 15-20 25-30 45-50 55-60 Barrels per year (thousands) 80-85 Figure 19 Second-year production from oil fields discov- ered since 1980. Source of data: Illinois State Geological Sur- vey, Oil and Gas Section. 0-5 10-15 30-35 Barrels per year (thousands) 100-105 Figure 20 1993 production from oil fields discovered since 1980. Source of data: Illinois State Geological Survey, Oil and Gas Section. indicates that most new fields are small in size, producing fewer than 5,000 barrels per year each (figs. 18 and 19); only 12 of the 36 new fields had a second-year production of more than 5,000 barrels. The 1993 production by these new fields (fig. 20) indicates that only 7 of the 36 fields still produced more than 5,000 barrels each, and only 3 produced more than 30,000 barrels. Production Economics of Typical Illinois Oil Fields Because most new Illinois oil fields comprise fewer than 10 wells, a model was developed to calcu- late the economic profitability of oil field production and applied to three hypothetical Illinois oil fields to determine the minimum annual field production or to project the future oil price required to break even. The cost basis of a typical Illinois oil field with five producing oil wells is described in table 1 , along with other operational parameters. The parameters used for the model, although typical, are not intended to represent all Illinois fields because actual field conditions may vary widely. Table 1 Input parameters for model break-even analysis of a five-well Illinois oil field. Acres leased 450 Initial bonus ($/acre) 55 Dry wells drilled 1 Dry well cost ($/ft) 17.5 Injection wells drilled 1 Producing wells drilled and equipped 5 Producing well cost ($/ft) 36 Well operating expenses ($/well/month) 650 Annual inflation of operating expenses (%) 3 Initial investment in pressure maintenance program ($) 30,000 Royalty (%) 12.5 Overriding royalty (%) 6.25 Cash flow discount rate (%) 1 980 discovery 20 1 994 discovery 13 60 The first analysis indicates that a five-well field discovered in 1980 could operate economi- cally — given the actual oil price development from 1980 to 1993 and the projected prices for the post-1993 years (fig. 21)— if it produced at least 10,000 barrels per year initially and if a pressure maintenance program were implemented in 1984. The price projections to $27.50 in year 2009 are based on a 0.7% growth above an average expected rate of inflation of 3% per year. The model reveals that the limit of economic production was reached in 1992; thus, such a field would produce about 89,000 barrels through 1992 before beginning to lose money. Fields that produced less oil from five wells, which applies to about 80% of fields discovered in Illinois since 1980, could not, under normal circumstances, have been profitable. The second analysis is for a five-well oil field discovered in 1994. For this analysis, oil prices are projected to rise from $16 in 1994 to $34.50 per barrel by the year 2023; an oil pres- sure maintenance program is assumed to begin in 1998. The model reveals that the economic production limit would be reached in 2009. The model also indicates that to be economical this field would have to be more productive than a similar field discovered in 1980. The initial annual production rate would have to be about 17,600 barrels (fig. 22), and the total production during its economic life of about 15 years would have to be about 166,000 barrels. The third analysis develops a price projection that would allow a field discov- ered in 1994 with an initial production of about 10,000 barrels per year to operate economically. A pressure maintenance program is assumed to begin in 1998. This analysis (fig. 23) indicates that for such a field to break even economically, the oil price in 1994 would have to be about $30.50 per barrel and rise to about $38.00 in year 2009. The model indicates that the limit of economic production would be reached in 2009. During its eco- nomic life of 15 years, this field would pro- duce about 97,000 barrels of oil. Actual oil field discoveries since 1980 have been of much smaller size, however, so that the required break-even price would have Pressure maintenance program begins 12 10 V) ■o c 35 O (0 & a.