02 June 2011

Dundernomics 101: the cost of doing business

Premier Kathy Dunderdale, displaying her keen awareness of mathematics – among other things -  in the House of Assembly on Monday, May 9:

Mr. Speaker, Hebron costs are driven by reserves, as are most projects in the offshore. So as we do our delineation work and we find out exactly how much oil is there, then capital costs increase or decrease accordingly.

Mr. Speaker, as a result of this work on Hebron, reserves have gone up by 11 per cent. Our costs in capital construction have increased from $360 million to $480 million, Mr. Speaker, and it will also mean an increase of over 50 per cent to the Treasury of Newfoundland and Labrador in royalties and benefits.


Not exactly.

Finding more oil in a field doesn’t necessarily increase the capital costs up front.  At Hibernia, for example, the capital costs didn’t jump as they found more and more oil.  The reason is that they could pump the oil out of the ground by drilling wells from the GBS or by using another cheap method.

Operating costs will change, of course.  That’s because they will have to run the production facility in order to get the oil out of the ground.  But day-to-day costs of keeping the wells going is not the same as capital cost, as in construction costs for new facilities to get the oil out of the ground.

In this case, it seems that the Hebron partners have decided to exploit this new oil with tie backs. Odds are that this new oil is some of the light sweet crude in the field. That stuff is easier to get at than the heavier stuff that comprises most of the oil at Hebron.  Plus it also commands a higher price for the crude and yields more reined products out the other end of the refinery.

Tie-backs are essentially pipes that run along the seabed.  They are a relatively cheap way to pump oil since you are not building a new ship or gravity structure to get at the oil.  Instead you just run these giant straws from the existing platform out to the oil.  Bob’s yer uncle.

So this idea that more oil drives up capital costs is just whack.

Then there is the math on the jump in costs.

Used to be the share of costs for Nalcor was $360 million.  Now it is $480 million. That is not an 11% increase.

That’s a 33% jump.


Curiouser, it becomes when you realise that while the House of Assembly was closed for a lengthy Easter break, the public found out that costs for the Hebron project had jumped by not 11% or 33% but 66%. 

From $5.0 billion to $8.3 billion.

Something does not add up here.

And it really does not add up when you look at the Premier’s claim that the provincial government’s royalties and benefits will jump by more than 50% as a result of an 11% increase in the oil reserves.

Let’s put some hard numbers on this. 

Let’s say, for argument sake, that the total amount of oil in the field was originally supposed to be 500 million barrels.

An 11% increase would give you a new total of 55 million barrels more oil.

According to the Premier, it cost $360 million for the province’s share of getting the 500 million barrels out of the ground. Finding 55 million more barrels didn’t lower the cost overall or the cost per barrel.  According to Kathy Dunderdale that small amount of oil will cost  - relatively speaking  - more than twice as much per barrel as the original oil.

That’s not a very attractive prospect.  The more oil you find, the more expensive each new chunk takes to produce it.  In fact, it makes no sense to keep finding more oil at Hebron if that is the case.  It won’t take too long before you have boosted costs to the point where the project would never be profitable.

Ah-ha sez you.

But those tiny extra amounts of oil actually produce more profit than the entire Hebron field.

After all, that’s what Kathy Dunderdale said and, Pakled that she is, Kathy is smart.

So it must be true.

Yeah, well, no.

What Kathy said was that this 11% more oil, the stuff that costs twice as much per unit to produce will actually return to the public treasury 50% more royalty and benefits.

To quote a famous politician, nothing could be further from the truth.

Simply put, royalty is a function of the quantity of oil, the price per barrel and the cost of getting it out of the ground. 

Let’s say that those original $500 million barrels produced royalty for the province of $500 million dollars.  According to Dunderdale, the 55 million new barrels would produce more than $250 million or roughly five times the return per barrel of any other barrel of oil.

Theoretically that could happen if the 55 million barrels were somehow handled differently than any other.  But they aren’t.  They are all barrels of oil sold at the same time as others for the same price and under the same royalty regime.


Between you and Kathy Dunderdale that makes one of you.

That concludes today’s lesson in Dundernomics.

- srbp -