Tag Archives: shale oil

oil at $80 a barrel–a Saudi plot?

October 24, 2014 By in Accounting, Capital-intensive firms, capitalizing vs. expensing, cash flow, cash flow/share vs. earnings/share, deferred tax, depreciation, Energy, Industry Analysis, shale oil, Strategy Tags: , , , , , , Leave a comment

I don’t think so  …and if the Saudis are trying to keep oil prices low in order to drive American shale oil out of business, it’s a pretty pathetic one  (Tom Randall of Bloomberg, for example, recently wrote an otherwise excellent article in which he supports the plot view).

Here’s why:

Any oil project starts with geology work to locate prospective acreage for drilling.  The oil firm then purchases mineral rights from the owner of the land where it intends to drill.  Next comes the actual drilling, which can cost $5 million – $10 million a well.  The driller also needs some way of getting output to market, which may entail building a spur to the nearest pipeline, or at least paving the local roads so that trucks he hires can get to the wellsite.

All that outlay comes before the exploration company can collect a penny from the oil or gas that comes to the surface.

In other words, the project costs are significantly front-end loaded.  This is important.  It means the economics of the situation change dramatically according to whether you’ve already made the up-front investment or not.

An example:

I took a quick look at the latest 10-Q for EOG Resources, a shale oil driller.

Over the first six months of the year, EOG took in $6.5 billion from selling oil and gas, and had net income of $1.4 billion.  That’s a net margin of 21.5%.  At first blush, it looks like a 20% drop in prices would put EOG in big trouble.

Look at the cash flow statement, however, and a different picture emerges.  The $1.4 billion in net comes after a provision of $1.9 billion for depreciation of some of those upfront expenses and after another provision of $479 million for deferred (that is, not actually paid yet) income taxes.  So the actual cash that came into EOG’s hands during the period was $3.8 billion.  That’s a margin of 58.4%–meaning that prices could be more than cut in half and EOG would still be getting money by continuing to operate existing wells.

Yes, at $70 a barrel, new shale oil projects are probably not sure-fire winners.  But oil companies will continue to operate oil share wells, even at prices below this in order to recover capital investments they have already made.  The right time for Saudi Arabia to throw a monkey wrench in to the shale oil works would have been three or four years ago, not today.

The wider point:  once a new entrant has made a big capital investment to get into any industry, it’s very hard to get the newcomer out.  Even if incumbents make the new firm’s position untenable, the latter’s goal just shifts away from making money to minimizing its mistake by extracting as much of its capital as it can.  It will be willing to destroy the industry pricing structure if necessary to do so.

 

 

 

oil: the view at 30,000 feet

August 15, 2014 By in Energy, Industry Analysis Tags: , , , , , , , Leave a comment

Oil is either a very complex subject or a very simple one.

There’s a wide variation among various types of oil, the kinds of input a given refinery can process, the politics/stability of the countries that provide the different grades of oil to the market, and the regulatory regimes in different countries where refined oil products are used.

Nevertheless, there are general patterns that can be of investment significance.

In particular, I think it’s at least possible that we’re entering a period of extended oil price weakness, due to slow economic growth in the US, and to a lesser extent in the EU, plus the sharp rise in unconventional oil production in the US.

Here’s why:

supply/demand

In the short run, oil supply is relatively invariant.  Major oilfields are very expensive long-term projects designed to bring large deposits of subterranean oil to the surface.  Once the oil starts flowing, it can’t be stopped without risking major damage to the oil reservoirs.  This could mean a lot of extra drilling to reach now-isolated pockets of crude.  So capping wells to reduce supply generally isn’t done.

Same with oil demand.  In the absence of large price moves,  people will continue to use transportation fuel in the same way.  Industrial processes won’t change.  So this major portion of demand is pretty much locked in.  And until a shockingly large heating bill comes in the mail, people won’t turn the thermostat down.

Because both supply and demand are relatively inflexible, small changes in either can result in large changes in price.  We saw this a few years ago when oil spiked above $150 a barrel as desperate users bid up the price of scanty supplies.  But the opposite could equally well occur:  panicked producers, running out of storage space to put barrels of crude customers don’t want, offering large discounts to get someone to take them off their hands.

On the supply side, OPEC is the largest factor, accounting for about a third of world output.

On the demand side, the US is the world’s largest, and most profligate, petroleum consumer.  We use 20% of the world’s oil while representing less than 4% of the globe’s population.  As I invariably try to work into the conversation, the US is also the only developed country not to have an energy policy that promotes conservation.   The intent has been to protect an inefficient domestic auto industry that ended up imploding in the last recession anyway.  One unintended effect has been to help preserve OPEC’s immense economic power.

shale oil

What’s new in the supply/demand story is coming out of the US.  It’s the rapid rise in production of shale oil, which has lifted total US crude output from 5 million barrels a day in 2008 to just shy of 9 million now–with at least another one million b/d gain likely over the next year.

Arguably (read: this is what I think, but have no definitive evidence for), the main reason oil prices haven’t been spiking up despite turmoil in the Middle East is the steady new flow of US crude from places like North Dakota.

The International Energy Agency has just pared a bit from its estimate of oil demand over the coming year, based on slowdown in the EU.  Large-scale purchases of new, more fuel-efficient cars in the US may begin to put a lid on domestic gasoline consumption, which is the biggest part of US oil usage.  China, the #2 world oil user, with about half the consumption of the US, is also growing a bit more slowly than anticipated.

Will all this be enough to tip the world oil supply/demand balance in favor of oversupply (and significantly lower prices)?  Who knows?   …but maybe.

effects?

…a shot in the arm for stocks generally (other than the oils).  Lower gasoline prices would mean higher discretionary income for ordinary Americans, which would be a plus for mass-market consumer stocks.

Bet on this?   …no.  Just something to think about, to consider what we’d buy if signs of a weakening oil price began to emerge.

 

North Dakota, fracking and flaring

July 8, 2014 By in Energy, Industry Analysis, Mining, shale oil and gas Tags: , , , Leave a comment

My internet is working again!!!

 

Oil production in North Dakota, driven by hydraulic fracturing in the Bakken shale, has risen from 400,000 barrels a day to over a million over the past three years.  This has elevated the state to second place in oil output, trailing only Texas–and the coastal waters surrounding the US.  At today’s rate, North Dakota accounts for 15% of total national output of crude.

No wonder North Dakota has sailed through the recession without many bumps or bruises.

Part of this expansion has been enabled by the wasteful practice of allowing drillers to “flare,” or burn, associated natural gas at the wellhead.  Last week, the North Dakota legislature took a baby step toward controlling this activity.

what flaring is

Many underground hydrocarbon deposits contain both oil and natural gas.  So output that reaches the surface is a mixture of the two.  Even in a remote area where there are no pipelines, crude can be saved in holding tanks and periodically trucked away.  Not so natural gas, which requires either a pipeline or  complex (and expensive) cryogenic system to get it to market.  This lack of transportability is the main reason natural gas often sells at a steep discount to crude oil based on heating value.  It also makes the gas a liability.

A generation ago, the most common way of dealing with natural gas that came to the surface with crude oil was to divert it to a safe distance from the well and set it on fire.  In today’s world, the accepted practice is to require the driller to pump it back underground.  That way it can be recovered and sold once there’s a transport mechanism in place.

Not so in North Dakota, though, where about 30% of the natural gas brought to the surface is wasted and burned.  Statewide, that’s about $50 million worth a month–four times that in energy value using its crude oil equivalent.  The 30% compares with 5% of gas flared from wells in Texas.

Environmentalists have been squawking about flaring for some time.  Landowners, too, who see potential royalty payments going up in smoke.

So last week, the ND legislature acted.  It is forbidding new wells to flare natural gas–meaning they must have a way to pump gas back underground–but does very little to stop the practice in already-producing wells.

The obvious consequence of this action is to raise the cost of future drilling in North Dakota.  This will gradually lower the profit growth of companies drilling there.  My guess, however, is that it will do little to slow the growth of production, since the new legislation just removes “Free lunch” from the bar.

 

 

 

 

 

 

shale oil and shale natural gas (iii): shale gas

January 31, 2014 By in Industry Analysis, Mining, shale oil and gas Tags: , , , , , , , Leave a comment

shale gas vs. shale oil

The impact of the development of shale oil deposits in the US is primarily macroeconomic and global.  The effects of shale natural gas, on the other hand, are very specific to the US.

Why?  …for natural gas, in almost all cases you need a pipeline to deliver it (the other (very expensive) option is cryogenics).

As I mentioned in my post two days ago, over the vast majority of my investing career an Mcf of natural gas (one thousand cubic feet, the basic unit) has sold at more or less the same price as oil, based on heating value.  Today an Mcf sells for only a fifth of that amount.

What happened?

The simple answer is “shale.”

Three factors, the first two of which natural gas and oil share in common:

1.  Most of the costs of finding oil and gas are up front–finding prospective acreage, buying mineral rights and then drilling a well. There’s also the cost of “dry holes,” meaning wells that come up empty.

In a successful well, outputs typically beings to flow to the surface without much assistance.  The out-of-pocket cost of delivering a unit of oil or gas, once the upfront money has been spent, is pretty low.  So prices can fall a lot before output is forced off the market by negative cash flow.

2.  It’s actually worse than that.  Petroleum engineers want to create a steady underground flow of output to a given well, to ensure that the most hydrocarbons will be drained before another well must be dug.  Stopping the flow creates the risk that output will start up later at way under the former rate–and that (expensive) extra wells have to be sunk to get at the oil or gas.

In the case of natural gas, sellers also typically have long-term contracts that require them to be able to deliver specified amounts. So they’re not free to turn off the taps, even if they wanted to.   Also, oil and gas sometimes both come out of the same well so the operator is stuck taking the latter to get at the former.  In this case, giving the gas away may be cheaper than reinjecting it into the ground–which is what most places require by law.

And, of course, the development company may need cash flow from its wells to pay salaries, service debt or fund capex.

3.  Unlike oil, natural gas can’t just be sold into a global commodity market, for use anywhere.  No pipeline network, no potential customers with gas furnaces and hookups to the local gas utility = cap the well.  The gas is worthless (this was the situation in the US right after WWII).

Today, the US is crisscrossed by huge networks of gas pipelines, so that’s not a problem.  But the customer base is relatively static in the short term (the pipeline thing).  In a situation where supply is expanding and demand is relatively inflexible, the only way for the market to clear is for prices to drop through the floor.    …which is what they’ve done.

It seems to me they’re going to stay there for a long while.

implications

Natural gas customers will continue to enjoy lower bills for heating and air conditioning.  For residential users, this means more money to spend on other stuff.  For industrial, it means higher profits.

Electric utilities are starting to substitute natural gas for coal in power generation.  Again, lower consumer and industrial prices.  European companies are already beginning to complain that their electricity costs are a competitive disadvantage.

The US petrochemicals industry is structured to use natural gas feedstocks;  Europe is based on oil.  …a huge advantage for US firms.

Foreign hydrocarbon-intensive industries are beginning to relocate plants to the US to benefit from low natural gas prices.  These are typically not labor-intensive operations.  So other than construction work, no employment bonanza.  But every little bit helps.

I think we’re still in the early innings of this story playing out.

investments?

I can think of three areas:

–strong consumer discretionary companies will probably enjoy a small, but continuing, tailwind

–shale oil and gas exploration/development companies.  I haven’t looked, but my instinct would be to zero in on small rather than large, and the lowest-cost operators.

–equipment suppliers (I own Chicago Bridge and Iron (CBI)), although these have had quite a run over the past six months.

 

shale oil and shale gas (ii): shale oil

January 30, 2014 By in shale oil and gas Tags: , , , , 2 Comments

conventional wisdom…

In recent years pre=shale oil),conventional wisdom about world oil supplies has been dominated by several ideas:

–that world oil production is at, or near a peak (Wikipedia has a good summary

–that steadily increasing demand will be generated by nations like China and India (when three billion Asians trade in bicycles for motorcycles, and then motorcycles for cars…), leading to sharp price increases

–the continuing pivotal role of OPEC–despite members’ competing national agendas–both in supplying oil to the rest of the world, and in asserting the rights of the oil-producing nations to be fully paid for selling their principal asset to the rest of the world

–the (oversimplified) asymmetry between major industrial oil consuming nations, which–ex the US–have little petroleum output of their own, and producing nations, with not much going for them economically other than oil

–the central role of the US, the largest and most profligate oil consumer in the world, in moving D-day for a supply crisis closer to the present.  Two powerful special interest groups, Big Oil and Big Autos, have forged a unique alliance to block the (demand-lowering, government spending-funding) taxation of oil and oil products that is the norm elsewhere.

Less talked about, but still important, is the activity of  hydrocarbon “national champions: in places like China and Japan.  These are firms, some publicly traded, whose main mission is to secure oil supplies for delivery to the home country in times of shortage.  To them, profits are a distant second to getting control of barrels.

Other forms of planning for the upcoming shortage have been high up on the political agendas of most countries (ex the US) for years.  The development of nuclear power generation is one prominent example.

…may be turned on its head,

in two ways:

1.  The situation of the US, as the glutton at the world energy table, is changing.  It’s not that we’re consuming less.  It’s that, thanks to shale oil, domestic oil production is beginning to increase.  Also, the extremely low relative price of domestic natural gas, thanks to shale gas (tomorrow’s topic) is prompting users who can do so to switch from oil to gas.  The shale revolution is also beginning to get foreign oil users to relocate plants to the US so they, too, can use cheap gas as a feedstock.

2.  The shale oil/gas business is so new that no one knows yet what deposits may lie within the borders of large European or Asian oil-consuming nations.  These may also be very large, although natural gas recovery faces the distribution infrastructure issues I outlined yesterday.

consequences

There are certainly geopolitical implications as/if the asymmetry between petroleum producers and petroleum users shifts.  If/as that happens, will the Middle East be as important in politics?  Probably not.

Commodities speculation based on the idea of ever-rising oil prices may abate.

Alternate energy, particularly forms requiring large government subsidies, may lose investment appeal.

The oil industry itself may shift further away from the idea of Indiana Jones-like exploration for mammoth new oilfields toward the profit calculations of pocket protector-equipped mining engineers assessing recovery prospects from well-mapped shale prospects.  This probably favors smaller companies over larger ones.

Energy exploration and development firms with marginal success rates, whose main appeal is therefore their leverage to rising energy prices, become (even) more speculative than before.