In my last column, I tried to draw a few long range conclusions about U.S. production of shale oil, using the terrific graphics from Enno Peters of Shaleprofile.com. In this column, I promised to focus on the kind of Oil Company you’d want to be invested in, based on those conclusions. If you haven’t seen those representations of shale production from the Bakken shale play and the Eagle Ford, I invite you to take a look at them again.
(Click to enlarge)
(Click to enlarge)
The fantastic color coding of the chart not only makes clear the total production of oil, but also when each part of that production was initiated, and how efficient the wells from each year have proven to be.
One fundamental idea is that as each year goes by, a percentage of production must be re-initiated in order for total production to remain the same and a logically greater percentage in order to increase production, as has happened in every year except this one.
I know this is obvious, but it bears repeating, and these charts scream out: Oil wells cost money to drill and inevitably run dry. They need to be constantly replaced with fresh drilling to maintain output. Those drilling and maintenance costs sometimes overwhelm the returns of the oil being sold, as is the case this year and the previous two, and sometimes the returns greatly outpace the costs, as was the case before the bust in 2014. We know that most of the independent U.S. oil companies operating in shale have bypassed this current cash burn problem in the short term by raising efficiencies – which lowers costs - and by slashing capex, which sacrifices the ability of potential future replacement.
I have argued in my last column and elsewhere that efficiencies are a very helpful cost tactic but one of continually lessening returns – there is only so much oil to be retrieved from a well -- and other charts I supplied from Mr. Peters’ website show that these limits are already close to being reached. I also argued that capex slashing would limit the amount of future oil that would be coming from these two major shale plays, no matter how high oil prices might get.
With all this in mind, and as we move through this (relatively) limited time of low priced oil, our job as investors (and my job specifically), is to find oil companies that are capable of three things:
1 – Surviving the oil price bust, but doing it so that the resultant debt burdens won’t be unsustainable and can deliver a superior return on equity.
2 – A portfolio of acreage capable of producing for many years, if not decades, at a cost that won’t outstrip oil prices, but run significantly under them.
3 – A stock price that reflects the challenges, but also the possibilities of the coming oil price recovery.
It happens that very few U.S. independents manage in my mind to come close to fulfilling even one of these requirements, let alone all three, which would indicate a solid and very profitable long-term investment.
As oil retreats again towards $40 (as we predicted), we might find oil stocks that will meet all of our criteria again, as they did in the early spring when we bought shares of EOG Resources (EOG), Cimarex (XEC), Hess (HES), Continental (CLR) and Anadarko (APC). In all of those issues now, however, it is the stock price - number three in our list - that has disappointed us currently. All of these names are now overvaluing their possibilities and undervaluing their likely challenges in the coming months and year, making investment in them today difficult. That will, I believe, change again – and if it doesn’t, I won’t feel bad about missing an opportunity with a very limited upside.
Better values lie currently in natural gas stocks, and we’ll talk about some of those opportunities in my next column. Don’t fret about missing an opportunity in the next week, as I feel confident that the markets will continue to mark time through the first week after Labor Day. Enjoy the long weekend.