Why Bigger Isn’t Always Better For Oil and Gas Stocks

by | published June 21st, 2013

During an investment meeting a few nights ago here in Las Vegas, a recurring theme emerged.

There is one particular type of oil and gas stock that stands to benefit the most–and it is not the kind of investment you might think it is.

That’s because it’s not how big a company is anymore that decides whether or not it will make a great investment.

Instead, there is another set of criteria that dictates how an investor should approach oil and gas stocks.

As I have noted in previous issues of OEI, smaller, well-focused and well-managed companies often provide a better return than larger oil and gas majors.

Those leaner producers with an emphasis on lower reserve fields in basins where they have had successful experience in the past tend to be lifting production at lower operating costs.

However, there is a real interesting development on the other side of this observation…

The Rising Threshold for the Majors

If anything, this trend has been intensifying and is the real key to what is of primary interest. The threshold is now being raised for the majors to operate fields effectively.

This means that more promising oil and gas production zones are now off limits to very large companies – whose overhead and return requirements necessitate bigger projects.

These are not simply low well count and daily production programs either.

Let me explain.

Up until recently, views of the U.S. market would begin with a few simple observations.

First, American production was in decline. Second, as the most geologically studied market globally, it was unlikely that there would emerge any major new fields.

And third, most daily production was coming from very small operations.

This last observation was particularly striking.

Only a few years ago, you could say with certainty that over 60% of daily U.S. oil production came collectively from stripper wells. These are wellheads producing on average less than 10 barrels of oil each per day.

They comprised the bulk of an overall declining amount of oil in what was universally considered to be a mature market.

As a result, major companies were obliged to move either offshore or abroad in pursuit of larger fields. The very structure of these companies reflected the anticipated size of their undertakings.

For a time we went through a period in which the majors would attempt to maximize return by coming to control operations from upstream production, through midstream transport, to downstream processing of oil products, wholesale distribution, and retail sales.

During these years, the big boys attempted to become bigger by expanding into vertically integrated oil companies (VIOCs).

The idea was to reduce costs by utilizing transfer pricing rather than arms-length market transactions. That is, VIOCs would be comprised of entities providing necessary elements in the upstream-midstream-downstream sequence that were actually part of the same corporation.

According to the approach, each component could charge the next for products or services rendered based on what the overall corporation needed, rather than dictated by each generating a sufficient profit (the result needed if they were arms-length, or genuinely distinct companies).

Those days are now over.

While there are still some examples of VIOCs, the more recent moves have been to divest less profitable divisions such as oil field services (OFS), retail networks or pipeline systems by either outright sale or spinning them off as separate entities.

Today, the largest tend to emphasize what they are good at, while attempting to retain only those aspects required for global operations. Yet the new emphasis has not completely reversed the earlier process.

These remain large, multifaceted companies that carry into a project certain requirements of size placing many otherwise profitable fields below their interest.

That threshold below which the large producers cannot effectively operate has been increasing. Only five years ago, any oil field having less than 100 million barrels of recoverable crude or 500 million cubic meters (17.7 billion cubic feet) of natural gas was often considered too small for the majors.

Now those cutoffs for separate standing fields (that is, those that are not satellite reservoirs of currently producing reserves) are approaching 250 million barrels of oil and over 1 billion cubic meters of gas.

This is placing some very prime field targets below the main players and within sight of smaller producers.

The Growing Boom for Smaller Players

The case in point was one of the projects comprising one of the main subjects at our meeting. At 190 million barrels of estimated reserves but located in shallow offshore waters, the project was abandoned by a global major as below their production threshold.

On the other hand, for a smaller company primarily interested in this volume range, it is ready made. Development capital requirements are lower, often much of the pre-drilling field study and geological requirements are already in place, and preliminary estimated reserve figures are known.

The key is bringing the project in at or below projected budget.

For this, you need managerial and geographic area specific expertise. That translates into relying upon companies with a successful track record of bringing in wells located within neighboring production zones.

This is hardly wildcatting. Rather, the drilling at issue is in well-known regions having substantial prior production. The limitation experienced by the big boys is no limitation at all for the smaller experienced company.

As the major company threshold expands, profitable projects increase for other operators. So do the opportunities for retail investors.

The environment emerging will provide a widening number of lower production success stories—along with some nice returns on the equity issued by them.

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