Why You Need to Invest in "Small Oil" (And Not the Big Boys)
It’s hard to think about the oil patch without an image of John D. Rockefeller’s massive Standard Oil.
From the hard work of a former bookkeeper, “Big Oil” was born.
But now, over 140 years later, the big oil majors like ExxonMobil are beginning to lose some of their famous grip.
You see, in today’s world, bigger is no longer better when it comes the oil industry-especially for investors who want to maximize their returns.
That’s why “small oil” investments are about to make us some big money.
It’s a stunning reversal from not that long ago when even the biggest players wanted to get even bigger still.
Back then, “vertical integration” was the major theme for all the big players.
The idea was to combine upstream, midstream, and downstream activities all under one roof to benefit from what’s known in the industry as “transfer pricing.”
Transfer pricing allows two units of the same corporation to determine prices (what “A” charges “B”) and costs (what “B” must pay to “A”) depending on the overall corporate bottom line.
With transfer pricing, “A” no longer had to make a profit. It only needed to contribute to the broader corporate good by meeting expenses.
The result would be higher efficiency and lower overall operating expenses.
The Birth of Mega Big Boys
What resulted was the creation of the huge mega-giants – where the same name would be on the field, the refinery, and the local service station.
It ushered in a wave of major mergers and acquisitions that also significantly reduced competition.
BP plc (NYSE: BP) is a good example.
The international major absorbed two primary competitors – Arco and Amoco – on its way to becoming one of the top five oil companies worldwide.
The M&A boom, along with the drive to become the next VIOC (Vertically Integrated Oil Company) did start to slow down in the early 1990s.
The decline in the cost of crude oil was one reason (since that narrowed the margins justifying integration to begin with). But there was another, more powerful cause.
It turned out being a “jack-of-all-trades” in the oil business wasn’t the route to increased cost savings.
By putting each element in the upstream-downstream sequence “in house”, expenses became bloated and distorted corporate budgets.
As a result, smaller more specialized companies could provide better results at lower prices, while also having the flexibility to better adapt to changing conditions.
Houston, We Have a Problem
As we moved into the new century, the vertically integrated big boys were already under pressure.
The first signs that the integration craze was coming to an end was when the big boys began divesting their oil field services (OFS) units and retail outlets.
OFS involves everything from conducting initial geological surveys and seismic studies, through analyzing initial data, spudding exploratory and test wells, building field infrastructure, well completions and workovers, maintenance, supplies, equipment, and a myriad of other related matters.
Retail is simply is where the pump is.
However, both OFS and retail outlets require specialized expenses, added network costs, and that bane of all corporate number crunchers – inventory costs.
As a result, the companies that focused on only one segment could consistently undercut the larger corporations.
Today, not a single top 20 oil company internationally drills its own wells. And even ExxonMobil Corp. (NYSE: XOM) has divested itself of what had been the world’s largest retail network.
Of course, when you fill up the family SUV it often still looks like a major outlet with an Exxon, BP, or Chevron sign out there on the street-but it’s not.
Most outlets today are actually operated by a separate retailer or they are franchised. The name on the sign is literally rented out while the new owner is often required to purchase the oil products from the major.
The same thing has been underway among OFS providers.
The biggest – Schlumberger Ltd. (NYSE: SLB) and Halliburton Co. (NYSE: HAL), for example – are active in acquiring smaller competitors, along with equipment manufacturers and distributors, analytical firms, transport venues, and the like.
Nonetheless, this is once again an expansion in one segment of the overall process not up and down the sequence from field to consumer.
Most of the VIOCs are now concentrating on production, while still having investing positions in other segments. Yet the focus is no longer on being big for its own sake.
When it Comes to Oil, Bigger Isn’t Better
That brings us to why “small oil” is a better investment these days-especially on the production side.
That’s because the large companies are experiencing a significant rise in their production threshold.
That is, their “big oil” size requires larger field projects.
Put simply, the overhead involved requires that bigger companies run bigger plays. That has been increasing the threshold below which a big boy can profitably operate.
What results is an environment in which a range of smaller companies are picking up productive acreage the big boys cannot possibly operate.
As I have noted on several occasions in OEI, solid companies under good management, emphasizing specific basins and often limited oil types, have been outperforming the majors.
In addition, the number of attractive fields open to these smaller players is increasing.
And with all the talk of massive unconventional oil production in places like Eagle Ford and the Bakken, one simple fact has gone unnoticed.
There are now more well opportunities available in smaller fields than ever before, especially in those areas where production is leveling off or declining.
That’s why the “step-out” or “fill-in” well is quickly becoming a significant investment prospect.
And it is not the vertically integrated majors that will be developing these wells.
These types of wells offer too small a production flow to meet the return objectives of the large operator.
On the other hand, these wells are tailor made for the well-focused, smaller producers.
And in a few weeks, I’ll be unveiling a way for the average investor to make some big bucks with the small fries.
This is an entirely new approach. You may want to hold on to your hats.