As Oil Falls, These Kinds of Drillers Become Irresistible
Thanks to the drop in prices, some TV pundits are now talking about the end of the “new” oil age.
Of course, most of these misfits couldn’t find an oil slick if they slipped on it. But that’s not stopping them, not one bit.
Now admittedly, it’s true. With oil now trading in a band between $80 and $88 a barrel, there’s a “new normal” for crude. (And as I’ll explain later, it just won’t last).
The little-known truth is that, in some cases, lower oil prices actually make some companies even more attractive.
Let me explain…
Why These “Chicken Littles” Couldn’t Be More Wrong
First, let’s get something straight right off the bat.
It’s important to realize that a decline like the one we’ve had lately is not a signal that there is a recession coming. If there was, that would be a cause for concern.
But there is nothing to even remotely indicate that an economic correction is coming – actually the indicators are all pointing in quite the opposite direction.
This is simply a supply/demand event. There is too much production to match what is needed and the market needs only a few months to compensate for it. That’s the way markets work.
Here’s where my major contention comes in, the one these talking heads fail (or refuse) to acknowledge. Keep in mind that those who fail to understand it are just not “oil savvy.”
What’s more, many of these guys are just really interested in making more money. They tell everybody “the sky is falling,” then rake in the cash by shorting the result.
My major point is this: When oil prices fall in a non-recessionary environment, it is all about the cost of production.
The onshore projects that are now falling off are the unconventional (shale and tight oil), deep horizontally drilled, fracked wells that are more expensive to develop. And while these projects have the potential to produce large volumes, they cost millions to complete.
Projects like these make perfect sense when oil prices are above $100 a barrel. At those levels, economies of scale take over and improve profit margins. The higher production volumes offset the higher operating costs.
That margin shrinks considerably when crude oil prices drop. On average, $90 a barrel is required for a “greenfield” or new unconventional project, while over $75 is preferred for a “brownfield” project, or the reworking of an existing wellhead location.
Of course, a project’s profit margin is calculated over the life of the well, not simply over a span of a few months. But the expenses are loaded upfront. That means more than 80% of what it costs to drill a well are paid before anything comes out of the ground. The longer the well lasts, therefore, the greater the profit.
Of course, a dry hole could easily cost $5 million or more. In times of higher oil prices, these non-producers are simply figured into the overall budget. It becomes a more difficult proposition if the market price is low.
The Market Just Loves These Kinds of Producers Right Now
But more conventional producers don’t have these problems.
The companies that prosper during lower price periods drill traditional, conventional, shallow and vertical wells. These wells are quick in and quick out. They cost very little in comparison to complete, usually less than 10% of a deep fracked horizontal. Dry holes, therefore, are less of a problem in a drilling program that can finish wells in a week, as opposed to several months.
So when oil prices drop, extraction from shallow vertical wells tends to crowd out production from more expensive competitors.
Why? It’s due to one simple overriding factor. Traditional wells are often profitable at $65 a barrel, and sometimes even less.
And remember, supply may be up right now (resulting in lower market prices), but demand – even a sluggish demand scenario – will still require product.
So the “cheaper wells” end up grabbing a greater percentage of an existing market and the companies that drill those wells actually benefit from the falling overall price. They just grab a bigger market share.
This is why both of our most recent direct investment projects – Money Map Project #2 and #2(A) – have emphasized combining already producing wells (where the operating costs are minimal) with cheap, quick, shallow, vertical drilling of new wells.
In short, these projects are designed to move right into today’s oil “sweet spot” where the bulk of the profits will be made. And, of course, those profits continue for the life of the wells. That could easily be 10 or 15 years and even longer – in all pricing environments.
That’s the advantage of owning what comes out of the ground, not simply stock issued by a company looking for it.
Of course, oil prices are never static. We may see some brief moves around $80 a barrel, but the most likely move from here will be up. Not to $120 or even $110, but above $90 a barrel.
The reason for this is pretty straight forward.
As I noted earlier, lower oil prices are not an indicator of approaching economic problems. They are rather a barometer of supply and demand.
Two things happen in these cases. First, the lower the price the more oil we use. It is just axiomatic that we use more of a product like oil when the price is lower.
However, the second factor (and more decisive) occurs on the supply side. Lower prices discourage marginal production. That reduces the supply side of things and puts upward pressure on prices.
This is going to occur regardless of the geopolitical situation (which could of its own accord result in a big price jump) or moves by the Saudis (who have “proved their point” and will be relaxing their own export price cuts).
So the truth is there are plenty of ways to make money in oil these days.