The Companies Poised to Profit From the New Energy Power Balance
As we await the next chapter in the ongoing Greek debt mess, something of interest is happening here in the U.S.
For the first time in my memory (which goes back more than four decades in this business), the normal supply-and-demand trade-off has been fundamentally altered.
As I have explained on several occasions in Oil & Energy Investor, energy debt matters will hamper some U.S. producers, while the inability to replace volume extracted due to the expenses incurred exceeding the wellhead profits will cause significant problems for others.
Put simply, some companies are going out of business. Either other corporations will acquire their assets (including producing wells and land leases) in what is shaping up as a major new M&A cycle or they will simply go bust.
We have talked before about the opportunities for the investor from this cycle. Today, however, I want to emphasize something else that is having a more direct impact on how you should be selecting your investment targets moving forward.
Here’s where the best opportunities are going to arise…
The Energy Balance Is Changing
There is no longer a genuine concern that the U.S. may not have sufficient oil supplies moving forward, at least for the next several decades. That, combined with the inroads being made by natural gas (where we also have the benefit of a largess from unconventional sources), renewables such as solar, wind, biomass, and geothermal, a return of nuclear, and new sources such as tidal, kinetic, and even clean coal are changing the larger energy balance picture.
In short, there are more sources providing energy, requiring that we be less reliant on any one. The trick, as I have mentioned many times before, is to fashion these sources so that they are more freely interchangeable.
Regardless of how this is cut, crude oil will remain a basic component of this new mix, leading us once again back to today’s discussion. The amount of oil available for extraction in the U.S. is one thing. The sourcing balance of that oil is something else entirely. And it is this changing balance that will provide some very nice investment opportunities.
What I mean here is rather simple. There may be a lot of oil out there, but some of it is more attractive to end users (in this case, refineries) than others.
There are two overriding considerations: 1) the cost of the crude to the refiner (still the largest single expense in producing finished oil products) and 2) the physical location of wells combined with the infrastructure expense of moving it.
The Target to Look For
All other matters being equal, the second of these factors would favor fields closer to the refineries, providing of course that they can guarantee sufficient volume. A refinery will have a combination of sources designed to maximize a range of considerations; this may even include imported crude at the right price. Nobody relies on one source only. Nonetheless, there will be a designated “go to first” source, and that is the target we look for as retail investors.
The target identifies companies likely to pop in value before others as the overall refining sector in the U.S. gets used to emphasizing domestic sourcing.
Nevertheless, the first element remains the most important. Cost is not simply how much a refiner pays for the raw material. It is also the grade of the oil received. Heavier and sourer (higher sulfur content) oil costs more to process. The crude may have been purchased at a discount, but there is greater expense on the refining side when it is used.
These days, when both of these cost factors are considered, a clear winner emerges. This is the change in the oil supply balance that will impact what companies and projects will have the greatest investment return potential.
Deeper, horizontal, fracked wells require a higher market price to be competitive. If the price of WTI is $60 a barrel, the producer has to figure on a wellhead price (the price he receives when selling to a distributor) of some 15-20% below that.
My Estimates Hold Up Quite Well
Let’s put all of this in perspective. My previous estimates are holding up quite well. I remain of the opinion that WTI prices will be between $65 and $68 a barrel by the end of July, and between $73 and $78 by the end of December.
A standard shale/tight oil well (requiring a depth of 9,000 feet or more, horizontal drilling, and fracking) is an expensive prospect. My present figures indicate companies require a breakeven price of above $74 a barrel. That is likely to come by the end of this year or the beginning of 2016, although I also calculate the breakeven price at that point to be at least $76.
These companies now have to hedge their contracts forward to keep working. That requires credit lines and also exposes them to a deteriorating high-risk bond market.
On the contrary, well-structured formula drilling programs (in which wells are spud in a specific low-cost pattern on known ground) in basins already producing from shallow (maxing out at 4,500-5,000 feet), vertical drilling are coming in a lot cheaper. My current average here is less than $56 a barrel, and $58 by the end of the year.
These Are the Companies That Will Make the Best Returns
There are a number of elements to consider in determining the sourcing mix used by refiners. But taking the most important single component – cost – shallow, vertical, formula (SVF) wells are providing refiners a benefit of more than $18 a barrel.
That has already become a major enticement for the cheapest and most flexible drilling approach there is. The average unconventional well costs more than $3 million. An SVF well can be drilled for $700,000 or less.
These companies will take an increasing portion of the “first up” sales to refineries. They are designed to profit from lower oil prices and pass that on to the processors. It costs them less to operate, while the oil market is dictating a price high enough right now for nice profits.
Once we are above $85 a barrel, just about all oil companies will profit. But for at least the next several quarters, the smaller SVF companies are going to be making the best returns. I’ll keep you posted as this scenario plays out.