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Where the Next Oil Profits Will Be Made (It’s Not What You Think)

by | published October 2nd, 2015

We now have another indication that the oil pricing environment is causing a constriction in forward project commitments: Two more oil majors recently announced that they will cut capital spending.

First, French international giant Total (NYSE:TOT) said that it was dramatically lowering its capital spending, delaying the start of projects, and increasing cost-cutting measures in the face of low prices.

The latest cut amounts to $3 billion, but combined with others previously announced, the company plans to bring the amount it spends on oil and natural gas projects down from a high of $28 billion in 2013 to $20-21 billon in 2016 with a “sustainable level” of annual capex at $17-19 billion from 2017 onward.

The news had hardly sunk in when an even bigger news flash hit. After being the focus of intense political battles over several years, Royal Dutch Shell (NYSE:RDS-A) indicated it would stop its $7 billon offshore drilling program in the Arctic.

These two announcements are the tip of a much bigger iceberg. The curtailment of future project commitments is just one of the results of low prices.

Here’s the other major effect, how it will shake up the oil industry, and how one group of companies will come out on top…

A Tipping of the Supply/Demand Scales

The other big change I’m seeing is a rather significant shift in production emphasis.

I have discussed this here in Oil & Energy Investor before. It is important to remember that, while pundits may note shifts in demand (often misinterpreting what the figures mean), the overall trend remains up. Demand, as with price, is determined by global, not domestic, factors. And worldwide demand should end this year at the highest point ever recorded.

With demand there, the question of why prices are subdued falls on the supply part of the equation. And it is here where the traditional trade-off changes.

In the not so distant past, an equilibrium between the two parts of the supply/demand relationship was what the market sought.

Spiking demand meant additional supply was needed, with prices rising until the new volume made it to market. Rising supply, on the other hand – absent additional demand to meet it – would result in lower prices.

That may still be the case these days, but with one huge caveat. Unconventional production – shale and tight oil – has tipped the scales. So much additional extractable reserves are now available in the U.S. that the ability to move these online has fundamentally altered global pricing expectations.

Great for those aspiring for “American energy independence,” but not so great for the companies trying to survive in such a brave new world. It is as if the supply part of the equation is no longer a concern.

Prices Can’t Support Drilling

What has occurred, however, has hit with a different effect, depending on what kind of production is undertaken. The more expensive, deeper horizontal drilling requiring fracking to open up rock is now under significant strain.

Such drilling has made the Eagle Ford Shale in South Texas and the Bakken Shale in North Dakota focal points for the new drilling. But such deep wells – often below 10,000 feet – are expensive. An average outlay of $5 million per well for all aspects of a project is hardly unusual.

It is true that such fracked wells can produce a substantial amount of oil, higher on average than conventional vertical wells. But the current price does not support such outlays.

Progress has been made in making drilling more efficient, while the recession in the industry has cut costs for oil field services. Both make the drilling cheaper. Nonetheless, on average, the shale/tight oil approach requires a price in excess of $70-75 a barrel to make it worthwhile.

And that is not happening.

Now companies like Total and Shell are careful to point out the projects are delayed, not canceled. Once prices improve, so will the potential of large projects. However, even here, there needs to be the likelihood of sustainably high prices over a period of at least a decade or more for the initial capital expenditures to be worth it.

In the case of Shell and other offshore drillers, the costs are much higher. Once again in counterbalance, offshore “blue water” (i.e., deeper water) wells provide the prospect of significantly higher volume than their onshore equivalents. In the Far North (including offshore Arctic Alaska), the projected available reserves are staggering. Yet the cost is even higher.

Where the Profits Will Be Made

Just about all of this is front-loaded. That means the vast majority of the funds have to be spent before anything comes out of the ground. The longer the well produces, the greater the payback of investment and eventual profitability. A dry hole, on the other hand, would be quite a setback.

Yet the demand for product remains. So, in this environment, where is the play? There is one, and it involves the new balance emerging. The other side of the production curve from the deep horizontal fracking encompasses more traditional, shallow vertical drilling.

Here, with drilling going down only a few thousand feet, no fracking, and no horizontal drilling, a well can be completed for a few hundred thousand dollars. A variation on this, which I have come to call “SVF” (shallow, vertical, formula) drilling, is coming in as even less expensive. In part, this is because the “formula” portion of SVF refers to spudding wells in a pattern over an already seismically studied area.

The big boys need to justify large projects with heavy financing requirements. On the other hand, not only can smaller producers focusing on SVF drilling afford to stay competitive, they can also afford dry holes and still turn a profit.

That is, if they can weather the encumbrance of debt. The smaller guys may be more efficient in maintaining production when oil is at $45 a barrel. But they also often carry higher debt to do so.

As I have discussed here several times before, the cost of servicing that debt is getting worse and will comprise one of the main reasons otherwise well-run companies will be going belly up.

The shift in profitability for American production may be moving from the very big to the much smaller.

Keep watching these pages, as I keep you up to date on all the changes occurring in the oil and energy markets and let you know which companies are the ones best suited to profit in this new environment.

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  1. Robert in Vancouver
    October 2nd, 2015 at 11:34 | #1

    Maybe the big oil companies will change their business model. Instead of putting their money into finding and developing huge oil deposits, they could just buy out smaller companies who have developed low cost low volume oil deposits. Like a roll up strategy. The big oil companies would become more like investment banks and holding companies than traditional oil companies. Maybe?

  2. Dale
    October 2nd, 2015 at 13:47 | #2

    Gee, cry me a river for the poor, all-time-record-setting-profits oil companies. Why cry for them because supplies are high, so price stays down ? They have a government-sanctioned monopoly (oh, you don’t like to pay the high price of gas to put in your car? Then go use something else – ha ha ha ha ha ha [evil laugh]), so they will purposely curtail production to artificially inflate the prices again. Somehow this doesn’t sound like free markets governing prices to me, it sounds more like sanctioned manipulation. But what do I know – I’m just a whining nobody with limited resources just trying to survive in today’s corrupt world, paying the high costs of oil products AND all the ripple-effect higher prices for every other product that has to use oil products for shipping, power supply, etc.

  3. October 7th, 2015 at 19:56 | #3

    It’s not the big oil company’s that are getting hurt in this it’s the 3rd party employee’s like myself. I have been what’s call a test operator for 4 years because I rely on the actual drilling itself because I provide services to various rigs the down sizing has hurt not just me but many of my friends and former co workers a ton. I can think of at least 20 2 30 people that I have worked with over the years that are affected by this ression in the oilfield. U guys think o boo hoo big oil company’s are still making money but when they aren’t making a ton they cut prices so much it cost mom and pop 3 party companies like the one I work for out of business cuz we loose money just to stay open. This is the majority of my work experience and I truly feel for the people like me who are suffering just trying to survive this and pray it picks back for a lot of families not just my own

  4. Shawn
    October 9th, 2015 at 12:57 | #4

    Excellent article and I agree with your thoughts. I look forward to hearing your thoughts on investing in smaller, financially sound (cash rich) companies that are poised for profitable production or even growth. Shawn

  5. October 21st, 2015 at 22:45 | #5

    I live on SSD FOR 20+ years,no fault of mine.I consider myself lucky. I’m 52yrs young I take home 1632 us dollars,a month with no wife or kids! What does someone, my age who is married and have kids do. GOD HELP THEM????3

  6. gorham k
    October 24th, 2015 at 03:46 | #6

    Sir, If oil prices remain low how can we make gain invesnting in oil stocls? Some wallstreet analyst suggested a dividend p[lay by investing in MLP companies which own oil pipleine/distribution network across usa. As they are immune to oil/natural gas price. would appreciate to her form you on this

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