Low oil prices are damaging most energy companies. Except one particular segment.
Oil prices are on investors’ minds, and for good reason. In the past three months, oil prices have fallen roughly 23% to around $75 a barrel.
Consumers like you and me are appreciative. But many investors are flummoxed.
After all, $100+/barrel was supposed to be the new norm. The U.S. Energy Information Administration (EIA) has been saying as much for three years.
However, when it comes to oil prices, there is no “norm.” Oil is marked by volatile price swings. What costs $140/barrel one year could cost $40/barrel the next.
What’s more, the price trend isn’t always up. Years of depressed oil prices are a possibility. Through most of the 1990s, a barrel of oil cost less than $40.
West Texas Intermediate Crude Prices (1970 – Present)
The fact that oil prices go down, and can stay down, is a problem if you’re an energy investor. Another era of prolonged depressed oil prices could spell the end of the U.S. oil shale miracle. A recent Sanford C. Bernstein & Co. report shows that one-third of U.S. shale formations are money-losers when oil prices fall below $80/barrel.
When it comes to oil investing, it pays to discriminate.
Oil production isn’t a homogenous blob. Things like capital structure, level of expertise, and geography matter. To buy into the general narrative and to overlook individual company characteristics is folly.
The upside is that low oil prices result in value-priced oil exploration opportunities, at least if you know where to look. And that can be tricky. When the tide (prices) again rises, all boats won’t be lifted. Many oil companies will be irretrievably sunk.
Therefore, investors need to look past the shale happy talk and focus on shale’s considerable shortcomings. High production cost is one; high depletion rates are another.
Production from an average shale well declines more than 80% within four years. That’s more than three times faster than conventional wells, according to the EIA.
More stable opportunities exist elsewhere, particularly offshore. The Manifa Oil Field in the Persian Gulf, for example, started production in 1964. The field continues to produce 200,000 barrels of oil a day.
What’s more, the deeper you go, the more efficient you get. Ultra-deepwater drilling (more than 1,500 meters) is surprisingly efficient. The companies that do it still make money even with oil prices below $80/barrel. Less than 1% of their production requires a price above $80/barrel.
With oil production, well-capitalized offshore drillers appear particularly enticing. Most of them carry depressed share prices that have lifted yields up to multi-year highs. In essence, offshore drillers have been pushed to the back burner in favor of the glamorous shale producers.
Within the forlorn offshore drilling segment, Diamond Offshore Drilling (NYSE: DO) is among the best of breed. The company is conservatively financed and well positioned to exploit its less frugal competitors. In the meantime, Diamond boosts a 9.8% yield.
Big integrated energy companies – key offshore drilling customers – also look value priced. ExxonMobil (NYSE: XOM), Chevron (NYSE: CVX), and Royal Dutch Shell (NYSE: RBS.a) still make money with oil prices above $70. Bloomberg data show that the last time oil prices dropped below $80 a barrel, in 2012, these companies reported returns on invested capital between 13% and 16%.
Higher oil prices may be on the horizon. Then again, so might lower prices.
One thing is for sure: not every oil production company will make it to the horizon.
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