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

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

First, French international giant Total SA (NYSE ADR: 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 Plc. (NYSE ADR: 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

oil wellThe other big change I'm seeing is a rather significant shift in production emphasis.

I have discussed this 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 many additional extractable reserves are now available in the United States that the ability to move them 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 oilfield services. Both make 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 deep horizontal fracking encompasses more traditional, shallow vertical drilling.

Here, with drilling going down only a few thousand feet with no fracking or 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.

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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 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'll 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.

Follow us on Twitter @moneymorning.

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About the Author

Dr. Kent Moors is an internationally recognized expert in oil and natural gas policy, risk assessment, and emerging market economic development. He serves as an advisor to many U.S. governors and foreign governments. Kent details his latest global travels in his free Oil & Energy Investor e-letter. He makes specific investment recommendations in his newsletter, the Energy Advantage. For more active investors, he issues shorter-term trades in his Energy Inner Circle.

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