Don't Fret Much About Falling Oil Prices

 | Nov 13, 2013 | 11:00 AM EST  | Comments
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dnr

There has been a lot of chatter lately about oil prices coming down, with more and more shale and deepwater capacity coming online and the prospect of the lifting of sanctions on Iran.

While the recent breakdown in six-party talks with Iran bodes well for higher oil prices, a downward trend in oil is apparent. Brent crude, for example, has come down from over $115 in August to just above $100 earlier this month.

Reacting to this momentum, the market seems to be orderly filing out of shale names, effectively breaking their spectacular winning streak from this summer. The reaction in non-shale names seems to have been milder, but concern about lower oil prices persists.

Where to be

While Brent has dropped by about $10 at over $106 per barrel, all of the new production methods, both shale drilling and deepwater, remain extremely profitable. And most deepwater and shale plays would still be profitable were Brent to drop another $10.

Some, such as Forbes contributor Bill Conerly, believe we will see $80 or lower oil prices within the next couple of years. He believes that the heavy lifting in rig activity from the last few years will result in substantial low-risk production increases now and into the future. Even in a scenario like this, many of the sources of today's production growth will remain profitable, but we would have to be more selective.

 

WTI Breakeven Price
Denbury Economics

 

Let this chart be a sort of guide to a worst-case scenario. At $80 oil the more marginal shale plays fail to fetch a 20% internal rate of return. Remember, many shale players get WTI pricing, not Brent. WTI today is $93 per barrel. Shale oil investors should therefore be selective. The core areas of the Bakken can operate at as low as $68 per barrel, and should do just fine. The oilier Eagle Ford producers seem to need $76 oil, but consider that a number of these names do get Brent pricing. In general, the safer names are in the Eagle Ford's lower-cost northeastern core.

Also, notice how profitable CO2 injection producers are. This "tertiary recovery" method taps mature basins for additional oil missed by primary methods, requires little investment and is therefore very profitable. CO2 injection is an important part of quite a few producers across the country, but is most common in the Permian and California. Denbury Resources (DNR) is the most well-known "pure play" CO2 injection producer, and could therefore have the lowest cost base in North America.

Since deepwater drilling is done offshore, all oil produced there fetches Brent pricing. So while deepwater may indeed have the highest cost base, it also fetches a higher price per barrel. The steep drop in oil during 2008 and 2009 severely hurt deepwater margins and caused rig day rates to plummet, but since then deepwater has recovered and never looked back. At the very minimum it would take a $15 drop in Brent from these levels before rig lessors and deepwater operators reevaluate their strategy. At $105 Brent, about where prices are today, the better deepwater operators can get returns in the 30s. There's no need to panic.

 Bottom line

 Lower oil is entirely possible, but as we can see, most new forms of production come with a good margin, which will act as a cushion. Deepwater operators will continue to be profitable, barring a major drop. CO2 injection is even safer, with a low cost base. A big drop here would effect production in some places. Investors in the shale should stick to the Bakken-Permian-Eagle Ford core plays, and avoid more marginal shales such as the Mississippian.

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