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  1. Home
  2. / Investing
  3. / Energy

Looking for Oil's Break-Even Point

That number is getting lower in Wood Mackenzie report.
By DANIEL DICKER Jul 19, 2016 | 01:00 PM EDT
Stocks quotes in this article: XEC, DVN, APA, APC, EOG, COP

The latest report from Wood Mackenzie on U.S. and other non-OPEC oil exploration and production into 2025 is worthy of a very deep dive, because it gives terrific information, not just on where U.S. oil will be coming from in the next 10 years, but where the best likely places to invest will be. 

I truly rely upon Wood Mackenzie as one of the finest, if not the finest energy analytics service out there -- and this latest report serves as a tremendous template for our investment purposes. While the report is fairly long and wonky, the major takeaways can be culled from this one very important slide: 

Wood Mackenzie Oil Report
View Chart »  View in New Window »
 

There's so much information here, it's hard to know where to start. But let's start where Wood Mackenzie did, pointing out the tremendous gains in efficiencies, spacing and techniques for shale drilling, and discussing at length the terrific gains (drops) in break-even production prices for various shale plays in the U.S. 

This note of dropping break-even prices was heralded by most of the energy world as the important point of the report, showing that oil was much more likely to remain under $100 a barrel for a very long time, considering the profits that several core plays could achieve even at $40 a barrel. 

But this, I submit, is an ultimately incorrect conclusion. Let's look deeper. 

First, it can be seen in the chart the break-even prices represented are weighted averages, meaning that while much of the oil that might be produced in a certain area will be at or below that average number, a healthy portion will be above it and sometimes far above it. Indeed, the Woodmac chart goes a good way to showing just how healthy each area is, how much oil is likely to be produced and how much of it is at or below its average break-even price and also, importantly, how much will be above it. 

Look, for example, at the Wolfcamp bar on the slide, a prime Permian area. The break-even for that play lies low in the bar, implying that a large portion of those wells will deliver break-evens below $40, but it also implies a sharp cutoff once those core wells are counted, with other portions of the play requiring upward of $75 to be profitable. The Eagle Ford bar shows a similar profile. 

This matters as we again take the slide in its entirety, because Woodmac points out importantly that 9 million barrels a day of new production will likely come online at a break-even price of $60 a barrel or less -- however, it notes that 20 million barrels a day of new production will be required of U.S. and non-OPEC producers to meet total demand by 2025. 

If, at this point, you don't have a reference about the marginal barrel price of oil and why that's what drives the fundamental market price of oil, I invite you to immediately pay $5 and read my book explaining the concept. It is the most critical point in understanding how fundamental prices are reached. To put it simply, for those uninterested in reading my book, it is not the cheapest barrel of oil that satisfies demand that sets the overall price. It is the last and most expensive barrel's price that does so. 

Now, understanding that and looking at this slide, instead of a stable and bearish view of oil, you come away with a far different, much more volatile and bullish view on oil. 

All of a sudden, the most expensive break-even areas become as necessary as the cheap ones in order to fully satisfy future demand; for example, in ultra-deepwater areas in the U.S. and elsewhere, where break-even prices are well above $100 a barrel. 

Further, the slide only accounts for what are recognizable non-OPEC reserves currently earmarked for development -- or about 13.5 million barrels a day. Even in a best-case scenario, Woodmac cannot account for where the other 6.5 million barrels to satisfy 2025 demand will ultimately come from. While plenty of other reserves exist that could be tapped, all of them have even higher break-even prices than those listed here. 

Suddenly, this slide looks very bullish indeed. 

From an investment perspective, there's a lot to be learned, too. Small, compact bars in the slide that have extremely low break-even prices stand out as superb investment areas, as that oil will in all markets be profitable and likely hugely so. Look at Bone Spring, a Permian area in New Mexico and West Texas where Cimarex (XEC) , Devon (DVN) and Apache (APA) have strong acreage. Look also at Mid Con Scoop/Stack areas of Oklahoma, where Anadarko (APC) has been deeply invested. Eagle Ford looks challenged, unless you've got a huge backlog of decades of core acreage to develop -- think EOG Resources (EOG) and Conoco-Phillips (COP) . 

There's a lot of great material to digest from the Wood Mackenzie report, not just about the future trajectory of oil, but who is most likely to benefit the most from it. This is a group worth following and reading every piece of info it releases, if you are interested in profiting from oil and gas stocks. 

Get an email alert each time I write an article for Real Money. Click the "+Follow" next to my byline to this article.

At the time of publication, Dicker had no positions in the stocks mentioned.

TAGS: Investing | U.S. Equity | Energy | Stocks

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