This column starts my series on $80-per-barrel oil and U.S. shale winners and losers.
My working thesis is that, although oil's drop into the $80s might be temporary, it won't be short-lived. That puts marginal producers at risk here in the U.S., as much of their current production, and certainly future planned production, is predicated on higher oil-price expectations.
I'm beginning the series by outlining the Bakken and Three Forks region, as I believe oil companies there are at the most risk of seeing slashed capital expenditures and production -- and, therefore, of dropping share prices. But before I begin, I must thank Michael Filloon of ShaleTrader for his excellent help. He is almost certainly the most informed independent analyst of the Bakken, and the companies invested there, of anyone I have ever read. His service is a worthy addition for anyone deeply invested in that play or, indeed, in other major U.S. shale plays.
The reason I focus on the Bakken first is not because of the potential oil supply there or the quality of the play. In fact, it's quite the opposite.
Yes, the diverse area involved, and the relative maturity of fracking programs in the Bakken, have led to a breakneck pace of production that has delivered tens of thousands of new jobs, dozens of new, successful oil companies and a fresh housing boom. But this has also led to an increasing lack of sufficient infrastructure in pipelines and storage, an incredible natural-gas-flaring problem and -- perhaps most important for the producers there -- a discounted price for Bakken oil, even though it is of perhaps the best quality of any currently being produced in the U.S.
That discount has run up to $15 or more below West Texas Intermediate (WTI) crude, the benchmark to which most people refer when they talk about oil on CNBC or elsewhere. WTI itself has labored under a $5-to-$15 discount to global crude for the last several years.
So that's the first point to keep in mind when we discuss the Bakken players: They are under the financial pressure of relatively low returns. These names return $20 to even $30 per barrel less than, for example, what's coming out of the North Sea -- and their production possibilities and growth will be measured by that discount. In short, a sustained drop in oil prices will be far more challenging for them going forward than it will be for virtually any other oil producer anywhere.
Every company is obviously going to be different, and it will be hard to generalize about the players in the Bakken in any completely revealing way. There are lease costs, the drilling companies used, efficiencies, wells per acre, production rates, growth plans, debt and other balance sheet liabilities, depletion rates, hedging programs in place and their costs and several dozen more factors to consider for each.
In general, if you've entered the Bakken early, retained favorable leases in the most productive areas and not expanded much outside those regions or promised superhero growth that's reflected in your share price, you're more than likely to survive the coming Bakken $80 winter -- or more like $65-basis winter. Continental Resources (CLR) is one of those companies that springs to mind, although even this company has projects that will need serious rethinking should oil stay near $80 for long enough.
One way to get an initial sense of which companies will be under the most and least pressure is to look at a map of the Bakken, with its most productive areas highlighted.
The central play in the Williston Basin is the Nessin Anticline, revealed in red. With fantastic production profiles allowing upwards of 40 wells per acre, this is the prime real estate of the Bakken. This area and the players in it will interest us less, as the production rates and costs in the Nessin and other adjacent areas are tremendously profitable. They are dominated by some of the behemoth U.S. oil companies in little danger of suffering complete failure, no matter how long oil stays low. Names such as ConocoPhilips (COP), Occidental (OXY) and Marathon (MRO) are deeply involved, as are EOG Resources (EOG) and the aforementioned Continental Resources.
While we will have to discuss the growth profiles of all of these companies should oil stay at $80 for a year or more, we're much more interested in those marginal producers that will struggle to maintain capex budgets and production growth if oil stays low for as little as six months.
These companies will generally be working in the relatively less productive areas of the Bakken. They'll have completion rates that are one-third of those in the center of the play, and they'll be seeing tougher lease conditions, faster depletion and more difficult credit. It is these "weakies" that we want to isolate and learn about. They will give us not just ideas on where to invest and not invest, but also about how long it might be before these marginal players will cause a flattening and even a decline in production growth in the Bakken and, therefore, in the U.S.
That is the ultimate goal of this series on shale winners and losers, as the correct prediction of that event is what will ultimately be most important to our portfolios. A dropping production profile will imply a consolidation and supply shortage to come -- and long-term positively tremendous investment opportunities in the survivors.
But, first, find the weak ones. That will be the focus of my next several columns. As a taster, both Michael and I agree on Emerald Oil (EOX) as a firm under severe pressure, and one to be avoided.