Where the Real Profits in Shale Oil are

Todays top stocks to buy“With America’s most prominent shale plays now known, producers are under pressure to turn their plays into bigger payoffs” —

Over the past decade, investors have bankrolled energy companies to the tune of more than $53 billion to snap up shale acreage across America.

With the cash, the industry has also been able to develop new technological innovations needed to economically extract oil and gas from the tight shale formations.

So far, their progress has been nothing short of remarkable.

Thanks to advances in imaging data, horizontal drilling, and hydraulic fracturing, over 40,000 wells are being drilled each year in the US.

Energy giants like Chesapeake Energy (CHK:NYSE) and Newfield Exploration (NFX:NYSE) have seen their hydraulic fracturing efforts reach a point where Chesapeake is drilling at ten times the rate from just a few years ago, while Newfield’s drilling is reaching ten times the distance at half the cost from a decade ago.

But that hasn’t necessarily translated into rising share prices.

In fact, companies like Chesapeake have had to shed billions in assets over the last couple of years just to survive the turmoil in the energy markets.

This is why companies are beginning to shift away from exploration and redoubling their efforts on production.

Now that all of the established shale plays are known, companies are starting to focus on the economics of these oil and gas plays – instead of more exploratory drilling.  In other words, they want to see the fruits of their labor as soon as possible.

Today, companies are pushing to transition their most promising exploratory wells into lucrative production wells and trying to maximize efficiency in the oil patch.

And as I’ll explain below, the pressure is on to squeeze the maximum number of dollars out of every barrel they churn out.

Turning Promises into Profits

For some companies, the past decade has been primarily one of land acquisitions.

Between 2003 and 2012, Bloomberg reported that Chesapeake spent nearly $20 billion on prospective US oil and gas leases – the highest of all the companies tracked on S&P 500’s Oil & Gas Exploration and Production Index (XOP).

But while they’ve been busy snapping up drilling leases, share prices have not returned to anywhere near their 2008 peak

It certainly doesn’t help that costs for petroleum equipment and supplies have risen, further squeezing profits in the process.  And weak natural gas prices have also cut into their bottom line.  In fact, gas prices that collapsed to a decade low in 2012 reduced cash flow and forced the company to erase some proved reserves from its books, elevating per-unit costs for finding and development.

So in order to boost shareholder returns, Chesapeake is now shifting money away from exploration, which is winding down, into gearing up production. The moves will hopefully help the company increase profit.

“Up to this point, we have been focused on building our asset base,” Chesapeake Acting CEO Steve Dixon said during the company’s annual shareholders meeting in June. “We are truly at an inflection point. We have exited the capture phase and entered the harvesting phase.”

But in making this transition, one of the main problems that companies are facing is increasing profitability.

Companies like Chesapeake and QEP Resources (QEP), according to Bloomberg, have some of the worst recycle ratios in the industry.

The recycle ratio is a common metric used to measure profitability.  It’s calculated by dividing the profit per barrel of production by the cost to explore and extract.

For example, if a barrel generates $50 in profits and costs are $25 per barrel, the recycle ratio is 2.  The number is rather ambiguous unless you compare it to ratios generated by other producers.  But as a rule of thumb, the higher the number, the better.

Looking at QEP and Chesapeake, the recycle ratios in 2012 were 0.69 and 0.97, respectively.

Meanwhile, industry leaders Exxon-Mobil (XOM) and Total SA (TOT) achieved impressive ratios of 4.5 and 3.3, respectively.

Comparing the two ends of the spectrum, you’ll see that Exxon-Mobil generates over six times the amount of profit from every barrel of oil it sells compared to QEP.

So how do they do it?

One way is through manufacturing.

Also known as refining, Exxon boasts 37 refineries around the globe.

By cutting out the middleman, companies with both upstream and downstream capabilities are able to take advantage of lower cost feedstock and convert them into higher priced end products.

2012 was already an exceptional year for integrated companies. Should oil and gas demand remain healthy, 2013 will likely be a profitable one as well.

Independents that remain in the conventional E&P business are not manufacturers. Although a couple years ago, Chesapeake spoke of potentially partnering with Marathon Oil to leverage Marathon’s refinery in Ohio.  The deal never panned out. But as they shift their focus to production, I believe the future for independents looks bright.

As gas prices increase above the cost of production, finding and development costs should drop dramatically as reserves are returned to the books and yearly recycle ratios increase.

Also, as producers continue to refine their techniques and equipment to increase the amount of oil and gas that can be squeezed from shale and other unconventional formations, profitability should increase.

In the end, and as it’s always been, companies who can control their costs and still provide the biggest return to shareholders will thrive.

With this new energy revolution, the only thing that’s changed is where the profits lie.

While traditional E&P companies were some of the most lucrative stocks in the market during the early stages of the shale revolution, the refining business appears to be at the top of the heap now.

Yours in profits,
Todays top stocks to buy
John Holt
for Top Stock Millionaire
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