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The Key to Finding Oil Stocks Worth Buying
12/01/2009 9:14 am EST
Devon Energy's decision to sell promising reserves speaks to how prohibitively expensive oil production can be—and why investors should look closely before choosing an energy stock.
I'd never say "forget about the price of oil" when you're thinking about buying oil and natural gas stocks. The price of oil is the tide that lifts all boats—or leaves them stuck in the muck.
But, increasingly, the difference between a good oil and natural gas stock and a bad one isn't the price of oil or even how much oil or gas the company has on paper or in the ground.
The "decider" these days is cost: The amount of capital the company has to spend to explore, discover, and develop oil and natural gas.
Costs have become so critical that one oil and natural gas producer, Devon Energy (NYSE: DVN), recently announced it would sell off its very promising Gulf of Mexico and international oil reserves in order to concentrate on expanding its onshore natural gas production in the United States.
The vast majority of Wall Street analysts cheered the move, even though natural gas seems stuck below $5 per million British thermal units (Btu) and doesn't look likely to go higher anytime soon. The International Energy Agency recently projected a global natural gas glut that would persist through 2015.
On November 23, the December contract for natural gas closed at $4.45 per million Btu. At that price, many, and perhaps most, natural gas producers aren't breaking even. A back-of-the-envelope calculation says it requires a commodity market price of at least $5.25 per million Btu to break even.
So why would Devon Energy, with a reputation as one of the sharpest pencils in the box, decide to focus on a depressed natural gas market with dismal long-term prospects, and in which almost no one is making money? And why would Wall Street cheer?
If you understand the Devon Energy move, you'll understand what is driving energy company profits these days and understand how to tell a promising oil and gas stock from an also-ran. After I've sketched out the logic of costs for you, I'll run through how a few of the big international oil companies stack up.
Here's what Devon Energy announced it was going to do.
The company plans to sell its Gulf of Mexico offshore assets. These consist of about 1.5 million acres. Most of that (87%) is undeveloped, but Devon's acreage includes some of the most promising recent deep-water discoveries in the Gulf of Mexico. The company has one of the largest deep-water inventories in the Gulf, and Devon Energy and its partners have done enough exploratory drilling to project the existence of sizable, recoverable reserves. Chevron (NYSE: CVX), one of Devon's partners, projects that the St. Malo and Jack drilling blocks, for example, hold 500 million barrels of recoverable reserves.
The company is also selling off nine million acres, again mostly undeveloped, in Azerbaijan, Russia, Brazil, and China.
What's the matter with these assets? They'll cost a whole lot to explore fully and then develop. Especially in comparison to their contribution to the company's overall production.
The Gulf of Mexico and international assets combined equal just 7% of the company's proven reserves of 2.8 billion barrels of oil equivalent. In 2009, they'll contribute just 11% to the company's estimated 248 million barrels of production. And yet the company's capital budget shows that the Gulf of Mexico and international assets will eat 29%, or $1.2 billion, of the company's $4.1 billion annual capital spending.
The cost picture for these assets gets even worse if you look at how long it takes for production from these assets to pay back that capital investment. Investments in developing deep-water or overseas fields can take five years before they generate significant cash flow. That means Devon would have to go out into the capital markets to raise cash to invest in developing these assets and then pay interest for five or more years, waiting for cash flow from these fields to come in the door.
None of this would matter a whole lot if Devon Energy didn't have an investment opportunity that required less investment, that took less time to pay back or that, because of its quick payback, could largely be funded from internal cash flow.
The Case for Gas
I'm talking about the company's onshore natural gas reserves in the Barnett shale region of Texas, the Haynesville shale region of eastern Texas and northern Louisiana, the Cana and Arkoma Woodford shale regions of Oklahoma, and the Horn River Ootla shale region of British Columbia. (In addition, the company is a significant player in Alberta's oil sands at its Jackfish project.)|pagebreak|
Let's take a closer look at the Barnett shale region, one of the largest onshore gas fields in the United States. Devon already produces about 1 billion cubic feet of natural gas a day from its Barnett Shale properties. That's about a quarter of the total production by all companies from this field.
But Devon could get more out of its Barnett Shale properties. The company has drilled 3,000 wells in the Barnett region since 2002 for a total of 3,500. That has taken production from 200 million cubic feet of natural gas a day from the current one billion cubic feet a day. But the company says it has a reserve of at least 7,500 proven drill sites that it hasn't yet tapped.
And Devon may have a pressing need to drill those new wells as quickly as it can—if critics are right about the relatively short life span of a natural gas well in a shale formation such as Barnett. Many companies seem to be projecting 40-year lives for their wells, but data analyzed by industry consultant Arthur Berman from 2007 production in the Barnett Shale region come up with an average well life of just 7.5 years and a common life of as little as four years. (I'll have more on this in Wednesday's post on my blog, "Is natural gas from shale the solution or problem?")
I frankly don't know which side is right on the average life of a well. (Although I do know that the literature says horizontal drilling—instead of drilling a vertical hole— extends the life of a producing well. It is also much more expensive. The figure I've seen suggests four to five times as expensive.)
But I do know that producing natural gas from a proven reservoir in shale on land in the United States is hugely less expensive than finding and developing a well in the deep waters of the Gulf of Mexico or in Azerbaijan.
Deutsche Bank has calculated exactly how much less expensive. Exploration and development costs for the onshore North American gas wells are roughly $6.86 a barrel of oil equivalent. I get an estimate of an exploration and development cost of $31.13 a barrel for the assets that Devon has announced it wants to sell.
Before you toss that $31.13 per barrel figure out as ludicrously high, especially given the $6.86 per barrel estimate for the onshore North American assets, take a look at the exploration and development costs for some of the major international oil companies.
Exploration and development costs at Exxon Mobil (NYSE: XOM) were $13.19 a barrel of oil equivalent in 2008, according to Deutsche Bank. At BP (NYSE: BP), $12.97. At Chevron (NYSE: CVX), $13.99. At Royal Dutch Shell (NYSE: RDS.A), $13.04.
Those figures are representative of a big group of companies with relatively modest exploration and development costs.
But there's an equally large group with exploration and development costs above $20 per barrel of oil equivalent. Sometimes far above $20.
Marathon Oil (NYSE: MRO) had an exploration and development cost of $22.87 a barrel in 2008, according to Deutsche Bank. Occidental Petroleum (NYSE: OXY) came in at $35.47. ConocoPhillips (NYSE: COP) at $55.1. And Petrobras (NYSE: PBR) at $58.04.
These figures, like the $31.13 for Devon's deep-water and international assets, make sense. When you have to drill really deep in very hostile climates and geologies that make it difficult to predict where you'll find oil and gas, your costs go through the roof.
You have to be careful interpreting exploration and development costs when a company is spending big now on future production. Otherwise I'd never have added StatoilHydro (NYSE: STO) to Jubak's Picks. In 2008, as the company ramped up spending on future production, it had exploration and development costs of $49.57 a barrel of oil equivalent. The company's exploration and development costs in 2004-2007 averaged just slightly below $17 a barrel.
And exploration and development costs aren't the only costs that count. There's also lifting cost, which includes all production costs, including taxes and royalties. That cost for Statoil was a low $7.11 per barrel of oil equivalent. Exxon Mobil, one of the most efficient oil companies among the majors, has a lifting cost, according to Deutsche Bank, of $10.87 a barrel. Occidental Petroleum came in at $14.82, ConocoPhillips at $19.26, and Petrobras at $22.02. (For more on my buy of Statoil, see this post.)
From these numbers, you can see how big a transformation Devon Energy's asset sale will produce. From a company with a combined exploration and development cost of $9.53 per barrel of oil equivalent—already low—Devon will move to a company with an exploration and development cost of an extraordinarily low $6.86. And it will accomplish that by shedding assets with an exploration and development cost of $31.13 a barrel of oil equivalent.
Lowering costs like this means that Devon won't be so dependent on oil near $80 a barrel (as the company assumes in recent projections) or natural gas prices rallying and then rallying some more. It won't have to raise capital and pay interest on the money it needs to develop its deep-water and onshore wells. But it will be able to fund drilling from internal cash flow, and pay down debt with the proceeds from its asset sales.
Looking at costs—and therefore, profits and the dependency of profits on oil prices that are higher than today—you'll come away with an appreciation of low-cost companies such as Exxon Mobil and Chevron, among the majors. And by looking at costs, you'll also come away with an appreciation for the potential upside, as well as the risk in development plays such as Statoil and Petrobras.
At the time of publication, Jim Jubak owned shares of the following companies mentioned in this column: Devon Energy, Petrobras and StatoilHydro.
Jim Jubak has been writing "Jubak's Journal" and tracking the performance of his market-beating Jubak's Picks portfolio since 1997 on MSN Money. He is the author of a new book, The Jubak Picks, and he writes the Jubak Picks blog. He is also the senior markets editor at MoneyShow.com.
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