The Opportunity in Unconventional Oil

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Be it energy geopolitics or pipeline politicking, oil markets are clouded by noise that push prices up and down. In order to make long-term investments in the space the trick is to boil it down to the bare bones of the issue. Recently an article was published espousing that oil was headed to $75. It was an interesting notion but not one we would put much stock in for a variety of reasons, the most basic of which being supply.

Conventional production (a category that includes onshore and offshore crude oil, natural gas and condensates produced by way of traditional vertical drilling methods) around the globe is in decline. Unconventional production is the primary source of new production coming to market today. Those unconventional sources fall into three broad categories. Shale oil, oil sands and ultra deepwater. Offshore, ultra-deep is pretty self-explanatory: it’s deep and expensive. The onshore complications, though, seem to get glossed over or forgotten so let’s review them.

Shale oil extraction is accomplished by way of horizontal drilling and fracking the source rock (shale). In lay person terms it is basically this: you drill a hole a couple of miles deep then steer the drillbit 90º and drill sideways another couple of miles. As if that weren’t enough trouble to go through to get a return, now you remove the drill, case the well and set to the process of breaking up the rock in a series stages by way of perforations. Once the “micro fissures” are created, you have to keep them open and encourage the oil to flow, so water, sand and often a myriad of other chemicals are pumped into the cracks. As you can imagine this is not a cheap process. What makes it more challenging though is that the decline rates—how quickly the oil flowing from the well peters out—are very high (we estimate 80-90% in the first three years so). As a result, you have to keep drilling at a very high rate just to maintain production levels.

Canada’s oil sands are the other key source of unconventional production. They are located in Northern Alberta where temperatures in the winter can routinely reach -40º Fahrenheit and in the summer the bugs are so bad small children can be carried away. 20% of the oil from the oil sands is minable (those are the nasty pictures you always see when anyone mentions the oil sands, or tar sands as they are affectionately referred to). The other 80% is too deep to mine and are thus only producible by way of in-situ thermal production.1 The most common thermal production method is called Steam Assisted Gravity Drainage or SAGD.

SAGD entails drilling two horizontal wells one directly above the other, called well pairs. The top well pair, called the injector well, injects stream, heated by natural gas. The bottom well pair is called the producer well and brings the water and bitumen to the surface. Numerous well pairs are required per reservoir. The time from first stream to production can be anywhere from 18-24 months. Once heated sufficiently the bitumen, which has the consistency of a hockey puck at room temperature, turns into a viscous sludge that by way of gravity falls downwards to the producer well at the bottom. From there the producer well pumps the sludge to the surface were it is mixed with condensates/superlight oils to be transported to market. By our estimates, based on conversations with industry professionals, the costs associated with building one of these facilities is about $50,000 per flowing barrel. So that means if you want to build a 20,000 barrel per day facility you need a billion dollars and then wait two years for any type of return.

We’re not peak oil theorists, but realists. If oil were plentiful nobody would care about shale oil, oil sands or ultra deepwater plays. They would be considered marginal barrels in a well-supplied market and would never get produced due to the lower prices that would accompany such an environment. That however is not the world we live in, and looking forward these barrels are the primary sources of new production coming to market.

When one looks at where oil is headed common sense tells us that it won’t be below the cost plus a decent rate of return that is required to bring these sources of oil to market. Ultimately, as we rely more and more on this unconventional production, we see high oil prices as here to stay and investors need to invest accordingly. 

But just where do you invest?  Are all of these oil producing regions making for attractive investments?  We argue no.  We believe that the Western Canadian Sedimentary Basin (Canadian oilsands) has a much different and more sustainable production profile than most shale basins in the US.  We do not see the shale “revolution” as anything of the sort; rather, current production and growth in this area is unsustainable.  The decline rates on these wells are extreme, meaning more and more holes will need to be punched to keep production flat.  A look at the U.S.-based crude growth numbers and expectations shows that the massive growth we have seen is expected to peter out over the next several years.2

Source: U.S. Energy Information Administration, data as of January 13, 2014.

With the easiest oil produced first, the marginal cost of a new barrel of production will likely continue to increase.  Above and beyond the rapid decline rates, we see other challenges to shale production, including that this is a water intensive process, yet we are seeing droughts in the Midwest and West, and legislation on the safety of fracking and the transportation of product is likely to get more severe.

Unconventional resources have become conventional.  The overall quality and access to some of these “new conventional” energy reserves is declining, increasing costs for producers and we expect to ultimately keep prices elevated.  We believe that investors should be long and strong this industry to take advantage of the sustained higher prices.  However, selectivity is warranted. Investors should avoid what we believe is the next CLEC-Telco disasters of 2002-03, which is the high yield market financing of many unsustainable business models known as shale/tight oil production.  Here we have seen incredible popularity, with deal after deal getting done, regardless of quality, and many done at very low yields, which we feel do not compensate investors for the risk of the lack of cash flow generation and sustainability of some of these businesses. 

We also believe that investors should be cautious in Master Limited Partnership (“MLP”) investing.  Investors have been enticed by the juicy yields offered, but unfortunately many of them are not generating true distributable cash.  Worse yet, “cash available for distribution” is a metric that the company themselves calculate.  This is a situation of the fox guarding the hen house.  This metric is calculated by breaking up capital expenditures into “maintenance” and “growth.”  So the more the company lumps their capital expenditures into the “growth” bucket, the more fictional cash flow they have available.  Some of the companies we have looked at state that 80% of their capital expenditures are “growth,” yet they aren’t growing.  For investors this then is a return of capital not a return on capital and we believe is unsustainable.

We have seen a recent pull back in the price of oil and believe it creates an opportunity to continue to invest in oil producers.  Our take remains that supply from US tight oil/shale is real but temporary and that many of the swing producers will continue to struggle to meet their production targets.  As examples, look to Libya, Iraq, Venezuela and Nigeria.  We continue to invest up and down the capital structures (loans, bonds and yield equities) of what we view are very sustainable producers to find what we see as the optimal risk/return characteristics. 

1 Source: Wikipedia, Athabasca oil sands,

2 Source: U.S. Energy Information Administration, data as of January 13, 2014.

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