Tags
BOEPD, CLR, Crude Oil, Hedging Risk, Long Short Equity, Offshore, Onshore, Pair Trades, PBR, Thunderhorse
Let me toss out the idea, and then we can take it apart and take a look at the pieces in the comments section at the end of this post.
I like a paired trade here. I would go long the common shares in Continental (Quote: CLR) and a short an equal dollar value in Petrobras (Quote: PBR).
Here is why.
This boils down to Onshore incremental growth story vs Offshore incremental growth story. Both company’s have stated their plans (CLR Presentation & PBR Presentation) on growing at a high rate via internally driven organic growth.
Since each is growing rapidly, via the drill bit, we can compare them to each other on a cost to develop each flowing barrel of equivalent oil. We have some commonality between like stories.
We can take that commonality, and compare and contrast the cost structures to produce them. However, for this simple blog post, lets just look at the quick and dirty facts that are obvious.
Not all BOE’s incrementally cost the same to develop.
Let’s compare two scenarios. The first is an onshore vs offshore drilling strategies.
In the case of onshore production, it is a lot cheaper to haul in standardized completion hardware, and build out the necessary production capacity incrementally. That is one well at a time, with the new production put on stream as take off capacity becomes available.
Onshore has very little learning curve left, in regards to unlocking new on shore oil & gas fields. The development of on shore fields has reached the turn key level in the US. The greatest issues today in onshore development is if there is enough takeoff capacity to get your product to a refinery cheaply. If not, can you still produce the well using temporary transportation means like trains, trucks and localized demand.
Offshore however, the newest & largest fields are in locations that have never been produced before. Typically, there are no pipeplines to tap into. Everything has to be installed in some of the most challenging locations in the world. Hundreds of miles from shore. This causes off shore to have to design and build expensive technology that doesn’t exist yet, to solve new and original issues.
It’s not uncommon that a field is so far from shore that a dedicated floating facility will have to be created from scratch for that specific field. It may not have any use after this field. The new equipment is custom tuned to the specific demands of producing that oil at sea safely. While converted tankers can be used on smaller projects, historically a major field development needs a custom design for it.
The off shore tanker portion of the field FEED design requires years of expensive lead time, to build and break in the new production capacity. This process doesn’t always go according to plans.
A single mistake like what happened at Thunder Horse can cost billions of dollars in lost production, and redevelopment of new equipment.
Two Growth Stories
Continental is rolling out an onshore building program focused on lowering incremental costs, while expanding production in lower risk drilling strategies like shale, where the formation presence is already known.
Petrobras is developing the most expensive and technically some of the more challenging oil fields in the world. It is never cheap to develop new technology. The challenges to bring on new production in the deep salt offshore markets isn’t fully factored into the equity price in my opinion.
What it means
In simple terms, I would prefer to invest in a lower risk onshore developments, then to invest capital into higher risk capital intensive projects that will need to design new custom hardware, to work.
If you agree or disagree, tell me what you think in the comments section below.
Disclosure: Jack Barnes does not have a position in any stock mentioned in this article, at the time of this being published. This blog post is an example of the type of investment I will be looking to place in my funds under management, once compliance clears my new business for client accounts.
Offshore concessions allow you to leverage intellect & exploration skills; you pay peanuts for access and more on exploration & development. Shorebased resources are great but the differential on buying a low marginal cost producer are often priced. I think offshore offers better LT returns provided that production expectations from low marginal cost sources of oil remain somewhat below current demand. But you need to examine the geology of the basin being explored before taking the exploration risk. With CLR at $82, you are paying for the fact that their resource come from a low marginal cost source; and acquiring new resources does not come cheap – they are paying $350 million for 17 MMBoE at Wheatland. Shale reservoirs are normally tight and often fractured; recovery of resource from the reservoir has historically been as low as 8% and as high as 40%. For Wheatland I’d say likely closer to 40% – but that means $50 is paid per barrel before a $ is spent on development. And extraction from Shale is not inexpensive (though it is compared with offshore oil).
I feel PBR is the better buy because valuation compensates for the higher cost of production.
Dear Kapil,
Thank you for replying. I believe that while Brazil has the oil, I also believe it does not have a cost effective way to develop that production in the scale that it expects to, for the price it has decided it will budget.
That is, it has budgeted $225 billion to be committed by 2015 or so if I remember correctly. Do you believe they will raise the necessary capital for all of those projects, as committed in their development plans?
Best,
Jack
Jack
Brazil has the oil & with current technology and cost, they can extract at about $65 to $70 per BBL. I don’t believe PBR will meet the budget of $225 billion by 2015; nor do I think they should. Their resource has subsurface value & unrealized value as well as value post extraction. Once it’s extracted, the gain is realized; and at this stage there is risk of value impairment. While oil demand grows, at present there is some scope of substantial new production out of Canada, US, Brazil, Kazakhstan & Russia. With a lesser degree of certainty, there is potential in Gulf of Guinea and Iran too. In OPEC Saudi, Qatar, Kuwait, Libya, Algeria, Ecuador, Angola, Nigeria, Venezuela also have some capacity creation ability; though I believe it unlikely that this will be brought online anytime soon. And while depletion occurs by the day, production declines for the near future are relatively small. I believe oil production and demand are reasonably well balanced for the next two decades; what more, the way technology is evolving it is likely that markets will remain balanced far longer. Deepwater is big; if there was oil in the 25% globes surface, it is likely that there is oil in the remaining 75% underwater – the problem has been an inability to explore and develop this area due to technology. Now the technology is in place, and it will improve allowing even deeper sea exploration; and with the rising marginal cost of production, oil prices are more than supportive of the use of the technology. The onshore area (mainly shale & oil sands) too has seen much progress; the tight & fractured reservoirs which were difficult to drain have now become drainable; and the recovery percentage is rising. But this too costs money.
In my view producers have to create capacity, but they have to match it with demand growth. If they end up in a surplus capacity environment, oil prices can fall to a level where long lead time investments in exploration, appraisal and development required to meet far future demand will be unviable.
I believe the advantage to low marginal cost fields is largely priced in equity. Deepwater players have enormous upside from growth. Low marginal cost fields have a higher survival chance in a production excess capacity environment. But the chance of occurrence of such an event is low. In oil I’d favor deepwater but I’d like to offset operational risk with financial risk and so like the less leveraged players capable of enduring an economic cycle.
Regards
Kapil
Correction: With a lesser degree of certainty, there is potential in Gulf of Guinea and Iran too. should be read as
With a lesser degree of certainty, there is potential in Gulf of Guinea and Iraq too. Don’t think Iran has too significant ability to raise capacity; at least not without access to global expertise.
My approach to energy: Focus on exploration assets. Find a geologist who can opine on the exploration asset potential. Then buy when it trades at or below book with an unleveraged balance sheet. An example might beCairn for its Greenland acerage.
For appraisal asset, the risk is lower, but the reseroir still needs delineation. Some premium over book makes sense. But you have to watch the premium being charged for 2P reserves. And it still makes sense for a geologist to opine on recoverable reserve. Leverage adds risk at this stage, I’d accept perhaps 25% on net debt to net debt plus equity, provided that there is plenty of liquidity. Examples might be PBR/CNOOC.
For developmental assets. Risk is low, resource potential is known. Leverage is acceptable at net debt to net debt plus equity of 33%. These assets are worth buying (to hold) only during times when oil prices fall below the marginal cost of production; and this will occur during periods of economic distress which visit us from time to time. Examples might be BP/XOM/RDS, which are valued for developmental assets with small value attributed to new exploration and appraisal assets (plus of course refining/mkting assets). It would also include CLR, though in the case of CLR some premium must be paid for their appraisal assets; which are good but currently in my view fully valued. Think CLR could trade at very interesting levels during the next downcycle because of reduced premium paid for appraisal BBL’s as a result of lower oil price levels. In addition the fear of leverage during downcycles will hurt their valuation further. But not now. Like the company, not the value at present.