Exploration & Production: An Evolving Business Model
The successful development of shale crude oil and gas has led to one of the most rapid and unexpected increases in production in the history of the energy sector. This remarkable turn of events is in complete contrast to the previous popular belief that the country was running out of both resources. The domestic exploration and production (E&P) industry only recently realized that, by using a combination of horizontal drilling and hydraulic fracturing, enough shale rock could be cracked to allow commercial quantities of hydrocarbons (typically crude oil or natural gas) to be released. These key enabling technologies have been and continue to be themes that Diamond Hill has invested in through our ownership stakes in several E&P businesses. We believe that the “technical renaissance” underway is changing the business model for a few domestic E&P companies in several favorable ways.
Exploration has always been a critical function for any E&P business, and one of the most difficult to quantify risks has been whether hydrocarbons are present. However, as a consequence of shale development, this risk is greatly reduced. A few astute early movers, including companies like EOG Resources, Inc. (EOG) and Cimarex Energy Co. (XEC), have been able to build an inventory of shale drilling prospects that provides years of reinvestment opportunity. This inventory is being supplemented with a steady improvement in subsurface knowledge and technical innovation in drilling and fracturing techniques. With less risk associated with the exploration function, these operators are intensely focused on the efficient recovery of commercial quantities of hydrocarbons. As a result, these companies’ business models are evolving from an exploration-based model towards a manufacturing-based model.
Not only are the early movers benefiting from an expanded opportunity set, but those with larger operations are beginning to extract economies of scale. Scale can provide operating leverage and potentially improve returns on investment. While technology has been instrumental so far, operational efficiencies also play a vital role in reducing costs. Some of the more significant areas of improvement include pad drilling, reduced downtime, and vertical integration. Another powerful aspect of modern manufacturing is the benefit derived from the broader digital revolution. The greater use of sensors, data analysis, and software are providing an edge to those companies skilled at interpreting and exploiting information. We believe future improvements in technology, subsurface knowledge, and operational efficiency are likely to continue to reduce breakeven economics for select operators and improve their relative positioning in the global energy sector.
Domestic Producers: Relative Advantage in a Commodity Business
As illustrated by developments over the past two decades, the global energy sector is in a state of constant change. Factors such as technological advancements, geopolitical disturbances, national policy directives, and geological realities intersect to determine future supply availability and requirements. This constant change is accompanied by the fact that all producers are price takers. Since all other factors are largely out of the producers’ control, the only thing that matters is the cost of bringing supply to market.
In a global marketplace that sometimes restricts the free flow of capital, labor, and technology, domestic E&P companies hold several key advantages. Domestic producers benefit from a relatively stable regulatory framework that allows private mineral ownership rights. They also have access to a large, innovative, and experienced oil service industry along with an extensive pipeline system that allows production to be efficiently brought to market. Perhaps most importantly, many producers have the entrepreneurial culture to quickly respond to market incentives. From this perspective, it is easier to understand how a few domestic E&P companies were the architects of the shale revolution.
Shale oil and gas deposits are not unique to North America. Similar technologies are likely to be deployed elsewhere but above ground challenges could slow development. In some cases, shale development may be restricted altogether for various political or environmental reasons. The most prospective shale rock globally is in places like Argentina, France, Poland, Libya, and Western China. In many commodity businesses, simply being a low cost producer may not be enough. Being a low cost producer is only an advantage when higher cost producers are also required to balance the market. The advantages in the United States, along with above ground challenges elsewhere, provide a unique opportunity for select domestic crude oil producers to gain market share relative to the global industry.
Domestic Oil Export Ban
Over the past decade, under expectations of a far different crude oil production outlook, the domestic refining industry reconfigured itself to process the heavier and sour crude oil expected to be imported from Mexico, Venezuela, and Canada. Many refiners now have a limited ability to process growing domestic crude oil, which is light and sweet, without a material loss in efficiency. The anticipated growth in shale crude oil production could overwhelm the limited light sweet crude oil currently being imported from other countries. As a result of the domestic oil export ban adopted in the 1970s, any excess growth of light sweet crude oil could be forced to compete domestically on price with alternative, lower quality, grades of imported crude.
In 2013, West Texas Intermediate (the domestic light sweet benchmark) averaged a $10 per barrel discount to Brent (the global light sweet benchmark). Historically, these two grades of crude oil have been close to parity but infrastructure bottlenecks and the export ban have made recent price dislocations more difficult to arbitrage away. The longer-term question is whether North American crude oil could significantly disconnect from similar global grades of crude oil. The extent to which this happens will be driven in part by policy choices. Restrictions on exports were part of a broader energy policy put in place during a period of significant crude oil disruptions and shortages in the 1970s. Many of these policies created unintended consequences and have subsequently been repealed. However, the restrictions on crude oil exports remain in place.
When it comes to analyzing policy, we are careful to distinguish what we believe should happen from what is likely to happen. Current price dislocations, and an expectation of steadily increasing crude production, bear little resemblance to the supply and demand fundamentals of the 1970s. This, along with the recent approval of liquefied natural gas (LNG) export terminals and ongoing coal exports, suggests a re-examination of the export policy is likely.
Any change in policy can be expected to be a drawn out process as many opposing views come into the debate. The most prominent concern is likely to be whether exports would impact domestic gasoline prices. The general public’s view seems to be that the price of domestic crude oil is strongly correlated with the price of gasoline. However, since there is no ban on domestic gasoline exports, domestic gasoline prices are actually more correlated with international gasoline prices, and consequently, domestic gasoline prices are more influenced by international crude oil prices. With the current domestic crude oil price dislocation, domestic refiners have an advantage. The most sustainable path to reducing domestic gasoline prices might be to encourage the supply of oil available to international markets.
The structural changes taking place in the energy sector are creating unique long-term opportunities for some exceptionally well-positioned domestic E&P companies. A number of favorable changes underway have the potential to create a growing relative advantage against the global competition. While recent industry success has created its own challenges, the economic motivations of various industry participants, including policymakers, are too high to not provide sustainable solutions to these challenges. In the event the export restrictions are eased, the potential consequences for the energy sector could be profound. The secular tailwinds for the domestic refining industry become headwinds, and secular crosswinds for the domestic E&P industry and oil service industry become tailwinds.
Commodity and stock prices can be volatile in the short-term, but intrinsic value is far more stable and is the critical benchmark for our investment decision-making. On this front, we believe several domestic E&P companies are uniquely positioned to grow production per share over the next five years and beyond. If these companies are successful, as we anticipate, their intrinsic value should also continue to grow.
Originally published March 19, 2014
The views expressed are those of the research analyst as of March 2014, are subject to change, and may differ from the views of other research analysts, portfolio managers or the firm as a whole. These opinions are not intended to be a forecast of future events, a guarantee of future results, or investment advice.