Oil Might Go Below $85, But It Won't Stay There For Long

Apr.19.13 | About: Core Laboratories (CLB)

The single most important item that is going to determine whether or not my portfolio does well is the price of oil. I've built my portfolio to benefit from what I believe will be a future of high oil prices.

I therefore enjoy weeks where oil drops by $10 a little less than most people.

By high oil prices I mean $80 plus, so I'm very comfortable with where oil has been for the past couple of years.

What I find hard to believe is how comfortable the general public now is with $80 oil. Thirteen years ago, the thought of $50 oil would have had people screaming about a financial crash caused by an oil shock.

The prospect of $80 oil would have seem outlandish and a catastrophe.

Will Oil Prices Stay Elevated?

The single biggest threat to my portfolio is, strangely enough, the very companies that my portfolio is made up of. Those companies are the unconventional North American light oil producers that have been responsible for recent growth in production.

My portfolio is loaded with these unconventional producers.

The media is full of stories about how booming unconventional production is going to cause a big drop in the price of oil. Peak oil is dead, they say!

Today I found an expert opinion that suggests that a long-term collapse in oil prices below $80 is something I likely don't have to worry about.

The experts I'm referring to are the management team at Core Laboratories (NYSE:CLB).

Core Laboratories is a leading provider of proprietary and patented Reservoir Description, Production Enhancement, and Reservoir Management services.

The company provides the technology oil producers use to develop oil and gas properties. Core Labs provides services to the world's major, national, and independent oil companies.

The company is, therefore, at the forefront of understanding the economics of the oil industry. Core Labs has to know how oil prices are going to impact demand for its products.

Most importantly Core Labs has a very good idea the price at which the various unconventional oil plays in North America make money.

During the Core Labs conference call this week, the following was said during the question and answer session:

David Demshur - Chairman, President & CEO

Yeah, we hope, we're wrong on this James, but our view is that when we looked at a lot of the unconventional plays, you've got now WTI that has slipped below $90. For us, that's kind of a benchmark where we feel outside of the sweet spot in the Bakken, in the Eagle Ford, and then the Niobrara that it's very difficult to reach a reasonable return on investment for our clients.

James West - Barclays

Okay. That's pretty interesting given your view that $90 is kind of the threshold level would suggest that WTI is not going to stay there for very long or below $90 very long?

David Demshur - Chairman, President & CEO

Yeah, well. I don't know how long it's going to stay there, but the $90 WTI, the level that is necessary for reasonable return is not our view, it's our client's view.

That is pretty interesting information. Outside of the best areas of the Bakken and the Eagle Ford, companies can't make money drilling oil wells without at least $90 oil.

And if the companies can't make money, they stop drilling. And if the companies stop drilling North American oil production is going to slip almost immediately because these unconventional wells have steep decline rates.

Below is the decline curve of a typical horizontal oil well that Petrobakken (PBKEF.PK) drills in the Canadian portion of the Bakken:

Click to enlarge

If oil prices should drop to $60, the next thing that is going to happen (in my opinion) is that within months oil will bounce up to $120 because production will have dropped very quickly.

The United States added something like a million barrels per day from unconventional tight oil in 2012. Production from those wells will have dropped by 65% to 350,000 barrels per day in the first year. And then that production will drop another 40% in the second year.

We are on a treadmill that requires a constant drilling of oil wells in order to fight decline rates. We aren't drilling vertical onshore wells that produce at 10,000 barrels a day for five years any more.

We have entered a new era of high oil prices. Yes, the unconventional revolution is real, but it is going to require $90 plus oil prices to be sustained. It is these very high oil prices that created this unconventional revolution in the first place.

It is going to take a lot of capital invested into thousands and thousands of tight oil wells month after month to keep growing production.

The only way that capital is going to be available is if oil prices are high enough to allow a reasonable return on investment. The sweet spot for that seems to be (according to Core Labs and its customers) $90 plus.

Disclosure: I am long PBKEF.PK. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.