Royal Dutch Shell Has Served Notice - The Deepwater Drillers Are In Big Trouble

| About: Royal Dutch (RDS.A)

Summary

Eighteen months ago Shell was considering exiting shale plays and focusing on its deepwater and LNG opportunities.

Shell's recent analyst day presentations revealed a company that is shifting its long-term focus towards shale.

We think that going forward the offshore drilling rig companies have major long-term challenges and investors need to be aware that pre-crash cash flows aren't coming back.

For the small sliver of global oil production that U.S shale oil actually represents it certainly has been a disruptive force.

Total shale production (there is no significant amount outside of the United States) is currently somewhere around 4.5 million barrels per day.

Source:SRSrocco

That is not much more than four percent of total current production which checks in at over 96 million barrels per day.

After having a look at Shell's (NYSE:RDS.A) 2016 capital markets day presentation we think shale oil is going to become even more disruptive going forward for a select group of companies.

Despite The BG Acquisition, Shale Importance For Shell Is Ramping Up

Shell just completed a major acquisition with the takeover of BG group. That was a $53 billion deal and like it or not, the company is now married to it.

A big focus of the deal was BG's LNG business. The other big attraction of BG to Shell was the deepwater business, primarily offshore Brazil. Despite this commitment to the deepwater, the 2016 capital markets presentation revealed that Shell is a company that is pivoting towards shale as part of its long-term corporate direction.

For the next four years, Shell will be spending on deepwater projects that it has already well down the road on. You can't stop a multi-billion dollar deepwater project once you have started it. Once these projects become cash flowing, it will lead to Shell's new focus on shale.

Source: Shell Capital Markets Presentation

This is quite a shift for Shell which was at one time considering abandoning shale altogether. The change of heart for Shell is that the company (and the entire industry) has gotten a lot better drilling shale wells. The chart below from the capital markets presentation shows how Shell has brought down costs by an incredible 50% since 2013.

Source: Shell Capital Markets Presentation

You don't need to be a rocket scientist to figure out that dropping the required investment in a well by half is game changer for economics. We would note that a portion of these savings are service cost concessions from the service companies, but Shell has clearly gotten a lot more efficient.

Say Goodbye To Risky Exploration Drilling

The appeal of shale isn't difficult to understand. If the economics of it are competitive, think of the other advantages shale production has over deepwater developments.

Advantage 1 - There is very little exploration risk involved in shale drilling. Shale production is about drilling wells into known deposits of oil and gas. The wells are small (relative to offshore) but there is virtually no risk of a dry hole.

Compare that to drilling deepwater wildcat wells that cost $100 million and have a 30% chance of success.

Advantage 2 - Shale production can be ramped up and shut down very quickly. If producers don't like the price of oil they can immediately stop drilling shale wells within weeks.

Deepwater projects, meanwhile, take years from when they are commissioned until production comes on line. Now that the industry has been reminded that oil prices are volatile, committing billions of dollars to a multi-year deepwater development is much less appealing.

Advantage 3 - Shale production is still quite new and the technologies and techniques keep getting better. Companies can experiment with shale production over many, many wells. These plays are only going to get better over time.

In the Deepwater you drill a small number of very expensive wells which doesn't allow for much trial and error.

Advantage 4 - Shale production is safer and easier. It is onshore and not out in the middle of hurricane alley in the Gulf of Mexico. You don't have to shuttle staff back and forth by hurricane and you don't risk creating a massive oil spill that can cost your company billions of dollars with one bad well.

The result of all of this is that companies like Shell are moving capital out of the deepwater and towards onshore shale developments. The slide below shows how Shell's exploration budget has been cut dramatically.

Source: Shell Capital Markets Presentation

Shale is less risky for producers than the deepwater and the economics are now better. Less risk and more return, that would make it a no-brainer.

Implications For Investors - Careful With The Deepwater Drillers

In our opinion, the offshore and deepwater exploration business has permanently changed for the worse. Permanently may be too strong a word, things could get better after shale reserves are exhausted a couple of decades from now, provided we haven't transitioned off of oil by then.

The industry first went out to look for oil and gas in the middle of the ocean because it had run out of oil and gas to produce on land. That is no longer true. There is an onshore option.

Yes, shale economics aren't as good as the conventional discoveries of decades ago, but they are now getting better than the deepwater.

Shale is simply a better alternative.

For companies like Transocean (NYSE:RIG), Ensco (NYSE:ESV), Diamond Offshore (NYSE:DO) and Seadrill (NYSE:SDRL) business is not going back to the way it was before the oil price crash.

That doesn't necessarily put these companies on death row, but investors had better ratchet back their expectations of how much cash flow these businesses are going to be able to generate going forward. And even more importantly, stay very far away from the most leveraged drillers.

We are contrarian by nature and would love to think these offshore drillers represent opportunity. But in this case we are very bearish on future cash flows for these companies.

We are much more optimistic about a company that is a 16% holding of "The Big Short" legend Michael Burry. We have a 20-page comprehensive report available on this company for our Seeking Alpha premium members. Click the link below if you would like to join the Superinvestor Bulletin Community.

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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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.