Several years ago, I became convinced that higher oil prices would be with us (on average) for many years to come.
I arrived at this conclusion for a few reasons.
The first factor that put me in the bullish camp was that the world pretty much stopped finding giant oil fields in the 1960s. As a result of that, I believed we were going to have a very difficult time adding enough oil production every year to offset the decline rates in these big fields. If production from a super giant oil field decreases by 6% year on year, we need to find a lot of small fields to offset this lost production. To add enough new production to both offset 6% global decline rates and grow production seemed to me to be virtually impossible.
The second reason for my bullish view was that global demand is going to increase relentlessly for years to come, as the developing world (where most people actually live) rapidly transitions to the developed oil consuming lifestyle. As North Americans, we only represent a small percentage of the global population, yet we consume a huge percentage of the oil that is produced. The rest of the world is striving to have our comfortable lifestyle.
The third reason I became an oil bull is that all new sources of oil require high oil prices in order for them to be commercially viable. We aren't finding new conventional light oil reservoirs in Texas anymore. Our new sources of supply are oil sands, deepwater, shale/tight oil and eventually the arctic. These sources of oil are just not going to be recoverable at $40 per barrel. Without $80 plus oil prices, new projects directed at these types of reserves will not move forward.
This combination of challenges on the supply side, a future of relentless demand growth and expensive new supplies made arriving at my conclusion of higher oil prices pretty simple.
Since I became bullish on oil however there is a not factor to consider, North American tight oil production. Yes, North American oil production is actually growing for the first time in decades, and with unconventional plays like the Bakken and the Eagle Ford, the growth appears set to continue for a long time to come.
I now need to determine if this new North American oil source should change my bullish view on oil prices.
For some help I decided to turn to a pioneer in unconventional oil production, Mark Papa of EOG Resources (EOG). He has been bullish on oil for quite some time, I wondered if the recent growth in North American production had changed his view.
In the most recent EOG conference call, Papa provided his current view on oil prices:
Now I'll provide our views regarding macro hedging and the concluding remarks. Regarding oil, we still think the global supply-demand balance is tight, and we expect prices to strengthen throughout the remainder of the year. Two recent concerns I've heard from oil bears involve horizontal shale oil. One concern is will the U.S. create enough shale oil to affect global supply. EOG's forecast is an increase in the U.S. of 2 million barrels of oil per day by 2015, which, we believe, will not impact a 90 million barrel of oil a day global market. We think there are only 3 consequential horizontal oil plays in North America: the Eagle Ford, Bakken and Permian, and that all other alleged oil plays are either inconsequential on a national scale or really NGL plays.
The second concern relates to possible international horizontal oil shale plays and their potential impact on supply. My answer there is maybe it will happen, but it's not likely for another 10 years at least. Remember, it's been 10 years since horizontal drilling unlocked shale gas in the Barnett, and no one yet has found commercial shale gas outside North America. Also, the key to commercial shale oil or gas is the ability to drill thousands of wells at low per-well cost, and whether this can be done internationally is likely problematic.
I feel pretty comfortable with Papa's view that international, unconventional production is not going to go anywhere fast. North America has the perfect combination of oil in place, infrastructure (takeaway systems), personnel/services, and land ownership to allow for exploitation of these resources. We can't come close to duplicating this in a short or medium time frame internationally.
Domestically, I think production growth is going to continue as long as we have reasonably high oil prices. If oil prices tank, so will tight oil production, because unconventional wells decline very rapidly in the early years. Without high oil prices, there won't be enough capital available to keep this unconventional production growing or even offset the rapid declines.
At this point, I don't think North American production (even with high oil prices) can grow fast enough to do much more than offset the million barrels a day of growth in demand that occurs globally. That belief leaves me still bullish on oil, although a little more cautious than I was a couple of years ago.
We aren't running out of oil sources. But we are running out of cheap oil sources.
EOG Resources - A Leader in Unconventional Oil Production
Since I'm using Papa's advice, perhaps I should also be investing alongside him in EOG Resources?
That decision, of course, depends entirely on valuation. With 270 million shares outstanding, net debt of roughly $5 billion and a share price of $110, EOG has an Enterprise Value of close to $35 billion.
Cash flow from operations for the first 6 months of 2012 for EOG was just under $2.6 billion, which annualized is $5.2 billion.
That means that EOG is trading at $35 billion / $5.2 billion = 6.7 times cash flow.
Year on year EOG's cash flow through June 30 is up 25%, so this certainly doesn't seem like an unattractive valuation given the rate of growth involved. With a big inventory of drilling locations in the Bakken, Eagle Ford, Wolfcamp and Barnett Combo unconventional oil plays that growth appears sustainable for several years.
I also like the fact that EOG's debt of $5 billion is a reasonable 1 time annual cash flow.
Personally though, although I do think the shares of EOG are fairly attractively priced, I'm going to just keep EOG on my watchlist for now. One thing I've learned the hard way about oil producers is that there is no sense buying them when oil prices are fairly steady and fear is absent. At some point in the future, fear will return and oil prices will take a dive allowing for better entry prices.