U.S. Oil Production to Increase 25% by 2016 - Is There a Way to Play It?

Includes: OIH, USO, XOP
by: Carlos X. Alexandre

If forecasts by analysts at Credit Suisse prove to be true, according to the Financial Times, the U.S. would be producing an additional 2.5 million barrels per day by 2016, “with the increase divided equally between deep-water fields in the Gulf of Mexico and new onshore sources.” The projection, although ambitious, is based on the fact that production increased last year to the highest level since 2002 mainly due to “unconventional extraction techniques,” leading analysts to believe that the U.S. was the largest contributor to global oil supplies in 2010.

According to the US government’s Energy Information Administration, domestic production of crude oil and related liquids rose 3 per cent last year to an average of 7.51m barrels a day – its highest level since 2002. The rise enabled a 2 per cent drop in US oil imports to 9.45m b/d, in spite of rising demand as the economy recovered. US oil imports have fallen steadily since 2006.

The increase in production would not be enough to end the country’s dependence on foreign sources, but coupled with higher efficiency and further development of unconventional resources, the equilibrium point would be far closer than anticipated. As “fracking” is adopted by other countries with similar resources, an example of which is the deal between ExxonMobil (NYSE:XOM) and Naftogaz, the Ukrainian national energy company, the affordability factor and the diminished exposure to geopolitical shocks would greatly contribute to the stability of the global economy.

The revival of U.S. production has been made possible by a rush of small and mid-sized companies into onshore regions such as the Bakken shale in North Dakota, the Permian Basin in west Texas and the Eagle Ford shale in south Texas. North Dakota’s production has doubled since 2008, reaching 355,000 b/d in November. Extraction of oil reserves in these regions was thought to be uneconomic, but has been made commercially viable by the transfer of techniques successfully used to extract shale gas; in particular, long horizontal wells and “fracking”, pumping water under high pressure to crack the rock and enable the oil to flow.

The only caveat that I can foresee relates to deepwater exploration and the production economics if oil prices are closer to the $50-$60 mark.

Certainly nothing is without controversy, and “the industry faces a threat from environmental objections to the use of fracking, because of fears that the fluids used, which are mostly water with chemical additives, could contaminate drinking water supplies.”

As I have stated before, disruptive technologies will change the energy landscape and to invest in oil or energy companies simply based on the premise that oil supplies will dwindle and prices will skyrocket, will prove unfulfilling. However, I wouldn’t be rushing into “unconventional energy” companies without a better understanding of the operations and assets of any particular stock, and would reevaluate any exposure to deep-water exploration using the $50 per barrel price stress test.

In short, and as an example only from a long-term perspective, I would be looking at the SPDR S&P Oil & Gas Exploration & Production ETF (XOP) and the Oil Service Holders ETF (OIH) instead of the United States Oil Fund (USO), although at this time both XOP and OIH are a bit frothy for obvious reasons.

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