Hydrocarbons are lighter than water. Generated deep within the earth in source rocks, they will migrate upwards towards the surface due to buoyancy. Their movement is typically stopped, when they reach an impermeable layer of rock, a seal. In the best case, the rock below the impermeable layer is either highly permeable and/or dominated by natural fractures. Those properties are typically found in two broad groups of sedimentary rocks: sandstones and carbonates. Such a scenario is called a hydrocarbon trap and most of conventional oil production originates from traps. Nevertheless, the migration process does not always work in a perfect way. Some hydrocarbons get stuck in formations with low permeability or near the source rocks. Such rocks are then called oil-bearing shales and the oil in it is called tight oil. The most known oil-bearing shales in the US are the Bakken Formation, Pierre Shale, Niobara Formation and Eagle Ford Formation. Those are also the fields, where most of the recently added production in the US comes from. The rise has been possible because of the spread of a method called fracking, which basically means to try to generate artificial fractures. The fractures provide then a flow path for the oil and gas.
Oil-bearing shales should not be confused with oil shale. Oil shale is fine-grained rock containing kerogen (an intermediate product in the formation of hydrocarbons). It is estimated that world deposits are up to 5 trillion barrels, the most prominent one the Green River Formation in Utah, Wyoming and Colorado. Despite that huge potential, production of oil shales nowadays is confined to Estonia and some parts of China. The reason for this is the expansive process that is necessary to produce crude oil from kerogen, as one would have to copy reactions that occur naturally deep within in the earth (pyrolysis). To sum this up: oil shale is incomplete oil without much economic relevance today, while tight oil is fully finished oil that is produced with fracking.
Due to the high increase of tight oil production in the US, its influence on the world oil market has risen dramatically. In 2013 the IEA even claimed that the surge of unconventionals in Northern America has led to a worldwide supply shock that would reshape global markets. Nevertheless, one should not forget that tight oil production is still more sophisticated and needs more technology than conventional oil production.
The recent drop in the price of oil has fueled the debate about the actual production costs in tight oil plays. Nevertheless, estimates differ widely from source to source. Reuters offers a wonderful compilation of this issue. The wide variety is especially troublesome, as most analysts just state their estimates, but do not explain their methodology or which kinds of costs exactly they take into account and which ones not. Additionally, they mostly focus on costs for different tight oil plays. The approach followed in my articles is different. I take all costs into account including administration and interest costs and I segment costs by companies, not by oil fields. I believe this is the most reliable way, as it does not need to include complex geological and economical estimates and hypothesizes, but focuses exactly on what companies actually had to spend the get one barrel out of the ground. Furthermore, annual statements have to comply with accounting standards and are therefore easily comparable.
In one of my recent articles I have already started with the cost calculation of three tight oil companies. In this article I add the results of four more companies: Approach Ressources (NASDAQ:AREX), Halcon Ressources (NYSE:HK), Kodiak Oil and Gas (NYSE:KOG) and Oasis Petroleum (NYSE:OAS).
Oil is hardly ever produced as pure liquid. Normally it comes as a mixture with natural gas and gas condensate. Although I only consider companies here, that mainly lift oil, they also produce significant amounts of gas. Hence, it does not make much sense to apply costs to the production of oil alone. To deal with this issue the concept of barrel oil equivalent - boe - has been perceived. 6000 cubic feet of gas at standard conditions are about one boe. All costs mentioned below refer to one boe, meaning that are the costs related to the production of 1 bbl of oil, 6000 scf of natural gas or a combination of both. Let's say the price for 1 barrel of oil is around $100 and the price for 1000 scf of gas is about $6. This means, revenue from 1 boe of oil is higher than revenue for 1 boe of gas ($100 versus $36). As there are also fields that only produce gas, this article tends to underestimate the costs of oil production.
Commonly, costs are divided in costs that can directly be related to production (cost of sales) and costs that cannot directly be related to output (overhead). However, many oil companies are also active in downstream and midstream or other economic sectors (e.g. ExxonMobil in chemical engineering). Hence, I have divided sales, general and administration expenses (SG&A) by total revenues and multiplied it with the revenue of the E&P division to get SG&A for E&P. I did the same for any similar type of cost (marketing expenses, R&D) and for financial expenses. Depreciation of assets, on the other hand, can be directly linked to oil production.
Costs of sales are divided into 3 sub-categories:
- Exploration costs
- Lifting costs
- Non-income related taxes
Exploration costs are costs related to all attempts to find hydrocarbons. This category includes cost for geological surveys and scientific studies as well as drilling costs.
Lifting costs are the costs associated with the operation of oil and gas wells to bring hydrocarbons to the surface after wells (facilities necessary for the production of oil) have been drilled. This figure includes labor costs, electricity costs and maintenance costs.
Non-income related taxes: as production of hydrocarbons is such a lucrative business, governments also want to have their shares. There exists an abundance of different models for how the state can profit from hydrocarbon production (profit sharing, royalties, etc.).
It might be that different companies use different categories for the same type of expenses, but eventually the sum of all costs should be their total cost for producing 1 boe.
The following figure shows the pattern of the cost model:
In a number of recent articles I have applied the same methodology on a number of oil companies from all over the world. The links to the articles can be found below:
- Majors I
- Majors II
- Independents I
- Independents II
- Independents III
- Oil Sands I
- Oil Sands II
- Tight Oil I
- European Former NOCs
Application on 4 tight oil producers
As mentioned before, I have applied the cost model on 4 tight oil producers. It is important to note that some of the other E&P companies I have investigated so far also produce oil from tight sources (especially the bigger ones). Nevertheless, tight oil production represents only a small percentage of their total production. As those companies do not specify their costs for certain fields, I could not include them in my investigation about tight oil production costs.
The first company investigated here is Approach, which is significantly smaller than the other three companies in this article. Nevertheless, a reserve life of more than 30 years based on 2013 production offers sufficient potential. The company has all of its assets in the Midland Basin in West Texas. The income in 2013 was positively biased by a gain on sale of an equity method investment. Halcon focuses on Bakken, Eagle Ford and the Tuscaloosa Marine Shale. Due to high impairments in 2013, the company had a loss in 2013. Kodiak got its production from the Williston Basin of the Bakken formation in North Dakota and the Green River Basin in Wyoming and Colorado. In June 2014, Whiting Petroleum (that will be handled in one of my next articles) announced the acquisition of Kodiak to create the number 1 producer in the Bakken formation, eclipsing Continental Resources. Oasis focuses its activities on the Bakken and the Three Fork formation. The company was able to six-fold its production within the last four years.
The results can be found in the table below:
Liquids do not only mean classical oil, but also natural gas liquids - NGL.
Different portfolios and costs
All of the four companies have a high amount of liquid production (on a boe basis) with Approach having the smallest share and also the smallest realized price per boe. Oasis, on the other hand, has the highest percentage of liquid and can claim the highest revenue per boe. Halcon and Kodiak have similar shares of liquids, but differ slightly in the realized price. This emphasizes the effect of different blends of oil and gas.
Total costs per boe of the four companies are also not directly linked to percentage liquids, but in combination with the pre-tax margin rather tell something about the efficiency of the companies. What immediately catches the eye is the very high cost for SG&A and financial issues for the four companies. Ironically, the smallest company also has the lowest costs, but they are still just below $9 per boe. The other three companies are worse and Halcon even exceeds $15 per boe. It is no wonder, that an M&A wave is happening in the industry today, additionally driven by the rapid decline of the oil price. The influence the economies of scale have in terms of SG&A and interest costs per boe can be easily seen when one looks at these costs for the majors and large independents or even for the companies in part one of this article.
Altogether, pre-tax margins for the three companies are not very high, with Approach being the best (22%), closely followed by Oasis. Halcon and Kodiak do not very well, with about 10%. Nevertheless, a big part of this can be related to high SG&A and interest costs. If it were possible to reduce those kind of costs to an appropriate value (e.g. together $3), pre-tax margin could rise significantly.
Comparison to oil sand producers
Due to the small scale of the 4 companies investigated here, it is not clear whether a direct comparison is possible fundamentally. Nevertheless, some aspects of the outcome are quite interesting: small tight oil producers are valuable because of the expectation of growth and not because of their current high profitability. The oil sand producer Husky, with a similar production volume , has a much higher pre-tax margin.
Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.