What’s the most important development in the energy business?
No, it’s not not pipeline gridlock or hydraulic fracking. It’s the rising cost of drilling a well.
In 2000, the average drilling cost per well was just under $1 million. Today, the rush into unconventional oil and gas plays has caused that figure to increase five-fold. Here is how this trend is fundamentally reshaping the oil patch.
End of the wildcatter
The players in the game have changed.
Wild-eyed prospectors and gutsy entrepreneurs have always played off the energy industry. Up until ten years ago, all you needed to do to break into the business was your life savings and some extra cash from family and friends. Empires were founded for under $10 million.
Today, the entry price for multi-well drilling program (not to mention the regulatory burden) is over $100 million. That’s completely out of range for small players.
Today it’s sophisticated private equity firms and other financial institutions backing energy projects. To secure capital, producers are increasingly turning to cash rich Asian investors.
Bigger is better
Higher capital costs and factory-like operations point to an increasing need for economies of scale. Success in this business will be determined by securing the lowest cost of capital and eking out operational efficiencies. Investors should expect more consolidation.
Nowhere is this more obvious than Alberta where’s it’s becoming increasingly evident that the province is a big boys sand box.
Names like Connacher Oil and Gas, Opti Canada, UTS Energy, and Synenco Energy remind us that juniors are not up to the task of developing unconventional plays. Junior players have been relegated to the task of identifying reserves as well as developing and licensing new technology. The actual business of production will be left to deep pocketed majors.
Vulnerability to weak commodity prices
Steep depletion rates are the signature of unconventional wells.
Consider the projected production decline curve for a well owned by Kodiak Oil & Gas Corp (USA) (NYSE:KOG). This graph shows an estimated production decline of 85% by 2015.
For small shale firms like Kodiak Oil & Gas Corp (USA) (NYSE:KOG), steep production declines leaves the company a short amount of time to generate enough cash flow to fund its next round of drilling. If commodity prices fall during this period, the company could be left with a portfolio of leases by no funds to drill the next hole.
When you find yourself in this situation you get bought out on the cheap.
Need for a strong balance sheet
Companies in the oil business are known for spending all of their cash and then some. But greater sensitivity to commodity prices increases the need to hold more capital in order to sustain drilling programs.