Capital Road: The Foundations for Oil & Gas Investing

[originally posted in 2015]

Greetings!

A few words of welcome to start:

1 — Welcome! I’m grateful you’re here. My mission is to provide succinct, useful reports to help make you more confident investors in Energy and/or Real Estate. If that is ever in doubt for you, don’t be afraid to let me know. This report is decently long — probably a 15–30 minute read depending on how deep you go into the provided links.

2 — Finally, if you do indeed find this useful, we encourage you to share it with other like-minded investors in your network. This is not a game of numbers, but of quality. And the stronger the community, the stronger the magnet for great opportunities. Send me a note to matt@capitalroad.co or fill out a form at capitalroad.co for any recommendations.

Now let’s dig in. What you’re about to read is intended to give you a good primer for learning what makes the oil & gas industry tick, with input and editing by successful industry veterans (special thanks to all contributors!).

So whether you’ve invested in the space before, or steered clear of “all those scam artists” you’ve heard about for decades, this will provide an overview of the opportunities, the risks, and the right questions to ask before you invest your hard-earned money.

It is divided up into the following sections, feel free to jump to whatever you’re most interested in:

• What do you mean, exactly, when you say Oil & Gas?
• Exploration
• Drilling — Conventional vs. Unconventional (Fracking)
• Risks — Price, Supply & Demand, Geopolitics
• Due Diligence Questions
• Deal Pipeline

What do you mean, exactly, when you say Oil & Gas?

This is a less naive question than you might think. It is extremely important to be clear on what we are discussing. Each sector is often thought of as a distinct industry. Are we talking drilling? Exploration? Transportation? Refineries? Crude Oil or Natural Gas?

The answer is yes. All of the above. It is typically broken up into three broad categories: Upstream, Midstream, & Downstream.

Here is the most simplified explanation possible:

Upstream: Everything involved in getting oil & gas out of the ground
Midstream: Everything involved in getting the oil & gas to a refinery
Downstream: Refining the oil & gas, all the way to retail

Those of you who’ve worked in the space will be quick to point out that there are dozens of intricacies involved in each of these sectors. There is buying the land, or selling just the mineral rights to the land, and multiple ways to drill. And there is a big difference between drilling for oil and actually getting the oil out and into storage containers (a phase referred to as Completion). Some of you would point out that there is actually part of the refining process that begins before it arrives at the refinery (Midstream Processing) or that there are hundreds of companies that exist solely to service drilling process (housing, lighting, water, electricity, etc).

There are books written on all of those intricacies, so I’ll stick to what matters for investors:

Overall we will focus on just Upstream and Midstream, as well as a few Service areas surrounding them, since those are the primary areas where private investment opportunities exist. For the Downstream you typically go to the public markets since refineries require an amazing amount of capital to build, among other reasons.

Here is what we’ll look at on the Upstream side of things:

1 — Exploration

The search for new oil. At this point, it’s more like the search for new pockets of oil within known oil field regions (plays). Also known as wildcatting. Personally, I love this term. It conjures up images of the Wild West and a time when men knew how to be men. But exploration is also responsible for most of the bad reputation and lost fortunes this industry can boast. That will happen when promises are made and dry holes abound. There have been many crooks to say the least.

Add to that the frequent strong-arming of land owners to sell their mineral rights (also known as leasing the land), and you have achieved villain status in the minds of many.

While the bad guys still exist, this should not be your biggest concern. Instead, you will do your due diligence on the team involved, you will review your contracts and deal structure, and you will know the level of risk you’re willing to take.

As for risks, be aware that exploration uses the same model as venture capital: Build investment parameters that you believe have the best chance of a big return, invest within those parameters (throw the spaghetti on the wall), and hope 2 or 3 out of 10 stick and more than make up for the failures of the rest. I work with a group here in Austin that does much better, though, and the key these days lies in the skill of the geologist. We’ll talk more about this in a bit.

2 — Drilling / Completion

If you had to choose one thing that is behind the U.S. “oil boom” over the last few years, it is drilling technology. Many people aren’t aware that fracturing rock to stimulate oil production has actually been around since the mid-1800’s. Back then it was called the the “exploding torpedo,” and they were pretty much just sending dynamite into the ground. In the 1930’s they did the same thing, but used acid instead of explosives. The current form of what we call “hydraulic fracturing” has actually been around for almost 70 years. It began as an experiment in 1947, and the first commercially successful application followed in 1949. The process has since been refined through enormous amounts of trial and error, and well over 1 million fracking wells have been drilled in the U.S. alone.

Simplified explanation of what fracking, often referred to as “unconventional drilling,” actually is:

1. Drill down to shale formation
2. Turn well laterally, continue drilling horizontally through sweet spot, eliminate need for multiple conventional wells into the same pocket
3. Fracture shale rock with mixture of water, sand, and chemicals (proppants). This releases gas stored in the rock
4. Sand keeps fractures open, oil/gas seep into well, pumped to surface

And for all you visual learners:

A obvious questions remains: Why did it take so long for this boom to occur?

The answer is that horizontal drilling technology finally made it economical. Even though the capital requirements for a horizontal well ($5–12M) are substantially more than conventional wells ($500K — $2M, depending on depth), the ability to tap into more of the pocket enabled the well to recover much much more of the trapped oil with a single well.

Here’s a simplified visual of the difference. It used to be about lining up the rig in the right spot and drilling in the right spot. With new technology on the unconventional side, it is more about guiding the drill through the right zone. Here’s a video showing how they do that.

[We’ll dig into the Midstream and the businesses that Service the entire process in a future newsletter.]

What are the real risks?

No good investor puts money into something without understanding the risks. Your threshold to tolerate these risks is another matter, but understanding what can go wrong is the cornerstone of due diligence. The risks in the Oil & Gas industry are plentiful, as are the rewards, but much of the discussion is often clouded with emotion and misinformation. Below are a few of the main risks you should consider in today’s investing environment:

Price Risk

This is the most talked about issue for a reason. The price of oil can make or break a business, and it has been extremely volatile and hard to predict since the beginning. That doesn’t mean you can’t mitigate your price risk, however.

If you are participating in a well, you should be acutely aware of what oil price is required to remain profitable. This is why the expertise of the operators drilling and completing the well is so crucial (more under Operator Risk).

Here is a surprising graph what price is needed for the major oil companies to break-even:

You can see that many need the price per barrel to be over $100 for unconventional drilling to be profitable. A big reason for this is the huge amount of capital expenditures they have undertaken, often with loads of debt, as well as their dividend obligations to investors. Personally, I’d prefer to avoid this predicament. EOG is a good example of a low-cost producer that claims they can be profitable at prices well below $80 (this article presents an opposing view to the graph above). Either way, low-cost production can certainly be done.

The last few months are a great example of the unpredictability and volatility of the price of oil. We’ve seen a drastic decline, from a peak of nearly $104/bl in June down to less than $80 in mid-November:

This piques my curiosity about what could cause such a thing. If we really know the factors that can cause this big of a drop, did anyone predict it? I found at least one group that did predict early this year that oil prices would hit $75 in the near future. Read this article — it’s fascinating, and a bit like time travel to read people’s predictions about a future that you’ve already experienced. Anyhow, most still expected it to continuing going up. Regardless of how hard it is to predict, there are certain factors always in play:

Supply and Demand:

An obvious one for sure. Even oil can’t escape basic economics. But oil is a global price, and the curve ball comes when you add in countries like Saudi Arabia, Russia, and the rest of the OPEC members. They don’t play by the same free market rules, and they have enough control still (Russia and Saudi Arabia still produce over 25% of the world’s oil, but their power is not quite what it used to be) to artificially keep the price high or dip it low.

Supply
For example, there is a lot of talk right now about the Saudi’s flooding the market with oil to drop the price. They might do this to (1) secure future market share by delivering a blow to Russia and Iran, who can’t withstand lower prices and operate in a deficit for nearly as long (Iran needs a whopping $140/bl price to break even!), and/or (2) to discourage further investment in the U.S. fracking boom.

Saudi Arabia needs high oil prices too, though. They are dealing with ISIS, the aftermath of the Arab Spring, and extremely high government spending, so many feel these low prices won’t last for long. Good articles here, here, and here if you’d like to dig deeper. We’ll also jump into the Peak Oil debate in a future newsletter — a fascinating topic that may require it’s own report.

The Demand side of the equation is a good fodder for a dinner table argument as well. Here’s a quick overview:

1 — U.S. demand (consumption) for oil has actually decreased in recent years. Will this continue as people move more and more into urban city centers and young people drive less? Will alternative energy sources gradually take market share?

2 — Global demand is still on a steady rise, mostly in developing areas (SE Asia, Africa). It is hard to imagine this changing in the very near future, but how long exactly? Can production keep up? If not, the price must climb. Good article here.

Bottom line with Price Risk:

Oil has a history of bankrolling and bankrupting companies that try to predict what it would do. A better strategy, in our opinion, is to keep costs low, avoid large amounts of debt, and be able to make money even if it stays around $70/bl.

Here are other risks that we’ll touch on more in the future:

Geopolitical Risk — Crisis in the Middle East affects production, political power struggles, etc
Environmental Risk — Spills, Freshwater Impact, link to earthquakes, contamination
Operator Risk — Poor management, accidents, unexpected costs, miss the target
Geologist Risk — Misreads seismic data, drill in the wrong spot
Production Risk — Hit the right spot, but doesn’t produce volume expected
Deal Structure — Make sure you’re not taking all the risk for little reward

I believe there is real opportunity in Oil & Gas investments, but to find the right opportunity I have to ask the right questions:

The questions below are where we start with our Deal Flow process.

• Is this opportunity in exploration or production? i.e. Are we trying to find oil or do we already know it’s there and we are going to drill the holes and produce it?
• What is the track record of the operator?
• What is the track record of the driller? Look at Initial Production Strategy and track the production curve over time so initial production optimized against life of the well
• Is this a low-cost or high-cost producer? What is my break-even oil price?
• Am I a General Partner (direct owner with tax benefits) or a Limited Partner without tax benefits?
• What are my moving costs? Is the area you are drilling accessible to pipelines? (costs ~$20/bl to transport via train in the Bakken, only $5/bl via pipeline in Texas)
• Are you hedging oil price risk? i.e. the use of collars
• What is the track record of the geologist? Compare % to other geologists
• Are there conflicts of interest? i.e. Does one company own both the service and drilling companies? If so, how are those contracts structured?
• Is this meant to be a cash flowing long-term investment or are we looking to divest over a shorter-term period?
• How is the deal structured? Make sure risk and reward match, and your liability is limited where possible

Moving forward, we’ll also talk about trends. I’m currently researching:

1 — The effect of deflation vs. inflation on the industry
2 — How we can continue to become more efficient in the drilling process
3 — The use of water in the fracking process and the opportunities for improvement
4 — Is the Midstream sector or the refining process acting as the bottleneck for the industry?

Still with me? I’m impressed. I’ll close by saying this: Please provide feedback. Email me with any ideas for topics to cover and ways to make it better.

Special thanks again to all those who contributed — I am extremely grateful.

Until next time, be well, do good work, and stay in touch.
The future looks good!

Matt McPheely & the Capital Road Team