The USA has had a rather rocky relationship with oil. In the 19th century, the discovery of massive reserves of oil set America on course to become a hugely powerful nation. Cities started to flourish. And vast suburbs sprung up as the country adapted to cheap car travel.
More recently, America has had to curb its consumption. The era of gluttonous oil consumption came to an end as the USA became dependent upon imported oil.
The USA began to feel the strain of rising oil prices. When oil spiked during the financial crisis, Americans left their car at home. And industrial oil consumption collapsed.
But now, thanks to two new commercially deployed drilling techniques, the USA is set to free up an abundance of trapped gas and oil. And that could help the US economy back on its feet.
Because, while the glamour boys of the oil industry are heading off to deep waters, and plunging hundreds of millions of dollars down exploratory holes with very uncertain results, plenty of other oil men prefer a low risk play that offers a fast pay-back.
I met one of them last week. Matt Lofgran is chief executive of Nostra Terra Oil & Gas (AIM: NTOG), and before long he was scrawling figures on a piece of rough paper – figures that show just why he is joining the rush for US on-shore assets.
‘An Energy Renaissance’ in America
Make no mistake – America’s energy security has taken a dramatic swing for the better. Goldman Sachs has predicted that America will soon regain its title as the world’s largest oil producer, knocking Russia and Saudi Arabia off the top of the tree.
As I mentioned earlier, this is not down to the USA suddenly stumbling upon new oil fields. No, the real reason is that the ever inventive oil industry has found a way of extracting some of the oil that is known to exist but which has not previously been accessible.
‘America’s renaissance,’ says Goldman Sachs, ‘is down to hydraulic fracturing, or “fracking”. A process that has already significantly changed the gas industry and has been adapted to oil.’
To recap, ‘fracking’ and horizontal drilling are techniques which involve the cracking of rock strata from underground that allows trapped gas or oil to flow freely. Without doubt these methods have significantly changed the gas industry, although not to everybody’s benefit.
The price of gas in the USA has tumbled from over $10/mmbtu to $2.80/mmbtu. This is great news for consumers and is likely to trigger a switch from coal-fired to gas-fired power plants.
But it is not, of course, so good for gas producers and some of these are now in financial difficulties and are off-loading assets at distressed prices.
Targeting a High Oil Price
That sounds like an opportunity for someone, but the easier play today is to apply this same fracking technology to oil rather than gas fields. Although you may think that the gas price and the oil price should move in tandem, in fact they do not. Logistical and other considerations mean that while there is effectively a world price for oil, gas prices are set locally.
Today, the price of gas in the USA is low, but the price of oil is still high so it makes sense to target the latter. Throughout North America from the Red Earth and Swan Hills fields of Alberta, to the Woodbine and Eagleford properties of Texas, old fields are being reworked with the new techniques of fracking and horizontal drilling.
To get an idea of how profitable this can be, Lofgran referred me to the website of SandRidge Energy (NYSE:SD) which has licences in Texas and Oklahoma.
In its ‘Operational Guidance’ Sandridge quotes lifting costs of $15-$17 per barrel of oil; ‘DD & A’ (depreciation, depletion and amortisation) costs of $18.25-$20.20 per barrel; ‘General and Administration’ costs of $5.85-$6.50 per barrel; production taxes of $1.75-$1.95 per barrel; and interest expense of $8.70-$9.60 per barrel.
Add up the mid-point of those numbers and you get a figure of $58.575 per barrel, all in, which leaves a healthy profit margin on each barrel sold for $90 plus.
For separate projects, Sandridge quotes Internal Rates of Return of 62% and 82%, which look highly attractive under any circumstances but especially for what is essentially quite a low risk play.
There Could Be a Stampede
Of course there are a few reasons for caution. Where there is a stampede into a sure thing you can bet that eventually some will overpay for their entry ticket. Depletion, the rate at which the flow of oil subsides, is not entirely predictable. And if the USA finds too much oil, it could just throw the whole world market into imbalance and sink the oil price.
But for the time being the outlook is rosy.
Contributing Writer, Money Morning
Publisher’s Note: This article originally appeared in MoneyWeek
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