Cashing in on the U.S. Energy Boom

article

Asset Values In, Around the Oil Patch

Date March 2014

Featured in the Journal of Corporate Renewal

With recent historic gains in onshore U.S. oil and gas production, the price of a barrel of domestic crude remains more appealing to refiners than foreign oil priced at the global Brent benchmark. By some estimates, the U.S. may well become a net exporter of natural gas liquids sooner than 2020, when that was initially projected to occur. This change of fortunes has put the U.S. in the enviable position of decreasing its reliance on foreign energy, especially in the case of crude oil production.

In the last 2 1/2 years, what had been a fairly even split between the number of North American onshore gas vs. oil rigs had become  lopsided in favor of oil drilling by the end of 2013. According to Baker Hughes, an oilfield service company that tracks rig counts, onshore oil rigs now make up nearly 79 percent of the total fleet as producers chase the much higher oil prices.

Nevertheless, gas production is also in a state of extreme readiness to ramp up production quickly when market conditions are favorable. The Bakken, Marcellus, and Eagle Ford shale plays, to name a few, continue to be game changers in terms of production potential. While the Henry Hub spot price of natural gas has remained at just above $4 per million Btu, many are confident that the adage “low prices will fix low prices” will again prove to be true. In other words, they believe that inexpensive natural gas will trigger additional demand and, with it, improved profitability.

By 2016, more manufacturing operations are expected to either have completed new facilities powered by natural gas or to have converted existing plants to operate on natural gas. Those actions, too, are expected to further boost demand.

The nature of oil and gas investing is challenging, as price fluctuations impact every corner of the industry, including the value of heavy equipment assets and the companies that rely on them. Even in the glow of soaring domestic production and signs that another great boom is underway, it is important to examine past boom periods and current trends to adequately understand opportunities to take advantage of and missteps to avoid in the space.

Rig counts have traditionally served as a primary indicator of the health of oil and gas production. Counts had been on the rise during the past few years, reaching levels not seen since the mid-80s, but those numbers have become less likely to tell the whole story. 

Advances in technology and enhanced techniques have spawned more-efficient drilling. Yields per rig are increasing, allowing producers to increase output levels while the number of active rigs has fallen since its peak. The result is an overabundance of rigs and other heavy equipment. 

A similar increase in efficiency, along with the possibility of overproduction and a drop in demand, played out in the mid-80s and resulted in a large number of rigs being stacked (stored for future use) or cut up for scrap. This also precipitated consolidation among drilling companies, resulting in fewer but stronger competitors. Such companies, of course, can better weather limited downturns. However, should a prolonged downturn occur again, another round of consolidation and/or rigs and equipment hitting the auction market could occur. If past boom cycles have taught anything, it’s that investors should be prepared for the possibility of stacked rigs.

A strategy to hedge against this possibility is to invest in profitable and stable companies with equipment that can be utilized, whatever the production flavor of the moment happens to be. After all, if only the strong survive, investors must know which assets are strong and who utilizes them. Even if a downturn were unavoidable, valuation services could provide insight to lenders and investors regarding their levels of exposure and the potential for liquidation.

Not All Rigs Are Created Equal

Those looking to invest in the oil and gas industry should work with experienced professionals to better understand the specific assets in play in the oil and gas market. This includes staying current on what equipment is likely to retain value and remain in demand for years versus what rig types are likely to be stacked or even sold for scrap. 

One litmus test involves determining the most prevalent rig classes within the active rig count and those that are dominating new builds. In both cases, rigs in the 1,000-2,000 horsepower range prevail. They account for 60-65 percent of the active rig count and nearly 90 percent of new builds. Rigs outside that range comprised the majority of stacked rigs in a rig census analysis conducted in August 2011 by the American Oil and Gas Reporter.

There’s still a place for 600-750 HP mechanical rigs, which once were widely used. However, their use is now limited to shallow drilling or, as a cost-cutting measure, for initial drilling before being replaced with a more powerful rig.

How a rig is powered should also be considered. SCR rigs are diesel-powered and electrically operated and, as such, offer slower motor speeds and less torque than purely AC-powered rigs. AC rigs can accommodate more automation possibilities, and a survey of new onshore rig builds suggests that a majority of new builds involve AC rigs. SCR rigs can be reconfigured to run on AC, but many are being stacked or, worse, cold-stacked for years at a time.

Horizontal drilling and fracking require more-powerful and programmable rigs than have been used in the past. These in-demand rigs offer high-powered triplex mud pumps, top drives, rotary steerable systems, and updated computer and electronic controls. Older rigs with duplex pumps and those that lack top-drive capacity are less desirable and are often being relegated to production in developing countries, if not abandoned altogether.

Another rig type that is increasingly in demand is the “walking” rig, which can be shifted or walked to multiple holes on a single pad more efficiently. Some walking rigs can move 20-25 feet in an hour, instead of having a third party rig down, move the equipment, and then rig up again in a new location, which requires dramatically more downtime.

The impact of these differentiators and the lessons learned from them are not isolated to rigging companies, but apply to other upstream and downstream suppliers, manufacturers, and service firms as well.

Tangential Considerations

With fossil fuel production raging in North America, more than 26,000 miles of pipeline are in the planning stages. Pipeline contractors and subcontractors stand to take on a lot of work. Opportunities exist on both ends of a pipeline project lifecycle, first as companies gear up and crew up in advance of a start date, as well as at the end of a project, when surplus equipment provides liquidation opportunities. A similar scenario played out in 1977 when Parks-Davis sent to auction a large amount of surplus equipment from the Trans-Alaska Pipeline System project.

Those looking to invest in infrastructure opportunities should be just as diligent as investors looking at rig types when it comes to assessing the value of all the equipment and technology used in pipeline construction.

Each pipeline project has different requirements. Some require more transportation pipeline, while others might call for smaller-diameter gathering or distribution components. It’s critical to know if a supplier’s valves, compressors, pumps, or other flow control technology are in line with current market demand.

Real-world events also can alter public opinion and political will and, in turn, impact the economics of a given strategy. For example, a string of recent oil-carrying rail car accidents in the U.S. and Canada involving crude being shipped from the Bakken region in North Dakota have focused much attention on how oil is transported. Most notable among them was a 74-car derailment in downtown Lac-Mégantic, Quebec, in July 2013 in which 47 people were killed and 30 buildings were destroyed in the ensuing fire. Each incident has stirred debate over the relative safety of moving oil long distances via pipelines versus rail transportation and may ultimately bolster the case for constructing new pipelines.

Still, pipeline proposals often face opposition. Perhaps the most hotly contested project at the moment is the planned Keystone XL extension of TransCanada’s Keystone Pipeline from Alberta into the Midwestern U.S. and down toward refineries in the Gulf of Mexico. Keystone XL has drawn opposition based on environmental concerns and faces a highly partisan U.S. Congress battling over whether to green light the project.

Two phases of the project are already in operation and, if it is completed, the XL phase would deliver an additional 830,000 barrels of oil per day to Cushing, Oklahoma, and the Gulf. It would also allow U.S. oil extracted from the Bakken region of Montana and North Dakota to be added to the pipeline at Baker, Montana, and shorten the overall distance traveled between Alberta and the Gulf. 

Market Forecasting, an Imprecise Science

Market forecasting is an imprecise science, whether on Wall Street or within the commodities landscape, and shifting oil and gas exploration and production trends can profoundly impact upstream and downstream companies. Recently, for example, Royal Dutch Shell pulled out of plans to build a $20 billion natural gas-to-liquids facility in Louisiana due to continued stagnation in natural gas prices. The effects of Shell’s decision to decrease production of natural gas in the area materially impacted a number of companies and had profound implications throughout the oil patch.

Naturally, oil and gas services companies aren’t the only ones susceptible to market forces. Clean tech companies involved in solar and wind power generation and biofuel production have had a difficult time putting their high initial start-up costs against the increasingly competitive prices of fossil fuels. 

In other instances, solar tech companies like Solyndra and Evergreen Solar pinned their futures on avoiding the use of what had been costly PV grade silicon. When shifting supply and demand in the silicon market resulted in severely reduced prices for raw silicon, Solyndra and Evergreen lost what had been their signature competitive advantage, and each shut down its U.S. plant in 2011.

Those pricing challenges, along with improved energy efficiency technology, have caused a number of other clean tech companies to go under as well. Venture capital investment in clean tech, which had been on the rise since 2009, dropped in both 2012 and 2013.

Opportune Times

An energy boom is most certainly underway in North America, and with it comes opportunity to profit by investing up and down the oil patch. Even so, this surge shouldn’t be interpreted as an invitation to throw money at every other new venture indiscriminately.

The very fact that there is a boom and, with it, a hoard of potential new players entering the fray means that it’s more important than ever for investors to be armed with as much knowledge as possible about trends and intrinsic values of hard assets as those trends shift. Experts in appraising all elements of the oil and gas industry can help investors do just that.

Having a solid strategy regarding the equipment and companies to align themselves with, no matter what energy source is hot at the moment, can make all the difference between an investment that succeeds and one that gets cold stacked like an out of favor rig.