Just as the entire world was watching the oil gush into the Gulf of Mexico just over a year ago, the whole world is now watching a very unstable situation in the Middle East.
I don’t think anyone is surprised that Middle Eastern turmoil has created a pop in the price of oil, but I think a lot of us are surprised at just how many countries in that region have been impacted by what is going on.
For a long while I’ve believed that the coming decades will see high oil prices. I envision a series of peaks and troughs in the price of oil created by a supply-and-demand imbalance for which we have no solution. 2008 was likely the first instance of the spike, with the collapse being exacerbated by the collapse of the housing bubble.
Because of my belief in higher oil prices, I’ve been positioning my portfolio to profit from -- and not be a victim of -- higher and higher oil prices. I’ve actually been surprised that my portfolio hasn’t gone up more in the past week than it has. I originally thought that was likely due to the fact that investors probably believe that the current oil price increase is a temporary phenomenon.
With this in mind, I thought I would check the future oil prices, thinking that I would see some serious backwardation with the near months being at $100 and prices a year out being $90 or less, reflecting expectations of the turmoil in the Middle East going away in the future. I was a bit surprised to see this from the close of trading yesterday for WTI:
- April 2011: $95.42
- December 2011: $99.74
- December 2012: $100.16
- December 2013: $100.09
- December 2014: $99.51
- December 2015: $99.43
- December 2016: $100.01
- December 2017: $100.79
- December 2018: $102.75
- December 2019: $102.69
$100 oil prices for as far as the eye can see.
My immediate thought was, what a great hedging opportunity for oil producers. And then I thought, what an especially great hedging opportunity for oil producers who own chunks of the huge new resource plays in the United States and Canada. Think of the Bakken in North Dakota and the Cardium in Alberta.
Why is it such an especially great opportunity for those companies? Because they are like manufacturing operations, with high volume repeatable drilling, the timing of which is completely predictable if you have the cash to do it. And if your production is hedged, you know you will have the cash. The key factor, of course, being that the production from these resource plays is very predictable and therefore excellent for aggressive hedging.
This is quite a bit different than an oil producer in the Gulf of Mexico who can’t hedge too aggressively because of the risk of having production shut in for an extended period. If your production is shut in and you have hedged too much of your production, you can put yourself in a very difficult spot if those hedges are on the wrong side of the spot price.
And these resource companies are also a bit different than a conventional oil producer, who has to constantly find new reserves to replace that which is being depleted through existing production. There are no guarantees that they can find new reserves and thus not be able to predict production for as far out into the future.
These large resource plays provide excellent visibility on where production will be for extended periods of time. Great for hedging ... and at $100 oil, these producers mint money.
For an example of just how consistent production can be from these unconventional resources, my favorite example (albeit in natural gas production) is Chesapeake Energy (CHK). See page 17 in this Chesapeake presentation. From 500 mmcf/day in 2000 to over 3,000 mmcf/day currently; you could set your watch by its production ramp-up. It isn’t just year on year growth; it is quarter on quarter for every quarter over more than a decade.
The oil shale and tight oil resource plays today, held mainly by smaller and mid-cap companies, provide the same sort of manufacturing opportunity except for oil. Once the boundaries of the play are established, companies basically know how many locations they have and how much oil is in place. All they then have to do is get a drilling rig, drill a hole, complete it and move on to the next location. Repeat the process again and again and again.
I own a few of these companies on the Canadian side of the border, and am looking at a few smaller ones who have what I feel are very unappreciated parcels of land. I hope the ones I own are out hedging today, because I don’t think they are priced for $70 oil -- never mind $100 oil.
What I like the most about my investments in these companies is that they have locked up large amounts of oil in place. Horizontal drilling and multi-stage fracs have made these resource plays very profitable. But every year these companies are learning how to recover more and more of the original oil in place, making their companies more and more valuable. I think most of them have potential for serious reserve growth just from their existing asset base. And there is no more economic way to find new reserves than to have it come from land you already own.
I’m going to look at many of these companies in the coming weeks and months. I’ll try and share what I learn through Seeking Alpha.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
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