Fossil Fuels Are Not the New Subrime, Just Ask Continental Resources

Thanks to a recent report, some are wondering if the fossil fuel industry is the new subrime bubble. There are oil and gas firms that have spent their cash poorly, but this does not mean that the entire industry is a basket case. Continental Resources (NYSE: CLR  ) is an example of an E&P that is making profitable investments while avoiding $100 million dry holes.

What does skyrocketing U.S. fixed investment in oil and gas really mean?
In the past decade investments in oil and gas have grown from less than 5% of private U.S. fixed investment to close to 20%, but don't get too scared. The collapse of the U.S. housing market pushed residential construction from 50% to below 30% of fixed private investment. The end result is that part of rising private U.S. fixed investment is energy simply due to the original subrime housing market. 

The other side of the equation is that the oil and gas industry is marked by large upfront capital expenditures followed by reduced maintenance capex. Billions are being spent to drill wells, upgrade pipeline networks, and reorganize refineries, but these investment levels will fall.

Do not compare aggregated numbers (apples) to dis-aggregated numbers (oranges)
Comparing challenged global oil production levels to rising U.S. fixed private investment in oil and gas is like comparing apples to oranges. U.S. fixed private investment in oil should be compared to U.S. oil production. 

US Crude Oil Production Chart

US Crude Oil Production data by YCharts

The above chart shows how U.S. oil and gas investment has grown, and how oil production has grown as well. The growth in horizontal rigs has sent production upward and allowed for profitable investments in new fields.

Continental Resources is a prime example of successful upstream capex. The company is not some wildcatter haphazardly putting holes in the ground. Continental Resources has proven acreage in North Dakota and Oklahoma. From 2010 to 2013 its annual production grew from under 15 million barrel of oil equivalent (mmboe) to 35 mmboe.

Continental Resources trades at an enterprise value (EV) to proven reserves ratio close to its peers' respective ratios. It is not cheap, but at an EV/proven reserves of around $31.67 per boe it is not at a nosebleed valuation.

Continental Resources is not the only company cutting costs and growing production. In one year Chesapeake Energy (NYSE: CHK  ) cut its average Utica well cost from $7.7 million to $6.7 million, and it hopes to cut well costs even further in 2014. In 2013 it boasted a 20% rate of return on its operated Utica wells. While the oil industry as whole has issues, U.S. natural gas drillers were forced to rationalize their operations after the 2012 price crash. The end result is Chesapeake already faced bankruptcy once, and it has no desire to be stuck in a similar position.

There are big oil and gas problems, but they are not found in established U.S. shale plays
Small U.S. E&Ps are developing proven acreage in an established market, but not all companies are as lucky. Royal Dutch Shell (NYSE: RDS-A  ) spent $5 billion on Arctic drilling in the past seven years with little to show for it.

Additionally Shell's upstream segment faces big challenges. Its Rotterdam and Singapore refineries have very low margins. Neither facility has access to cheap landlocked U.S. crude. Thanks to generous refining capacity the Asian market is especially challenging.

Shell is working to improve its operations. It shut down its Arctic drilling program in 2013 and 2014, but a history of expensive failures is not reassuring. 

Not all big oil firms are in Shell's position. Instead of charting relativity new waters, Statoil (NYSE: STO  )  simply moves up the Norwegian Continental Shelf to develop its Arctic assets. One of its major strengths is that its majority shareholder is a national government that puts long-term interests in front of short term profiteering. Statoil also has acreage in some of the top U.S. shale plays. In Q1 2014 its equity production brought in 49.4 mboepd in the Bakken and 31 mboepd in the Eagle Ford. 

The oil and gas industry is not the next subrime
The oil and gas industry is not one homogeneous body. While Shell's Arctic drilling program has had many challenges, it is not representative of the entire industry. The smaller U.S. E&Ps Continental Resources and Chesapeake are not cheap, but they are developing fields at a profit. The bigger firm Statoil is slowly developing its northern assets in order to optimize capex.

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