The Fickle Cycle of Oil

Anyone with the simplest grasp of economics can explain supply and demand, and oil is no exception when these laws are applied. As the market jumps and dives with crude and shale at the helm, it's hard to determine the best companies to put your hard-earned money into.

Special guest Matthew DiLallo is here today to help us make those picks and help us decide which ones we should ditch.

A full transcript follows the video.

Sean O'Reilly: Oil prices just can't make up their mind, on this energy edition of Industry Focus.

Greetings, Fools! I am Sean O'Reilly, joining you here from Fool headquarters in Alexandria, Virginia. We have a special treat for our listeners, as the prodigious Matt DiLallo is joining us on air. How's it going, Matt?

Matthew DiLallo: I'm very well. How are you, Sean?

O'Reilly: Not too bad. How's life down there in Charleston, South Carolina?

DiLallo: It's great in Charleston. Always sunny, always nice.

O'Reilly: Awesome. First up, diving right in, we're anxious to get your thoughts on the roller coaster -- and I might be a little conservative there in calling it a roller coaster -- that has been crude oil prices. To start, can you just recap what's been going on over the last 12 months?

DiLallo: Crude oil has just been going bonkers this year. It fell off the table last year when OPEC decided they weren't going to cut production, and it's fallen and fallen and I think it's about $40 a barrel this year. Then it balanced for a while and then it has recorrected over the summer and it hit a six-and-a-half-year low a couple weeks ago of $38 a barrel.

However, then it went ballistic by 27.5%, more than $10 a barrel to the end of August. It caught everybody off guard. At the end of the month, it was up 4.5% for the first time in a long time, but it's continued to be volatile lately. Some days it goes up, Venezuela was begging OPEC for an emergency meeting, that skyrocketed oil. U.S. production is starting to decline; that helped oil prices go up.

O'Reilly: The U.S. production climb was the interesting thing that I noted. Obviously, Venezuela is begging for this, that, and the other thing, but finally we're getting some kind of production decline.

DiLallo: That's what the market has really been looking for. It takes a while for all the wells to flow through because companies had a budget plan last year and they were drilling, and now they've finished a lot of their contracts with drilling rigs and those rigs are stopping and oil production really falls off because shale wells have such a large decline rate.

We're starting to see that, and that could really accelerate later this year. That's what the market has been waiting for. Once this oil starts to roll over, then oil prices should take up because it will help supply and demand better balance.

O'Reilly: As I understand it, the average shale well's decline rate is around six months. Given the rig count drop, why didn't the market have any faith that the production would actually decline? It seems to me like 1 + 1 = 2, and it was like the market didn't trust that oil production would decline, despite the cuts in capex and the decrease in the rig counts.

DiLallo: A lot of that had to do with the fact that shale drillers had gotten so efficient that a lot of them are still projecting growth year over year. It's kind of like the hump day for America. Oil production hits a plateau through March and April; it kept accelerating because they were still drilling and completing all these wells. Now it's finally falling over.

The market just wasn't sure if oil prices would stay high enough that drillers continued to drill more wells and they'd been so resilient that that's played into some of the problems with crude oil. They're just able to drill more wells with less money and that has really surprised the market, and that's part of the reason why crude has been so wild this year.

O'Reilly: The other problem has been China and the growth concerns over there. With oil prices this low, we've been told that production would fall; that's starting now. The other thing we've been told is that bankruptcies are starting to become prevalent. There have been a few, but in your opinion has this proven true at all?

DiLallo: Not yet. One of the things that really helped oil companies is the spike in oil back earlier this year. A lot of them raised capital. They went to the debt markets and they got...

O'Reilly: When oil popped up to $60 in the spring, where you had that 50% ride, they all raised money.

DiLallo: Oh, yeah. It was like a flood to the market. Everybody raised as much cash as they could get and that has really helped a lot of the companies. There's this thought that if they could just make it through a year or two they'll be fine. That has helped a lot of them to not go bankrupt, but that might not last forever.

If crude does stay lower for longer -- which a lot of big-name companies are banking on, like ConocoPhillips, BP... they're all saying "lower for longer." That could lead to bankruptcies later this year. We're seeing a lot of oil companies really starting to cut costs and dig in for this "lower for longer." ConocoPhillips, like I mentioned, just laid off 500 people in their Houston headquarters as part of a 10% workforce reduction. One of the things that they said is, "We don't see a lot of correction in the short term. It's really changed the way we work."

A lot of companies are going with that mind-set. They think this could be a really long downturn. We also saw a Canadian company, Penn West (NYSE: PWE), who reduced their headcount by 35%, they suspended their dividend, they cut capex, and this is all in an effort to get their costs as low as possible so they don't go bankrupt. Penn West has been one of those that has been an issue.

There's a number of other ones. There's Sandridge Energy, Halcon Resources. These are...

O'Reilly: I know Noble laid off people. Yeah.

DiLallo: They just drilled and drilled no matter the cost. Whatever the market would give them as far as debt, they just sopped up as much debt as they could because the returns are really good. They thought that oil would stay $100 or so forever. It hasn't appeared to be the case.

O'Reilly: As I understand it, since the Great Recession, the net job gains in every industry have been flat, but the one gainer has been oil and gas. All the other industries just traded people. If what you're saying is true, it seems like those days are over.

DiLallo: You would think that. One of the things going into the downturn is the energy industry is actually really worried it wouldn't have enough people. There were projections by the Bureau of Labor Statistics that the industry would create 1 million more jobs by 2020. Going out of the recession, it had a 41% increase.

What really helped America get out of the recession was this oil economic engine, because for every job that an oil company created, it would create a lot of indirect, and induced jobs.

O'Reilly: Yeah. You hear these stories like McDonald's workers in North Dakota making $15 an hour just because they needed McDonald's for all the oil workers.

DiLallo: Yeah, and truck drivers up in North Dakota were getting six figures and a lot of people were moving up there because that's where there are actual jobs. There are two problems. One is that a lot of the people that work in the energy industry are older. The industry hasn't been a growth industry, so they haven't been hiring a lot of young people. They have what's called the "Great Crew Change," which is the flood of retirements that are happening now, and will continue to happen.

That's going to leave them without the skilled workers, there's going to be a huge gap, and what the downturn is really going to create is this huge gap between skilled workers and people that actually want to work in the energy industry. Not only is it not "green" and it's dirty, but it's so cyclical that a person coming out of college isn't going to want to work in an industry where they could get laid off because it goes into this crazy downturn.

That's just going to make it harder for the industry to cope with these situations. They're going to lose a lot of their people.

O'Reilly: Got it. Before we move on, I want to make everybody aware of a very special offer for all of our Industry Focus listeners. If you found this discussion informative, and you're looking for more Foolish stock ideas, Stock Advisor may be the service for you. It is our flagship newsletter started more than 10 years ago by Motley Fool co-founders Tom and David Gardner.

We're offering the lowest price out there for all of our Industry Focus listeners. It is $129 for a two-year subscription to Stock Advisor. You will get two stock recommendations every month with insight from our team of analysts. Just go to focus.fool.com to take advantage of that deal. Once again that is focus.fool.com.

Joining me today is Fool contributor Matt DiLallo, and I'm anxious to get his thoughts on the best plays for Foolish investors, given the current energy environment. There's a lot of -- what would you call it, Matt? Uncertainty.

DiLallo: Yeah.

O'Reilly: A lot of companies seem to be driving a lot of their competitive advantages at this point from being a low-cost producer in the top geologic formations. Matt, for our listeners that may not know, what are the top geologic locations for shale oil production and what are your favorite companies in them?

DiLallo: There are three big shale places in the United States. The Bakken up in North Dakota, the Eagle Ford in Southeast Texas, and then the Permian Basin in west Texas. They are these incredible shale oil places. There's so much oil packed underneath the ground that it's revolutionized American oil production, and one of the worries going through the downturn is that this was a really high-cost production.

Some thought they needed $9 a barrel just to make money. What companies are finding through the downturn is that they can make the same returns now in the $50 to $60 range that they were making when oil was $90. A lot of that has to do with becoming so efficient. They can drill wells super-quick now and they've been able to figure out ways with hydraulic fracturing and putting more sand down in the well bore that they can get more oil out of each well.

That's improving returns and that's making this a really good, long-term opportunity for the companies and for investors. Back to those key players: EOG Resources (EOG 1.07%) is probably the best of the best if you're talking about shale. They've got great positions in the Bakken and the Permian and Eagle Ford. They're actually one of the few oil companies that aren't growing production right now.

They decided that with the market oversaturated, they weren't going to grow production. What they've done is drilled, but not completed wells, which means they're not fracking as many wells. When oil prices start to rise, EOG said when it hits about $65 a barrel, they're going to turn on the spigot and start growing production. That's a great company, very well managed. It's one of my favorites.

O'Reilly: I actually wrote an article on them a few months ago, and I was curious who was the most efficient. I quickly realized that it was EOG. They have that investor presentation, they talk about how they're making just as much money at $65 than they were in 2012 at $95. They make their own fracking sand, as I recall, so they're vertically integrated. I quickly realized that they were the best in the business.

DiLallo: Yeah. They're one of my favorites. Another really strong one is Devon Energy (DVN 0.78%). They've taken a bit of an opposite approach. They're actually growing production very rapidly. It's something like 25% to 35% oil production growth this year, because they are so efficient.

O'Reilly: So they're the cause for the glut? I'm kidding.

DiLallo: That's part of the problem. Some of these companies are looking at their returns and they're saying, "It's still pretty good and there's no reason to cut." In Devon's case, they have the cash, they have the cash flow, and they have no reason to slow down. What they've been able to do is set a budget and then they've become so efficient that they're just chopping their budget and still getting the same growth. They're a really good player and they're in the Permian and Eagle Ford.

Then if you just want to look at the Permian, which is a massive oil play that we've had since the 1920s: Pioneer Natural Resources (PXD 0.87%) is a huge one. I think they say they can pull out 22 billion barrels of oil equivalent. All of America's crude resources is something like 30 or 40 billion. There's so much potential there.

O'Reilly: You said "oil equivalent." Does that include natural gas?

DiLallo: Right. Natural gas and natural gas liquids. I think the Permian is 65% oil, so we're still talking a lot of oil.

O'Reilly: Yeah, for sure. Which of these three companies is most attractive to you right now? From what I can glean some companies have just been decimated. Their share prices are down 90%. The market is aware that these guys are really good at what they do and they've fallen a lot, but it hasn't been nearly as bad. Which one do you like the best?

DiLallo: I like EOG a lot. However, when we talk about stocks that have fallen, Devon Energy, the last time I looked they were down 50%. I can't remember if that was off their 52-week high or what, but they've been really blasted and there's no reason for it. They are operating so well and they're so efficient. They have such a good balance sheet. I think when oil prices turn, that one can really do well.

O'Reilly: Very good. Thanks for your thoughts, Matt. Have a good one.

DiLallo: You, too.

O'Reilly: Looking forward to talking with you again soon. If you are a loyal listener and have questions or comments, we would love to hear from you. Just email us at [email protected]. Again, that's [email protected]. As always, people on this program may have interests in the stocks that they talk about, and The Motley Fool may have formal recommendations for or against those stocks. So, don't buy or sell anything based solely on what you hear on this program. For Matthew DiLallo, I'm Sean O'Reilly. Thanks for listening, and Fool on!