What Investors Can Learn From the Life Cycle of a Barrel of Oil

It's life-cycle week at Industry Focus! In today's energy episode, Sean O'Reilly and Taylor Muckerman talk about how a barrel of oil is found, extracted from the ground, and produced.

Listen in to find out what technologies and analysis go into the exploration phase and how much it costs, how the drilling process works, how sharply decline curves hit wells after just a few years, why companies still tend not to cease production on old wells, and more.

A full transcript follows the video.

This podcast was recorded on May 26, 2016. 

Sean O'Reilly: Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. Today is Thursday, May 26, 2016, so we're talking about energy, materials, and industrials. I'm joined by Motley Fool analyst Taylor Muckerman, and following through on this week's life-cycle theme, we're going to be talking about the lifetime journey of light, sweet crude oil. How's it going, Mr. Muckerman?

Taylor Muckerman: It's going well, swimmingly.

O'Reilly: Swimmingly?

Muckerman: Swimmingly.

O'Reilly: Swimmingly. Since this is life-cycle week and we're talking about the journey that a barrel of oil goes on from being in the ground to... we probably won't get all the way to the gas tank...

Muckerman: No, that's for another day.

O'Reilly: Another day.

O'Reilly: Shall we start in the beginning with a dinosaur dying 300 million years ago?

Muckerman: If you were to walk us through the biology and the chemistry side of how it became oil, sure.

O'Reilly: I think I took my last chemistry class about six... I would have been in high school, I don't know, 14 years ago. We obviously won't get into the chemistry or anything like that. Let's just pretend... Let's talk about exploration first. There's oil in the ground, it's there, we don't know how deep it is, how do companies go about finding it?

Muckerman: They have data, the seismology, the geographic regions are conducive to oil; you can target certain areas of certain countries that you know are more likely to have it than not. Once you get into it, they're using lasers, they're using...

O'Reilly: They're using lasers?

Muckerman: ...discover wells...

O'Reilly: Where do I get one of these?

Muckerman: I don't know, if the Fool's paying you enough to buy one of those lasers, I need to switch jobs.

O'Reilly: Wasn't it that Drake's Well in Pennsylvania? They drilled there because there was a natural pool of oil hanging out somewhere. That's how they found oil 130 years ago.

Muckerman: That was the lowest of the low-hanging fruit.

O'Reilly: You know, the thing is still pumping, by the way.

Muckerman: Really?

O'Reilly: Yeah, I went there on a road trip, because me and my friend were huge nerds. It produces like 12 barrels a year.

Muckerman: That's the old decline curve for you.

O'Reilly: How much money do... Let's pretend you have X dollars of a capex budget, if you have some examples, great. How much of a capex budget goes to going out and finding the oil?

Muckerman: For a producer, let's just say look at U.S. exploration and production. Looking at just U.S. spending this year, estimates of $73 billion will be spent on exploration and drilling. The remainder of that will be from the production side, so you're looking at $73 billion for just exploration and drilling, and expectations of $87 billion total.

O'Reilly: Big chunk, 80%.

Muckerman: That's a big chunk and exploration being the largest of that, drilling it's expensive, but finding this oil is arguably the hardest and most expensive.

O'Reilly: Yeah, it's the riskiest part.

Muckerman: Those totals that I gave you are both down, the $73 billion for --

O'Reilly: Yeah, way down.

Muckerman: ...exploration and drilling down 40% from last year, and last year 2015 was down 37% from 2014.

O'Reilly: Jeez.

Muckerman: We're seeing big numbers, $73 billion is a lot of money but it's a pittance compared to what we were spending in 2014, 2013, 2012.

O'Reilly: Got it. Has the cost of exploration through technological advances come down at all?

Muckerman: Somewhat, it depends on where you're exploring. If you're in a familiar area like Texas...

O'Reilly: I was about to say in the Permian...

Muckerman: ...Saudi Arabia, somewhere where they're already producing a lot of oil. Not necessarily as bad, but if you go offshore, not only is it expensive but it's risky. You have oil fields, but at the same time it costs a heck of a lot of money to drill that first discovery well, then you have appraisal wells to see... Hey, maybe discovery wells find the oil, then appraisal wells determine how much you're going to produce from that well, and in between those two, then you determine "Hey, we're going to go full bore and drill to the depths of this well and try and extract as much as we can." In total, really, it isn't that much, because the average around the world... Really only extracting about 35% of the oil that they're discovering.

O'Reilly: Oh, wow.

Muckerman: There's a lot left and... Because technology. We just don't have it to extract all that. We're trying to extract more, we've been getting better at that, but the global average is less than 40% coming out of the ground.

O'Reilly: Yeah and not only that, sometimes wells are duds. Correct me if I'm wrong, but they fail, especially the offshore stuff. I hear all the time that like, "Yeah, we drilled here and there's nothing."

Muckerman: They either find it and it produces, just not as much as they were expecting, or it's totally a dud. I feel like I hear about that less often now, thanks to companies like Core Labs (CLB) that can identify where, how, and when to produce this oil.

O'Reilly: The science. Mad science.

Muckerman: Yeah, science has really taken over this industry, it's no longer just brute force.

O'Reilly: Let's just pretend you and I, we'll call it Muckerman & O'Reilly Producers of Oil and Gas, or something. We go out, we found some oil in the ground. Our exploration guys are successful. There's 10 million barrels down there, how long are we going to be leasing a rig? How does the drilling process work? Because that does seem to be the next step in the life of a barrel of oil.

Muckerman: Companies like Halliburton (HAL -0.49%) and Schlumberger (SLB -0.85%), they've reduced the drilling time significantly. We're looking at a few days now, where we were several weeks, thanks to pad drilling, where they put these drilling rigs on tracks and they... Instead of having to totally disassemble it for each individual well, they leave it on tracks and drive it to the next site and can start immediately.

O'Reilly: When you say tracks, are you talking like reusable railroad tracks?

Muckerman: Some of them use that, some of them are on glorified bulldozer...

O'Reilly: With the treads?

Muckerman: Exactly. A lot of them are on a system where, the track system, where it's straight line, a lot of cubes, these are aligned in square plots and they drive this thing around.

O'Reilly: Taking a step back, if we had gone out and we're over there in the Permian Basin in West Texas, and we're like, "We just bought this lease, we think there's oil down there." When we did the test well for the exploration... Did Halliburton or Schlumberger give us that rig, too? Who did that? Do we own our own?

Muckerman: Some of the bigger companies will own their own rigs, it's probably a small expenditure.

O'Reilly: Do companies do that to be more flexible? They don't want to put up $50 million for this stupid rig, they'd rather just pay somebody else.

Muckerman: They're expensive and like we've seen, rig use ebbs and flows. You overexpose yourself to ... I would imagine only the super-integrated have...

O'Reilly: Have their own.

Muckerman: ...an impactful number of rigs.

O'Reilly: So we drilled, does it... What does it look like, still? You ever see There Will be Blood and...

Muckerman: The donkeys?

O'Reilly: ...They drill the well... No, not only the donkeys, it explodes up when you strike oil?

Muckerman: No, it's still dirty, there's still the, the workers are still coined "roughnecks," it's still a very labor-intensive dirty job. Thanks to technology and regulations that necessarily don't want oil spurting out of the ground willy-nilly, and leaking gas. You still see gas flaring, so you're still going to see the flames at a lot of these sites, where they're flaring off the gas that is coming out in increments too small to be monetized, which the government's cracking down on that as well, because it does release harmful gas into the atmosphere. With all these wells, people think they just produce forever, which they don't. Especially in the U.S., these shale wells you're looking at... In the Bakken and in particular, 70 to 80% decline rates in that first year.

We're seeing tremendous initial flows, very impressive initial flows, but you have to keep drilling, which is why we got into the mess we're in, because companies had to keep drilling, because these wells, they don't dry up, but 70% lost production in one year after four years, you're down to 20%, it's not good.

O'Reilly: It's crazy. How... It's going to depend on the region we're in, maybe throw out a few scenarios. Our oil company, for this barrel of oil that we're going out to find, Muckerman & O'Reilly...

Muckerman: I want more than one barrel, though.

O'Reilly: You do? Fine. Stick with the theme, man! Throw out a couple of scenarios for Permian and the Bakken, and maybe offshore if you feel like it, how long before we actually have to drill again? I know with fracking, you can pull the rig back up and go another direction and all that stuff, but how long?

Muckerman: Yeah, you have the horizontal drilling and these bits, they basically... I can only imagine when virtual reality really sets in, and you are the drill bit just following along. You can drive these... They're making gradual directional changes but...

O'Reilly: Over hundreds upon hundreds of feet...

Muckerman: ...They're not going in straight lines anymore.

O'Reilly: Right. You and I go out, we got this field in the Permian and we drill, and there's oil coming up, how long do you think until we have to drill again?

Muckerman: You're looking at, globally, if you stop drilling, these decline rates are going to impact anywhere from 5 to 10% globally. Probably on the lower end of that, because the bulk of oil produced is mature fields, conventional oil like Saudi Arabia, the Middle East, has very low decline rates compared to...

O'Reilly: Like 3%, something like that.

Muckerman: ...and that's where the bulk of oil is coming from. Outside of North America and shale production, you're probably looking at maybe a 5% drop if no one produced for a year.

O'Reilly: If nobody drilled another well.

Muckerman: If no one drilled another well, yeah. Demand is supposedly increasing and...

O'Reilly: Plus 5% is 5%.

Muckerman: Yeah, that's a lot of oil.

O'Reilly: You're producing 94, 95 million barrels today, 5% of that would be four.

Muckerman: That's a big crunch. You certainly would see prices spike, which is why I don't think you're going to see a cease in drilling ever. There's a lot of these... What Americans producers have been doing is drilling the well, they're just not fracking it. They're doing the expensive part, which is the spudding, the drilling, then they're just sitting on it waiting for the right time to...

O'Reilly: They're storing it in the ground.

Muckerman: ...the best economical time to go ahead and frack the well, which is the explosion and the influx of sand and water, or CO2, to then separate those fissures and allow the oil to free itself. There's a lot right there behind the spigot. They just have to turn it on.

O'Reilly: The next step in our journey, as I understand it, is actual production. We went out, we spent all this money and took all this risk finding the barrel of oil, or the oil in the ground. We drilled for it, now we have the production, which is the fruits of our labors. How hard is it to keep a shale well going? -- because it's probably one of the most interesting things we can touch on. What about one of those huge fields off the coast? How hard is that to keep going? I found this one company, name escapes me, a company that specialized in helicoptering oil employees to these rigs...

Muckerman: Yeah, there are companies that have really been hurt as far as their stock prices are concerned. That was a big business and it probably will be one day, unless something magical happens and we no longer rely on oil, because offshore is the next big thing. There's a lot of oil there to be had, but it's expensive. The production side is relatively easy compared to the exploration and the drilling side. The intense pressure is what keeps the oil flowing out. All they're doing... It's one of the more serious sides of the business, because we've all seen the oil leak in the Gulf of Mexico. Smaller oil leaks around the country happen from time to time during the production phase. It's equally as serious if not more serious, but it's relatively easy. The hard work is done, unless you're going to go back and refrack these wells, which is about to be a new thing, where they're going to utilize the same wells, try to access more than just 35% of the oil underground. Also, using enhanced oil recovery techniques like water flooding...

O'Reilly: Pump some carbon dioxide down there.

Muckerman: Pump some water, pump some carbon dioxide, they'll backfill it. They'll drill a separate hole where they'll only pump the water or the CO2 in and that'll enter the well they've already drilled and force that leftover oil there. Even starting to add microbes into this water to somehow attach to the oil and they make it more fluid, so it moves itself from the well a little bit easier. There's a lot of these new techniques that people are trying that are working. The production side still has some maintenance if you want to extract more than just a typical well will pump out itself. It's really all just about the pressure, which is what created the oil in the first place, heat and pressure, now you're releasing that. Relative to the finding and the drilling, it's the easier part.

O'Reilly: You're talking about all these alternative newer methods, all that. Are there any companies that come to mind that are at the forefront of all of that?

Muckerman: Devon Energy as a producer is most certainly; Schlumberger has been talking about 10,000 or so wells that have been drilled in the last five years that are eligible for refracking they think, not eligible like somebody signed, "Yes, this well can be refracked," that would benefit from being refracked and have the right geology that would support it. You're looking at the bigger players in this picture. Core Labs comes to mind as an assistant, they're not going to go out there and do the drilling, but they do all the core sampling. If you have a well that maybe isn't producing like you thought it would, you can go in there and give them a core sample of the earth, five, 6,000 feet below the surface and they can analyze that and maybe adjust the grains of sand that you're using in terms of size or the amount of sand that you're using, or the type of water, or the type of CO2 or whatever. They can analyze that and give you the ultimate specific nature of what you can drill with.

It's very confusing. We toured Core Labs a couple years ago, and what they're doing there is quite outstanding. I can't imagine the business without companies like that. You look at Exxon, Chevron, you would think that they're doing it in-house, but Core Labs actually had equipment from those companies that they're like, "We give up, we'll pay you to do this, here's our old equipment." Core Labs went in and retrofitted it to make it operate like theirs. It's funny, the money that they said that those bigger companies were spending on this, this equipment to analyze wells and things... Core Labs had built something better out of a regular washer and dryer.

O'Reilly: Oh my gosh. Unbelievable.

Muckerman: Core Labs is just better at it because they specialize in it, which is why these companies...

O'Reilly: And guys like that are needed for more advanced stuff.

Muckerman: Absolutely. You would think... Taking with them, couple years ago, the way that they're levered to offshore drilling, when offshore drilling picks up, Core Labs might be a company to look at outside of the drillers like Ensco or Seadrill or Transocean or whatever.

O'Reilly: You keep mentioning offshore here today. Do you actually think a couple of years down the road that's going to be big again?

Muckerman: I don't know how many years, but I think it will be big, in my opinion. I don't want to say it is, but in my opinion, yes. That offshore will be a very big part of this industry.

O'Reilly: Cool. That is it for the life cycle of a barrel of oil.

Muckerman: The upstream. Upstream life cycle of a barrel of oil. Maybe we'll get to the pipelines and the chemical refineries, and...

O'Reilly: Gas stations.

Muckerman: Gas stations, and the internal combustion.

O'Reilly: The show will culminate with the purchase of a hot dog at the gas station.

Muckerman: I'll take a taquito.

O'Reilly: Three days old. Thanks, man. We'll catch you later.

Muckerman: Appreciate it.

O'Reilly: That is it for us, folks. If you're a loyal listener and have questions or comments, we would love to hear from you. Just email us at [email protected], once again that is [email protected]. As always, people in this program may have interest 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 Taylor Muckerman, I'm Sean O'Reilly. Thanks for listening and Fool on!