Image source: Apache Corporation.
Analysts from energy research group Wood Mackenzie recently released a report detailing the game-changing reduction in costs shale drillers captured in recent years. The report noted that drillers cut the cost of new supplies by as much as 40% in the past two years alone. That not only makes shale viable in the current environment of low oil prices, but also poises it to fuel big winners when prices improve. In fact, the report pointed out that Apache (APA 0.87%) would likely be one of the winners. The reason it can win boils down to two critical characteristics: structural cost declines and controlling the right rocks.
Permanent cost reductions
Like most drillers, Apache has aggressively driven down costs during the downturn to mute the impact of low oil prices. In early 2015, for example, it laid off 5% of its workforce; it followed that up by cutting another 38 jobs earlier this year at its North Sea operations. Meanwhile, it worked directly with suppliers to obtain lower pricing on services and supplies. These initiatives pushed the company's gross overhead costs and lease operating expenses down 19% and 21%, respectively, year over year, while drilling costs dropped by an even more remarkable 45%.
That decline in drilling costs is particularly noteworthy because over half of the cost savings are structural in nature:
Image source: Apache Corporation investor presentation.
Unlike the savings from service cost deflation and headcount reductions, which are likely to reverse when oil rebounds, a combination of design and efficiency savings has permanently reduced Apache's well costs.
An example of a permanent cost reduction is the switch toward drilling longer laterals. In the Midland Basin, for instance, Apache recently drilled a 1-mile horizontal well for less than $4 million and a 1.5-mile horizontal for less than $4.5 million. The company can (in this case) drill a 50% longer well for only 13% more capital, therefore lowering the total cost per foot.
The right rocks matter
For an oil company, two inputs are required to calculate drilling returns: drilling costs, and the estimated ultimate recovery (EUR) of oil and gas. That latter input plays right into Apache's hand: It has a prime position in the Permian Basin of Texas and the STACK and SCOOP plays of Oklahoma, which have a higher volume of recoverable hydrocarbons due to geology and greater quantities of oil and gas saturating the rocks.
For example, while crude oil soaks the Bakken shale of North Dakota, leading Bakken leaseholder Continental Resources (CLR +0.00%) only expects to produce an average EUR of 850,000 barrels of oil equivalent over the lifetime of a well drilled today. However, in the STACK and SCOOP plays of Oklahoma, Continental Resources projects EURs of 1.7 million BOE and 2 million BOE, respectively. Because Continental Resources expects to extract double the hydrocarbons per well, it is no surprise that its returns at a $50 oil price are 90% in the STACK versus 45% in the Bakken.
Meanwhile, wells in the Midland Basin are generating a more than 1 million BOE EUR for leading producer Pioneer Natural Resources (PXD +0.00%). Furthermore, thanks to well design changes, Pioneer Natural Resources' most recent wells are outperforming its 1 million BOE EUR expectation by as much as 90%. Again, that is a function of the enormous volumes of oil and gas saturating these rocks: Pioneer Natural Resources estimates that the Spraberry/Wolfcamp shale layers alone contain more recoverable hydrocarbons than all but one of the world's oil fields. That bodes well for Apache, because it has a leading acreage position in the region.
Investor takeaway
In shale drilling, a prime position in the best plays and low structural costs are what matter most. Apache has both, which puts it in the position to thrive as industry conditions improve over the next year.
