Continental Resources (CLR) recently reported a 40% year-on-year slip in fourth quarter earnings. The company, which drills for oil in North Dakota, Colorado, and Oklahoma, posted a net income of $132.8 million compared with $220.5 million in the year-ago quarter. High costs have negatively affected profitability in the entire exploration and production subsector. EOG Resources (EOG 0.68%), for instance, has seen two straight quarters of slowed earnings growth, from an 81% increase in the second quarter of 2013 to gains of 34% and 24% in Q3 and Q4, respectively.
Despite the decline in profitability, Continental Resources is still trading intimately close to its 52-week high. Investors are largely unmoved by the slip in profit and, from the look of things, expect even more upside. This bullishness is widely informed by the fact that despite decreased earnings, Continental Resources made gains on the measure that matters most for upstream companies: output. In Q4, production increased 35% to 144,254 barrels of oil equivalent per day.
Investors see the continual increase in Continental Resources' production output as future profit, explaining the strong interest in the stock. However, turning this increased output into profit is not as simple as it may sound.
The U.S. doesn't have more oil reserves than traditional big oil producers such as Russia and Saudi Arabia. The production resurgence is merely an outcome of better production technologies such as fracking. However, there is a downside. Shale output from better technologies such as fracking declines faster than production from conventional methods. The International Energy Agency says that it will take up to 2,500 new wells a year to sustain output of 1 million barrels per day in North Dakota's Bakken shale. In stark contrast, Iraq could comfortably do the same with 60 wells.
This essentially means that U.S. producers have to drill at an extraordinarily high pace in order to sustain or increase current output levels. Again, there is an even more glaring downside to this. The cost of fracking is significantly higher than conventional methods. So basically, the high costs that have suppressed E&P players' profits will remain for as long as the pursuit of higher output holds. This means that producers' long-term profitability is exclusively predicated on higher crude oil prices.
Next on the agenda: getting past the export ban
The domestic supply glut can't guarantee the kind of prices that E&Ps are looking for. Lifting the U.S. oil crude oil export ban, which has held for 40 years, seems like the only way to go.
This is for two core reasons. First, opening up the U.S. market will allow an uptick in U.S. oil prices as global demand outstrips domestic demand. Naturally, this will lead to an ultimate convergence of the West Texas Intermediate benchmark and international Brent crude. This will present a single price regime that will be easier for U.S. E&P players to control for their benefit. Second, opening up exports will lead to energy interdependence, allowing U.S. to leverage its position as both a supplier and a consumer to shift the price of crude -- which will have by then converged -- in the direction that makes the best business sense.
Clearly, the export ban is the only barrier that's preventing U.S. E&P players from transforming the increased output and reserves into profit.
Is there a way around this one?
Yes. First, there are some gray areas that will allow proponents of ending the ban to widen the cracks in their opponents' walls. The law bans exports of condensates (byproducts) that are sourced directly out of the ground in liquid form. It does not necessarily ban condensates that are stripped from natural gas at processing plants. RBN Energy consulting analyst Sandy Fielden previously told the WSJ that there is now more condensate than chemical plants and refineries can process. Furthermore, condensates trade at a heavy discount to the WTI, so its exportation is highly unlikely to have any impact on local prices. If this argument is explored further, the case for exporting crude will only get stronger.
Second, supporters of exporting may have finally gotten environmentalists, who happen to have a strong lobbying position in Washington, on their side. Opening up the U.S. to exports will put some refiners out of business. As I discussed in a previous article, the lost business in refining will be taken over by alternative energy such as solar. Solar energy is becoming cheaper.
The cost of installed solar equipment has dropped more than 50% since the beginning of 2010, according to industry reports. In addition, there is a wider call for a broader, greener energy mix in the U.S. Before, opponents of opening up exports said that increasing fracking to match global demand would put continued strain on U.S. water resources -- which is true. However, a solution from General Electric (GE -0.24%) is in the offing, and with it, the move that firmly puts environmentalists behind the proponents of lifting the export ban. The conglomerate is working on a capture-use-recapture system for fracking that uses C02 instead of water. Furthermore, the system recycles the C02, effectively reducing carbon emissions into the environment.
The case supporting the lifting of the U.S. export ban is growing stronger. Better still, Harold Hamm, the chairman and CEO of Continental Resources, is at the forefront in an effort to push congress to lift the ban. Harold Hamm has been drilling for close to 40 years and has a wide sphere of influence. I don't know about you, but I wouldn't bet against him.
The export ban will come down, perhaps not this year as it is an election year, but probably soon thereafter. When it does, expect growth bonanzas for E&P players such as Continental Resources. There is still time to get on board and make incredible capital gains.