Summerland Oil fields circa 1915 (Photo Source: National Oceanic and Atmospheric Administration via commons.wikimedia.org)
If you do a basic search for the term "US oil production," chances are that you will come across a slew of articles singing the praises of the oil and gas industry. Adjectives like "flooding" and "overwhelming" are used to describe the amount of production coming online, and Americans are having a serious conversation about the possibility of overturning decades-old laws that restrict the export of oil. Here's the funny thing, though: This isn't the first time that America has experienced a near euphoric mindset surrounding a surge in a high value commodity.
Everyone knows the investing mantra that past performance does not guarantee future results, but knowing the history behind these previous booms can teach us some very valuable lessons about how to approach this one. So let's take a stroll down memory lane and see what we can learn from three previous booms: The California Gold Rush of 1849, the Spindletop discovery of 1901, and the Texas Oil Boom of the 1980's
Eureka, I found it! (but went broke in the process)
In 1848, gold was discovered along the banks of the American river in what is known today as Coloma, California. While the first discoverers tried to keep it a secret, it all broke loose when one man who had stumbled upon the discovery ran around the streets of San Francisco with a glass jar full of gold screaming, "Gold! Gold on the American River!".
Just about everyone has heard this storybook version of the California Gold Rush, and many of the statistics show the impact of this transformative event. Between the 1840 and 1850 census, California's non-Indian population went from a paltry 8,000 residents to over 120,000, and the total gold extracted during the boom years was worth more than $14 billion (Note: all prices and costs in this article are adjusted for inflation and expressed in 2014 dollars unless otherwise noted). The rapid expansion in population, largely due to the gold rush, helped push through California statehood in 1850, just two years after the US had acquired the territory from Mexico.
The thing that seems to be overlooked when we tell this story, though, is the thousands of people that went broke in the process. It's not that many of these people couldn't find gold. For the most part you could pretty much kick the ground and stub your toe on a gold nugget back then. The actual reason that so many people walked away from the rush penniless is that they couldn't find enough gold to stay ahead of their costs. Because of the high demand--and as a result exorbitant costs--of mining equipment and sometimes just basic goods, the average prospector needed to find at least 1 ounce of gold--$1,200 based on today's benchmarks--just to break even.
The lesson here is that even the most lucrative ventures--whether gold, oil, or even precious minerals--can be a poor investment if the costs are simply too high. This is a message that certainly isn't lost on today's energy boom, either. Some may recall that just a couple years ago, Chesapeake Energy was in a situation where despite the promise it held with vast acreage positions in several prospective shale formations, the costs of holding those leases as well as the debt load to cover their purchase became extremely cumbersome and impeded its ability to spend on the actual development of those fields. This forced Chesapeake to sell off huge swaths of land to lower lease expenses and trim its debt profile, leaving it with a much smaller portfolio, but a much more profitable one today.
Also, remember that man who went around San Francisco crying "Gold" in the streets? His name was Sam Brannan, and he also was the first millionaire in the state of California. He didn't reach that status because he had found loads of gold. Instead, he made his fortune because before that trip into San Francisco he bought the only supply store between it and the gold fields, stocked it with every piece of mining equipment he could get his hands on, and sold it to star-struck miners for an incredibly hefty profit. Keep that in mind when looking for energy investments, sometimes the most profitable ventures aren't the ones doing the dirty work.
Today's gusher could end up being tomorrow's bottomless money pit
One of the most iconic pictures of the oil industry is from the Spindletop dome formation in Beaumont, Texas back in 1901. The "Lucas gusher" well that discovered this field shot more than 100 feet into the sky and took 9 days to get under control.
Image Source: American Petroleum Institute via commons.wikimedia.org
In 1902 alone, this formation produced more than 17 million barrels of oil, which was 20 times the production in all of Texas just two year prior. This prolific discovery also sparked the first wave of oil exploration in Texas that, like the California Gold Rush, bought thousands of people far and wide looking to make their own fortunes.
The picture that fewer people have seen, though, is what that same area looked like just a few months later.
Image source: Independent Petroleum Association of America
The number of wells that tapped Spindletop dome within a year or so was absolutely staggering, and one company that invested heavily in that development was Gulf Oil Company, which eventually become a part of Chevron. Gulf Oil spent loads of money developing this field, about $6 million in 1901 dollars (close to $155 million today) in only a couple of years. The original promise of the Spindletop dome didn't quite pan out, though. By 1904 all of the wells in the region produced less than 10,000 barrels per day, 90% less than its peak production. The significant decline at Spindletop led to near financial ruin for Gulf Oil, and for several years it teetered on the brink of bankruptcy for close to three years before it was able to turn things around through some other investments.
The biggest mistake that Gulf Oil made was that it tied itself way too much to the success of this one region. Granted, knowledge of oil reservoirs was not as vast as it is today, so perhaps the company and its managers were not fully aware of the physical limits of this reservoir. For investors today, though, the Gulf Oil experience should be a message that heavily investing in a company with production in just one region carries with it a much higher risk than those with a more diversified production portfolio.
Market conditions can change faster than you think
If you're reading this, you weren't around for the California Gold Rush or the Spindletop discovery. One that may be slightly more familiar to you, though, is the the Texas Oil Boom of the late 1970s and early 80s. After reeling from energy crisis after energy crisis in the 1970s due to embargoes from the newly formed Organization of Petroleum Exporting Countries--also known as OPEC--the US said "turn on the taps" and lifted many restrictions on the oil industry. Texas by far and away heeded this call. In the 1970's total oil production from the state peaked above 3 million barrels per day, allowing producers in the state to capture record high oil prices. Between 1978 and 1981, oil prices climbed from $53 per barrel to just under $100.
Unfortunately for those producers, two things started to work against them: 1) OPEC nations turned their spigots on again to supply the world with oil; and 2) demand was waning from increased efficiency and the economic slowdown resulting from high oil prices. These two factors caused oil prices to decline for five straight years, almost completely collapse to $30 per barrel, and then never again rise over $40 per barrel until 2003.
Source: US Energy Information Administration
This long-tenured weak price environment caused a lot of pain for both producers and lenders in Texas. Many banks made loans to producers in the early 80's under the assumption of $70 oil, so when prices slumped, lenders and investors lost their shirts. For investors today, the lesson of the 80's is quite clear: Making investments in oil production without preparing for or, at least considering, a worst case scenario will likely lead to trouble down the road.
What a Fool believes
Of all the historical boom and bust cycles in America's history, the 1980's one seems to parallel today's situation the closest. Abroad we have several geopolitical events in major producing nations--Iraq, Libya, Nigeria, Sudan/South Sudan--restricting several million barrels per day of production, we have OPEC nations scaling back output they could turn back on at the drop of a hat, and American oil companies are riding a wave of euphoria while taking on quite a bit of debt to make it happen. I'm not saying that history is destined to repeat itself, but it's not completely crazy to think that oil prices could fall further than they have in the past couple years. Investors who heed the historical lessons from these previous booms--and the busts that happened within them--could potentially avoid these issues, and their portfolios will thank them down the road for doing so.
