One of the knocks against tight oil is that it's so expensive to drill a well. This has meant that oil companies needed high oil prices to make a decent return on drilling new wells. It's also meant that if the price of oil fell, then some of the higher-cost plays, like in the Mid-Continent region, where SandRidge Energy (NYSE:SD) is focused on drilling, would become uneconomical.
However, what oil companies are finding is that the price of oil isn't the only thing falling these days; well costs are also dropping, too. That's enabling companies like SandRidge to see a future where it can earn the same returns at $50 oil that it had been enjoying when crude was $80 a barrel.
Three pronged attack
Over the past two years, SandRidge Energy has innovated $600,000 out of its well costs by using new techniques to more efficiently extract oil out of tight rocks. That's a 17% drop from what the company was spending in 2012, which has helped boost the company's returns as long as oil stayed in the $80 range.
Now that the price of oil is in the $50 range, it needs to cut another $600,000 out of its well costs, or about 20%, to get its returns back to where it needs them to be. However, the company believes it can get there by the second half of this year by attacking three specific areas within its well costs, which are noted on the following slide.
On the company's fourth-quarter conference call, CEO James Bennett went through that slide and addressed each area the company plans to attack:
First, operational improvements. This represents 45% of the total identified savings. These are durable process improvements, such as using the most efficient rigs in our fleet to reduce cycle time, changes to completion methods and wellbore design, location high-grading, increased use of skid pads and co-mingled tank batteries. These efficiencies will continue to enhance return, no matter what future price environment we operate in. The second, improve pricing, will account for about 40% of the total. This is coming from several areas, including lower stimulation and artificial lift costs, and reductions in drilling rig and directional day rates. Third, multilaterals and long laterals will comprise the balance of the 15% of the savings. We're going from 20% multilaterals in the back-half 2014, to 40% in 2015.
Bennett points out three specific areas the company is attacking in order to boost its returns. However, he notes that the company is not just banking on temporary service cost relief that it expects to see as a result of the current downturn, but that its simultaneously pursuing permanent cost reductions that will stay with the company once activity levels, and services costs, normalize.
Its hope is to permanently reduce some costs through efficiency gains in how it develops its acreage, as well as expanding its use of multilaterals, which includes drilling a number of horizontal laterals from one vertical well. If successful, this approach will lead to better returns in the current price environment, while really boosting returns should prices rebound.
In fact, the company estimates that if it can get its well cost down to $2.4 million per lateral, then its average well should be able to generate a 30% internal rate of return at a flat $50 oil price and $3.50 gas price, as we see on the following slide.
However, what's compelling about this is that return could actually end up being even higher given the current outlook for oil prices in the market, which are signaling a $60 oil price by the end of the year. What that suggests is that based on this strip price, if SandRidge Energy could drill a well for $2.4 million, then its internal rate of return would actually be 45%. That just happens to be the return the company was enjoying at a $3 million well cost, and an $80 oil price not that long ago.
SandRidge Energy is attacking three key components of its well costs in order to shave its costs by 20%. If the company can get that job done, then it could boost its currently meager returns back up to the returns it had been enjoying when oil was $80 a barrel.
It's certainly an ambitious goal, but one the company really needs to pull off, as it can't really grow very much until it can earn more money in the current environment.
Matt DiLallo owns shares of SandRidge Energy. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.