Sunset to Sunrise

My father loved the oil business. He grew up in West Texas during the World War II oil boom and worked his way through college “roughnecking” in the oilfields. Because the derrick crew did the dangerous work out in the weather on the rig floor, my grandfather told Dad to go to college so he could be a “company man” as they did all the “think work” in the trailer. When Dad graduated, he got his dream job as a geologist with Gulf Oil and took part in one of the greatest industrial developments in history. The World War II boom and the domestic oilfield development of the ‘50s and early ‘60s led to a surplus of deliverable supply, which provided the U.S. with low cost oil into the 1970s.

From my childhood, Dad taught me about geology, the oil industry and that oil was a depleting resource. Like most in the industry, he recognized that the abundance of cheap oil was finite and depletion of domestic reserves meant domestic oil was a sunset industry (i.e., an industry believed to be in terminal decline). This low-cost, secure domestic resource contributed to the creation of the modern American middle class during the greatest period of growth in U.S. history. Because domestic production was in rapid decline, we believed an alternative to domestic oil and natural gas would be necessary in my lifetime.

The resource is finite. But the supply is much greater than we believed just five years ago. The creation of recovery methods for developing “unconventional” oil and natural gas resources is a game changer. The U.S. can replace much of its imported oil with domestic oil and generate needed electricity with domestic natural gas rather than with coal. The development of domestic reserves can be a major part of the engine of economic recovery.

The Great Economic Drag

Until recent years, U.S. oil consumption increased in lockstep with the growth of the economy. Domestic production decreased each year and imports increased. It is probably not a coincidence that the deterioration of the U.S. economic condition correlated with the loss of energy independence, increased oil imports and increased deficit in our balance of payments. The cost of maintaining a military presence, fighting multiple wars in unfriendly parts of the world and using our Navy to protect critical shipping lanes has compounded the economic drag.

The U.S. has run a balance of payments deficit for the last 40 years. In essence, we buy more goods and services from foreign countries than we sell to them. This can be beneficial when we purchase goods for less than we can produce them domestically. In relation to oil, such has been the case.

Energy is incredibly important to economic output. Imagine your life without it. What would your day be like without oil and electricity? Tomorrow, turn off your electric meter and avoid cars, buses, planes and trains, and see where you focus your time! No economically competitive substitute for oil as our primary transportation fuel currently exists, even at $100 per barrel. The failures in “alternatives and renewables” illustrate the difficulty of doing without oil. Ethanol as a substitute is a politically driven scam. The failure of other government financed alternative energy companies in the past year illustrates the difficulty of the problem.

But the economic cost of imported oil is high. In 2010, the United States spent about $265 billion on net oil imports. Moreover, a tremendous amount of the U.S. military budget is allocated to security of oil producing nations. Economic forecasters estimate that every $10 per barrel increase in the price of oil reduces U.S. economic growth by 0.2% due to the impact of oil imports. The money that we send abroad provides little stimulus to our economy. It has no “velocity”.

Velocity of Money

Economists talk about money spent or invested as having “velocity”. High velocity is good for economic growth. Low velocity is less so. The problem today with much of the government stimulus is that it has no velocity. If the government provides capital to a bank and the bank buys U.S. Treasury securities, the funds do not do much good. The government is providing the money to the bank for less than the bank is lending it back to the government by buying U.S. Treasury securities. Other than the earnings accrued to the bank in this cycle, there is no economic stimulus. This money has no economic velocity; it is merely cycling in a non-productive treadmill. The government is effectively giving money to the banks.

If the bank takes the same money and lends it to a company to build a factory, there is a lot of velocity. The company hires contractors who provide wages and consume products from subcontractors, and so forth. When finished, the factory provides jobs and produces a product (hopefully at a profit). Employees from these companies spend their wages on goods and services, stimulating other businesses to hire more employees, and the cycle continues. Those dollars loaned had a lot of velocity and contributed to a lot of economic activity.

Money spent on imported oil has limited velocity for the U.S. It is much like the first example. But we now have the opportunity to replace low velocity money spent on foreign oil with domestic production. Developing domestic resources is highly stimulative to the U.S. economy. Money invested in developing domestic production is high velocity money, creating high paying jobs and consuming goods and services that stimulate other businesses.

The 21st Century Domestic Energy Boom

The current boom in domestic energy production was inconceivable ten years ago. Since the ‘60s, each year more oil and natural gas was imported to meet our country’s energy needs. In the ‘80s Mitchell Energy began to attempt to produce natural gas from the Barnett Shale. Up to that time it was widely believed shale formations were too “tight” to recover the natural gas trapped in the rock. It took years of experimentation and millions of dollars before Mitchell Energy began to have commercial success. As natural gas prices rose in the early 2000s other companies were drawn to the Barnett play and new techniques and technologies quickly evolved. The most significant of these were the widespread use of horizontal drilling and improved hydraulic fracing methods. Today almost all new unconventional (and many conventional) wells include horizontally drilled lateral “legs”, and all require hydraulic fracing to increase the permeability of the reservoir rock.

The technology and techniques developed in the Barnett Shale were applied in other natural gas shale plays across the country. The Fayetteville in Arkansas, the Haynesville in Western Louisiana and Eastern Texas, and the Marcellus in Pennsylvania all became significant natural gas plays. The speed at which the reserves in these plays were being developed was astonishing. The number of rigs drilling for natural gas went from approximately 500 in the mid ‘90s to over 1600 by ‘08. The pace of drilling combined with the high initial production from these shale plays flooded the market with natural gas.

Sunset to Sunrise

Similar exploration and production began taking place in oil plays. Engineers and geologists began to revisit formations previously thought to be uneconomic. As natural gas prices fell in 2009 natural gas focused operators began directing more of their capital budgets to more lucrative oil plays. These companies, armed with the knowledge they acquired drilling for shale gas, soon began to develop new oil fields throughout the country. The Bakken formation in North Dakota and Montana, the Permian Basin in Texas and New Mexico, and the Eagle Ford Shale play in south Texas have led the way in this revitalization of domestic oil production.

The results have been astonishing! The Bakken shale has elevated North Dakota to the 2nd largest oil producing state in the U.S. Today North Dakota produces over 600,000 barrels of oil per day. The development of the Eagle Ford shale and the reemergence of the Permian Basin have pushed oil production in Texas to over 1.7 million barrels a day, the highest level in twenty years. Today our country produces more oil than it has in over ten years, and the rate is still increasing.

Booms Lead to Busts

My grandfather was a drilling contractor in the World War II boom and during the following two decades. He started as a roughneck and worked his way up to foreman, saving enough money to start his own company and make a down payment on a drilling rig, which was the primary asset of his company over the next 20 years. He never went to college, but over my 30 years in the industry, his counsel has proven to be some of the most salient I ever received. As the boom of the ‘70s peaked, he warned me that every boom sows the seed of its own end.

The record production in natural gas outpaced record demand and resulted in the current price collapse. Fear of such a collapse was a primary factor in our decision to sell our natural gas assets in 2007. Current prices are below replacement cost, making natural gas attractive on a fundamental basis. We believe there will be wonderful new investment opportunities in natural gas in this lower price environment over the next three to five years.

The boom in unconventional oil, combined with the worldwide recession, may result in a decline in oil prices. Many argue that without the political instability in the Middle East prices of oil would be much lower today. Although we do not believe that a downturn would last as long as in natural gas, management of price volatility is critical in these investments. That is why we continue to maintain an active hedging strategy, locking in future prices to reduce the volatility of our expected results.

Conclusion

I sometimes think of investing in oil and gas as riding a roller coaster blindfolded. You can have a great time as long as you don’t get thrown out of the car! Hedging smooths the peaks and valleys, in this case making the ride much more enjoyable.

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