Here's a way to make millions of dollars from the oil boom with little money down (and a lesson in the economics of oil exploration). Step 1: Start an independent exploration company. Raise $10 million with a listing on the Toronto Stock Exchange or London's Alternative Investment Market (AIM).
Step 2: Negotiate an exploration license with a national government to drill wells off the Gulf of Mexico, in Papua New Guinea, or in another far-off locale. Governments are keen to cash in on the high price of oil and lack the expertise to develop their reserves themselves, so they are fond of royalty agreements or production-sharing agreements, which require them to put no capital down, and encourage investment in exploration, in exchange for a share of revenues once production is underway.
Step 3: Drill four wells at a cost of $2.5 million each (the average cost of drilling a well in 2006).
Step 4: Suppose a 50% success rate for prospective well-drilling, which means you've got two successful wells on your hands. In 2006, the average successful well drilled by "independents" contained 160 mboe (million barrels of oil equivalent), so you've now got 320 mboe in reserves. These reserves are under the ground, without any equipment to extract them or pipelines to distribute them.
Step 5: Sell your wells to a "major" (e.g., Exxon Mobil (XOM), BP (BP), ChevronTexaco (CVX), Royal Dutch Shell). The typical selling price, depending on location and degree of certainty in reserves, is roughly $10 per boe of proven reserves. At 320 mboe, your two successful wells are worth $320 million.
You've turned $10 million into $320 million in as little as a year!
The example above, though stylized, typifies the economics, and unique dynamics of oil exploration and production. The major oil firms require large, established operating oil fields in order to meet the tremendous demand for production. High oil prices and a seeming decline in the number of "major" oil discoveries has created a market for much smaller "independents," who independently scour the planet for oil, but typically are not involved in refining and distributing the finished product. Some, such as Anadarko Petroleum (APC) or XTO Energy (XTO), have a history of success in the U.S. and are therefore subject to more predictable cash flows. Others base their entire asset value on investing in, for example, Papua New Guinea, such as Interoil (IOC) has done.
Oil exploration represents the very first piece of the long petroleum value chain that ultimately brings gasoline to the gas station at which you fill your Ford Explorer. Exploration and production are often referred to as the "upstream" pieces of the value chain, as compared to refining, distribution, and marketing, which are typically considered downstream activities. The process of oil exploration looks a lot like the stylized example above. A company identifies a potentially attractive area to drill, either onshore (i.e., on land) or offshore (i.e., in the ocean). This area could be attractive because its near another major discovery, or because it used to be an operating well that has now dried up, or because government has released some data that suggest the presence of hydrocarbons (i.e., gas and oil).
Next, the company and/or the government conducts initial surveys, such as seismic mapping (see photo) to better understand the presence and availability of hydrocarbons under the surface. (A seismic map is created by exploding dynamite or by stamping the ground with a large pillar and measuring the way in which th resulting seismic waves travel through the underground formations) At this point, the company considers a number of factors in its decision about whether to drill a well: How deep are the hydrocarbons? What rock formations are beneath the rock and above it? Is there porous rock which might serve as a "sponge", soaking up an oil? How big might a potential hydrocarbon discovery be?
As would be expected, oil exploration companies prospect for oil in the lowest risk / highest return environments first. These are typically onshore sites in politically stable countries. Riskier exploration prospects are offered in off-shore facilities -- exploring off-shore is also more expensive, requiring a larger discovery in order to break-even. The riskiest of all exploration plays involves "non-conventional" sources of oil, such as oil shale or the oil sands.
Price of oil - The backdrop to all conversations about oil exploration is both the price, and the current worldwide proven reserves, of oil. Taken together, these determine whether a specific exploration project will be economically attractive. In particular, the higher the price of oil, the more expensive it can be to draw oil out of the ground and still make a profit. This makes smaller fields, more remote fields, and oil that require more processing all the more viable.
Technology - As one might imagine, the availability of computers and advances in seismic technology have drastically improved the process of oil exploration, which was once little more than drilling a well and crossing your fingers. Advances have pushed the envelope of what is feasible, both in terms of finding where oil is and figuring out how to extract it once a company has identified where it is. General Electric Company (GE), for example, offers "Intelligent Drilling" technology, while a variety of engineering and seismic services firms offer the latest in technology to find oil (e.g., 3D seismic mapping).
Availability of oil field services - The availability of equipment and qualified professionals to service it represents a genuine bottleneck in oil exploration. The price of "oilfield services," which includes all the ancillary requirements for drilling and operating a well, rose 20% in 2006. Lack of availability of drill rigs (for drilling oil), skilled petroleum services professionals, seismic trucks, etc., can be a constraint in oil exploration. Note especially the increase in drill rig rental rates experienced around the world (chart on left).
In its Q4/2007 Earnings Call, Andrew Gould of Schlumberger pointed out that, worldwide, 93% of jackups, 97% of semi-submersibles, and 100% of drillships are currently being utilized, with very few new offshore rigs coming online in 2008. This makes significant offshore growth in 2008 relatively unlikely, as capital is already being used almost to capacity. This lack of capital to meet demand will probably drive up oilfield services rates significantly.
Weather - Difficult weather, especially hurricanes and tropical storms, can create a challenging environment offer a double whammy for oil & gas companies. Not only do they disrupt current supply chains (making tanker deliveries difficult, for example, or disrupting refining processes), but also they may disrupt or disable offshore drill rigs. This disruption ultimately feeds through to the oil field services pricing, as discussed above. And, of course, leads to further difficult conversations about the impact of climate change on extreme weather patterns....
OPEC and Political Instability - The majority of current oil reserves are controlled by a handful of politically unstable countries, especially those in the international energy oligopoly, OPEC. OPEC's control over the market allows it to control how much oil enters the market, and the fact that the majority of OPEC countries constantly contend with terrorism adds an added element of unpredictability to the international oil price mechanism. Oil companies have a major incentive to explore in order to diversify their reserve holdings and hedge against unforeseen issues in any one unstable part of the world. Furthermore, there is a growing focus by governments around the world on achieving energy independence by helping non-OPEC corporations find new reserves through investment in new technology. This manifests itself in a number of ways, from tax cuts and subsidies to the loosening of environmental regulations.
High oil prices have opened the window to a sea of new exploration opportunities, leading independents and majors to try to develop non-conventional oil from a variety of sources. Two of the most exciting, and most heavily watched, are oil sands and oil shale.
The oil sands in Canada are particularly interesting for a number of reasons, most notably because they are estimated to hold between 1.7 and 2.5 trillion barrels of non-conventional oil (by contrast, Saudi Arabia, the world's largest oil producer, has about 260 billion barrels of proven oil reserves). The question, of course, is how to get all that oil out. Oil sands mix bitumen, a carbon-rich sludge, with sand, water, and clay. In order to get crude oil from the sands, the bitumen must be extracted, typically by literally digging up the sands and transporting them by truck to plants, where the bitumen can be processed and "upgraded" (by adding hydrogen) to produce what is known as "syncrude." Additional bitumen can often be recovered in situ, where steam is injected into the sands to pump liquid bitumen out of the ground. This is an energy intensive and expensive process, but it is widely recognized to be cost-effective at $30 per barrel.
Oil shale has similar dynamics. There are an estimated 2.6 trillion barrels of recoverable oil in oil shale around the world, of which over 1 trillion are in the U.S. Essentially, oil shale is sedimentary rock which contains enough organic material to yield oil and gas upon distillation. Numerous methods have been tried to produce oil from oil shale cost-effectively, but the basic technology involves strip-mining the oil shale rock, crushing it, heating it, whereupon the gas, oil vapor, and char separate (a process called "retorting"), and then condensing the oil. Few efforts to process oil shale have been economic at a commercial level, though Estonia, Brazil, China, and Russia currently use oil shale in one form or another (one common, and easier, way to use oil shale is as a power source for power stations).
The economics of oil shale remain shrouded in mystery. Estimates range from an effective oil price of $75-$90 per barrel, from RAND, to Shell's estimates that it can make oil shale profitable in Colorado at $30 per barrel. The truth is likely that oil shale, on a small scale, will be expensive, and like oil sands, very energy intensive. If it can achieve commercial scale, it will likely be cost competitive with other forms of exploration, especially if large discoveries can be made.
According to estimates from Exxon Mobil (XOM) and the recently released report of the National Petroleum Council however, oil will continue to make up the overwhelming majority of world liquid fuel supply and the majority of that oil will come from conventional extraction methods. The charts below show estimated world liquid fuel supply and demand through 2030 and estimated sources of oil supply through 2030.
Suncor Energy (SU) is the leading producer of oil from oil sands in Canada, currently producing about 260,000 barrels per day. To the extent oil production and/or oil sands exploration takes off (though it is already taking off), SunCor should benefit.
Given the oilfield services boom heralded by the above trends, all the major oilfield services firms have, and should continue to, benefit. These include the giant Schlumberger N.V. (SLB) and Iraq specialists Halliburton Company (HAL), as well as seismic experts Baker Hughes (BHI).
Grant Prideco (GRP) is well-positioned to benefit from the oilfield services boom, as a leading provider of advanced and intelligent drilling technologies.
National-Oilwell (NOV) manufactures drill components for companies drilling oil wells. The company has 90% market share for drill components and would benefit from any increase in oil explorationg and drilling.
Transocean (RIG), like Grant Prideco, is a niche player with specialized expertise, in this case in the area of deep water offshore drilling. Transocean owns and operates a series of rigs, and therefore benefits from the increase in rig rental rates and utilization broadly seen across the oil exploration industry, as well as specifically the trend towards riskier offshore exploration opportunities. Other offshore drilling companies include Hercules Offshore (HERO), ENSCO International (ESV) , Noble (NE) , Pride International (PDE) , and Diamond Offshore Drilling (DO) .
Among onshore, existing companies, XTO Energy (XTO) and Chesapeake Energy (CHK) are two established independent oil exploration and production companies with a series of stakes in potentially interesting, though speculative, onshore, U.S. exploration prospects.
The majors face a series of challenges given the exploration dynamic described above. Companies such as Royal Dutch Shell are particularly susceptible to increasing exploration costs, as a result of the recent downward revisions in their reserves.
Due to weak demand, natural gas prices fell by more than 60% between September 2008 and September 2009. In order to reduce supply and boost prices, producers have reduced the number of vertical drilling rigs by 60% and the number of horizontal rigs by 23% in 2009. However, advances in new drilling technology that makes it easier to extract gas from dense rock formations have led to large supplies of shale natural gas. As a result, it has been more difficult for producers to curtail supplies and control natural gas prices. In October 2009, Baker Hughes reported that the rig count has begun to stabilize as producers lock in prices on future production in anticipation of colder weather and an economic recovery that would spark demand for the fuel.
Light, sweet crude, which typically is less expensive to extract, is becoming scarcer by the month. As a result, oil majors are spending more money to develop their deepwater operations and oil sands operations. However, extracting oil from these kinds of fields is expensive. Because extracting usable oil from oil-soaked sand requires a lot of money and energy, oil is capable of reaching $100/barrel before Canadian oil sands becomes a profitable operation. On the other hand, advances in drilling technology and the potential size of reserves underwater have made deepwater drilling more financially viable, and many oil companies have expanded their deepwater oil operations in the 2009. In September 2009, companies including BP, Petroleo Brasileiro and Eni have found nearly 10 billion barrels of oil equivalent of potential reserves. Many western oil majors are spending billions of dollars on exploration operations in the Gulf of Mexico, offshore Brazil, and offshore West Africa.
Although the global economy seems to be recovering and the growing need for oil in China and India both have the potential of leading to rising oil prices, deepwater drilling faces several political obstacles. Russia, Venezuela and Ecuador changed their oil policies in favor of the state and altered pre-existing contracts with international oil companies. Brazil’s president has proposed moving away from competitive bidding for oil-exploration concessions to a strategy in which companies sign production-sharing deals that give most of the barrels to Brazil.  Political risks have the potential of deterring many oil majors from exploring for potential offshore deposits. However, oilfield service companies have the potential of benefiting from increased offshore drilling because both oil majors and nationally owned companies require advanced drilling equipment..
Since the summer of 2008, the number of oil and gas rigs located in the U.S. has fallen 50% in response to American natural gas prices and Global oil prices, which have fallen to two-thirds of their summer 2008 levels. For many oil and gas producers, drilling has become unprofitable. During March 2009, oil prices fell below their levels in 2005 while production costs were close to double what they were in 2005. As a result, low oil and gas prices have the potential to force oil and gas companies to cut production in order to reduce costs. Domestic oil production in the Gulf o f Mexico is expected to increase, but many oil and gas companies have cut back on oil and gas production as well as capital investments in 2009.
However, significant production cuts are capable of causing a supply glut if energy consumption levels were to return to their first-half-of-2008 levels. If oil and gas producers cannot respond quick enough to rising energy demand, prices have the potential to increase substantially.
According to a report by Barclays Capital, 32% of surveyed oil production companies plan to increase spending by at least 20% in 2010. According to the report, annual spending globally has the potential of dropping 15% this year compared to 2008. In December 2008, Barclays predicted spending had the potential of dropping 12% in 2009. According to Barclays, spending drops are most severe in Russia, the U.S., and Canada. In the U.S. and Canada, spending has the potential of dropping 38% and 36%, respectively. Spending in 2009 and 2010 depends heavily on the price and demand for oil in the second half of 2009.
In the second quarter of 2009, drilling increased internationally in response to rising crude prices. Oil prices during the second quarter rose to more than $60 per barrel. In response, international drilling operations increased for Halliburton Company (HAL), Weatherford International (WFT), and Schlumberger N.V. (SLB). In particular, Halliburton Company (HAL) reported revenue increases of 27% in Russia and double-digit growth in Mexico, Norway, and China.
While oil prices increased to around $55 per barrel in the last week of May 2009, the cost of drilling has declined in the first five months of 2009 as production companies have reduced the number of operational rigs. The declining prices of steel used to make drilling pipes and diesel fuel used to power rigs have contributed to the reduction in costs. However, smaller demand for drilling equipment has been the biggest contributor to the decline in operating costs. Due lower oil and gas prices beginning in the second half of 2008, oil producers have reduced their drilling and the number of operational rigs. In the U.S., more than half of the number of rigs were operational in first quarter of 2009. Oilfield services rates also declined in the first quarter of 2009. The average rate oilfield service companies charge for drilling rigs has dropped by about 30% since the fall of 2008. Declining service rates and less production have the potential to increase profit margins for exploration and production companies for the first five months of 2009.