The Innovation That Will Drive the Next Oil Supercycle

Oct 7, 2017 by

You’ve heard of “fracking”… the cutting-edge technology critical to exploiting the American energy renaissance. But you haven’t heard of the new tech that will drive the next commodity supercycle.

By Flavious Smith –
40-year Texas oil veteran and author of Oil $500: Why the Next Oil Supercycle Is Closer Than You Think

What were a couple of Oklahoma oilmen doing in the heart of coal country, we wondered…

I met Marty – one of my good friends from Oklahoma City – at Pittsburgh’s PNC Park in the summer of 2006 to catch a Pirates ball game. They were playing the San Francisco Giants.

A year earlier, I had moved to Pittsburgh to be the division landman for energy firm EOG Resources (EOG). Marty moved to Charleston, West Virginia a few months after that to take over the land department for oil and gas giant Chesapeake Energy (CHK) after it acquired Columbia Natural Gas.

Over a couple hot dogs slathered in sauerkraut, we marveled at how a sleepy oil and gas basin – the Appalachian Basin – had exploded with activity. Pittsburgh was booming.

During the conversation, Marty told me about the time that he had first talked with Chesapeake Energy CEO Aubrey McClendon about the Marcellus Shale. Marty laid out a map during a strategy meeting in early 2005 and said, “Aubrey, this is the Marcellus Shale. And it’s the next big resource play.”

Aubrey looked at the map and asked, “What counties are those, Marty?”

“Aubrey, those aren’t counties,” Marty replied. “Those are states. That’s New York. That’s Pennsylvania. That’s Ohio. And that’s West Virginia.”

This is huge!” Aubrey said, as the size of the resource he was looking at suddenly blew up 100-fold before his eyes. “We need to be in this.” Marty said, “Aubrey, it just takes money.” And Aubrey quickly answered, “We’ll find the money.”

Chesapeake Energy always seemed to be able to find the money…

In the early years, that helped the company become the largest natural gas producer in the country. Later, it got Aubrey and Chesapeake Energy in a lot of trouble.

But make no mistake, Aubrey knew a huge opportunity when he saw it… The Marcellus Shale – the resource my friend, Marty, showed him more than 12 years ago – made Pittsburgh a boom town in the mid-2000s.

Today, we know the Marcellus Shale is a massive resource play.

The U.S. Energy Information Administration (EIA) estimates that 141 trillion cubic feet of recoverable natural gas is contained within its rocks… The formation stretches through parts of nine states, including large areas in New York, Pennsylvania, Ohio, and West Virginia. It even crosses below Lake Erie and into portions of southern Ontario in Canada.

But back then, the potential upside in the region was mostly a mystery…

Cutting-edge technology was critical to exploiting this huge energy resource in the Northeast… and technology will drive the next supercycle, too.

The Winning Ticket

More than a dozen years ago, I took a job with EOG because the company had excelled with directional drilling and hydraulic fracturing – “fracking” – in central Texas’ Barnett Shale.

I wanted to be part of a team that was using advancements like these to transform the oil and gas industry. In the first quarter of 2005, we began to analyze the Marcellus Shale…

We quickly realized its immense size and the magnitude of the opportunity in front of us. Our geologists and engineers determined that the Marcellus Shale rocks contained high levels of total organic carbon. This meant the rocks were full of natural gas.

They also discovered that the Marcellus Shale was overpressured and had natural fractures throughout much of the formation. This meant that the natural gas wanted to get out of the rocks and that there were natural doorways for it to move. Horizontal wells and fracking seemed to be the ideal way to unlock the gas in the Marcellus Shale.

Within six months, I was sitting in a boardroom with Mark Papa – EOG’s CEO and chairman at the time – and several other senior executives. I was ready to make a pitch for the company to come up with the money to buy acreage in my team’s target areas.

It was going to be a hard sell. EOG was spending billions in the Barnett Shale. It was a proven winner for the company, and it was sucking up all the available cash.

The meeting didn’t start well…

Mark kicked things off by noting that the Appalachian Basin had never been good to EOG. “Rocks 7, EOG 3,” he said… referring to the seven times EOG had failed with exploration in the region and the three times the company had succeeded.

With natural gas at $9.53 per million cubic feet at the time, though, Mark realized that the company should ramp up its efforts in the space. The Marcellus Shale – and its substantial acreage – could be the key to EOG unlocking millions of dollars
in profits.

I had noticed that Mark had a habit of leaning back or leaning in. Leaning back meant he liked the idea and was thinking how to move forward. Leaning in meant he wasn’t interested. I’m not sure if Mark knew this, but the indicator never failed me.

After our presentation, Mark leaned back in his chair. That was a good sign.

Mark made us an offer: He would support our efforts in the Marcellus Shale if we could drill our way in. That way, EOG could avoid the costs of buying the land and instead focus on using its horizontal-drilling and fracking expertise to test our ideas.

At the time, no one knew if the Marcellus Shale would produce or become a reliable, economic source of income. But at least Mark was giving us a shot.

“Deal,” I said. We’d figure out a way to make it happen.

Later that year, we got a big break…

Seneca Resources – a subsidiary of National Fuel Gas (NFG) – revealed that it was searching for a partner to explore and develop its land in the Marcellus Shale. The company owned the mineral rights to 1 million acres across Pennsylvania and New York.

After Seneca’s announcement, the race was on… Texas-based E&P companies Range Resources (RRC) and Cabot Oil & Gas (COG) put in bids. Then, Chesapeake Energy threw its name into the mix. I heard the company offered $30 million in cash.

That offer would be hard to beat… Seneca likely wouldn’t turn down $30 million in cash for a five-year lease. We weren’t spending that kind of money at EOG. Not in Appalachia, at least. Instead, we needed to rely on our technical expertise – or “use the drill bit” – to get in the game or we’d miss out on this opportunity.

A few days later, I watched in real time from a conference room in Pittsburgh as we fracked a well in the Barnett Shale – roughly 1,200 miles away. EOG had partnered with Pinnacle Technologies to gather data that would allow the company to improve its production and increase the overall recovery of natural gas from its shale wells.

Pinnacle developed a way to “hear” rocks breaking as a frac job progressed through the various stages. The sounds – picked up by geophones placed in a nearby “monitor” wellbore – helped determine the extent and effectiveness of the frac job.

As the frac job progressed, Pinnacle’s software converted the sounds to small points that were plotted on a wellbore and subsurface diagram. Those points were then projected onto the big screen in front of us. Each stage was color coded.

The example diagram to the right, which appeared in trade publication American Oil & Gas Reporter in May 2012, gives you an idea of what happened with Pinnacle’s technology…

You can see the location of the vertical monitor well on the left side of the image, as well as the path of the horizontal well drilled into the Marcellus Shale formation. The sounds (frac points) are plotted along the wellbore. The colors represent the different frac stages.

As I continued to watch, I realized this technology would be our ticket to winning the bid for Seneca’s land in the Marcellus Shale.

To my knowledge, no one else was using this advanced technology. I convinced Mark to let us share this top-secret, state-of-the-art information with Seneca.

We headed to Houston a week later for a meeting with the company’s top management. As the men in the room watched the different stages of a frac job unfold in front of them, I could see their eyes getting bigger. We were in… Negotiations started immediately.

Six months later, EOG and Seneca reached an exploration agreement that covered all 1 million acres in the Marcellus Shale. We would pay the cost to drill and complete the exploratory wells on Seneca’s land. Once the development-drilling phase began, the two companies would participate and share the costs evenly.

It’s exactly what Mark had in mind when he leaned back in his chair more than a year earlier and made that initial deal with me. By staying one step ahead of the competition, we were able to score a major victory in an emerging hotbed of shale exploration.

The point is, I’ve always believed that money follows technology and innovation… Companies that can develop, deploy, and monetize new technologies have an advantage.

This premise helped me achieve an important victory during my early years at EOG. And it’s an easy way for you to identify which companies will thrive across the oil and gas sector… look for the ones leading the way with technological breakthroughs in oil and gas…

Remember, commodity prices follow a cyclical pattern. What goes down will eventually come back up.

We’re going to get to a point when demand from countries that are evolving – like China and India – will completely overwhelm our ability to meet their needs with existing supply. This is the long-term trend that we’re interested in… It’s a supercycle.

It’s something I’m calling “Oil $500.” We’re approaching the next bottom, but when demand for oil ramps up, the need for services in the oil and gas E&P sector will kick into top gear. Here’s what drives it…

Setting the Stage

Every year, the management teams of E&P companies huddle and set their capital budgets.

As with all companies, these decisions can go a long way in shaping the path of the business. Operations, profitability, and overall investor perception are all at stake.

Through the budget process for E&P firms, many questions must be addressed…

How will oil and gas prices move throughout the coming year? How many wells will the companies drill – and at what cost? Who will drill and complete the wells for the companies?

E&P companies must also decide which acreage to focus on. They need to try to project which regions will be more profitable over the course of the coming year… and what technological developments over the previous year could unlock more productivity.

When companies decide their capital budgets, it sets the stage for what they can expect in the coming year… how much they can grow, how much they can earn, how many people they can hire, and even any potential mergers and acquisitions across the entire energy space.

To be clear, I’m not talking about a budget that puts a few crews back to work fracking wells in Midland, Texas… I’m talking about worldwide oil and gas producers that combined to spend more than $500 billion at the last peak in 2014 and will get close to that again by 2021. The above chart from consulting firm McKinsey & Company illustrates my point…

Historically, North America has been – and will continue to be – where the most money is invested worldwide. That makes sense, as the U.S. is the dominant player in the space. This chart gives us a good idea of what it’ll cost to feed global oil and gas development. But with so much to spend, where’s all the money going? Who will profit the most?

In the oil and gas sector, a group of companies exists that’s just as critical as the E&P firms… Yet the success of these businesses depends almost entirely on how much capital those E&P companies set aside each year.

This group is responsible for much of the modern technology that’s used in oil and gas production today. They provide the manpower and know-how to get new wells drilled, completed, and producing oil and gas… and keep them on line through their entire life cycle.

I’m talking about oilfield-services companies…

Call in the Experts

E&P companies don’t usually own and operate their equipment… The technology changes quickly and the highly specialized equipment is expensive to make.

A modern, new land rig generally costs between $20 million and $40 million today. In addition to this initial outlay, it costs a lot of money to maintain and operate these rigs once they’re built. The pressure-pumping equipment that’s used in fracking is expensive, too.

E&P companies don’t want the costs associated with having crews on call to maintain these operations 24 hours a day, 365 days a year.

Instead, if a drilling or well-completion operation hits a snag or specialized operations are needed, E&P firms want to call on an oilfield-services company that can quickly fix the problem… a business that controls a large emergency staff with the needed technical expertise and experience to get the job done.

Plus, since these companies design and manufacture much of the equipment to drill, complete, and equip the wells, it makes sense that they also operate and supply those services.

You can think of an oilfield-services company as the guy who comes to fix your office printer when it’s broken. You might spend hours trying to repair it yourself, but it’s a lot more efficient to call in the expert who makes a living doing it for hundreds of other customers.

Today, the oilfield-services business is separated into many different segments…

Some companies own and operate just the drilling rigs and supporting machinery. Others focus on maintaining the pressure-pumping equipment and cementing the well casings.

Other companies only operate ships to haul large platforms of drilling equipment around the world. And some firms focus exclusively on providing helicopters and housing for seasonal crews. These companies all fall under the umbrella of oilfield services.

Few companies have the breadth and depth to provide virtually all the services that qualify. So before you invest in this cycle, you have to understand…

The Barometer for Oilfield-Services Companies

To measure drilling activity and get an idea of what’s currently happening in the industry, we can look at the official rig count from oilfield-services firm Baker Hughes (BHGE), which just merged with conglomerate General Electric (GE) this week.

This count tells us how many drilling rigs are actively running at any given time.

Right now, 940 oil and gas rigs are operating in the U.S. That’s up from about 430 at this time last year. That means production is clearly ramping up across the sector today.

Looking at the trends in rig activity can tell us a lot about the overall health of the oil and gas sector in general. As you can see on the following charts, it’s highly correlated.

When oil and gas prices are high, more companies want to drill wells in order to make as much money as possible. On the flip side, low oil and gas prices lead to a reduction in drilling activity. The following two charts show you these relationships over the past three decades…

While the rig count tells us what’s happening with oil and gas production today, it also gives us a glimpse into the current activity in the oilfield-services space.

Remember, the oilfield-services companies provide the equipment and services needed to produce the oil and gas as new wells are drilled and completed. As the rig count grows, the need for these various services increases. More wells equal greater demand for services.

The inverse is also true… As the rig count declines, the need for services also diminishes.

When the price of oil fell to less than $30 per barrel in January 2016, E&P firms didn’t have much use for these oilfield-services companies. Rigs were “stacked” – meaning they were taken out of service. They’re put in a storage facility. Rig maintenance and upkeep cease… Therefore, the company saves the money that those tasks would typically cost.

That led to a flurry of bankruptcies from drilling contractors and related oilfield-services companies. In 2015 and 2016, 111 public oilfield-services companies went bankrupt.

We’re currently a little more than a year out since the U.S. rig count bottomed in May 2016. You can see in the following chart that a recovery phase is clearly underway. It’s on par with a similar cycle from 1997 to 2001, while other cycles rebounded at around the 200th day.

We can’t expect substantial returns when the U.S. rig count bottoms. If the rigs aren’t active, oilfield-services companies aren’t going to have as much work. At that point, companies simply hope to survive and win enough business to keep their fracking crews employed.

In the near term, I believe the near-record oil-storage numbers, increased drilling in the Permian Basin, and OPEC’s inability to maintain production cuts will drive an oversupply problem

That means oil prices will likely fall before they head higher. But if we wait until the cycle reaches that point, we’ll likely miss the opportunity created by this complex bottom. The oilfield-services industry has been oversold and underappreciated.

And if you’re willing to be a contrarian investor, you can get in ahead of the masses… And your potential upside will be tremendous in the coming supercycle.

Flavious Smith is the former Chief Oil and Gas Officer and Executive Vice President of Forestar Group (FOR), a publicly traded company where he grew the value of the oil and gas division from $30 million to $312 million in seven years.

He recently published a book called Oil $500: Why the Next Oil Supercycle Is Closer Than You Think. In it, he outlined all the reasons why oil is poised to go to $500… And tells readers how to invest your money to take advantage of the next supercycle. If you are in your 50s or older, this may be the last oil supercycle you’ll see in your lifetime. Click here to learn how you can get your copy of Oil $500 to read immediately.

Source: The Innovation That Will Drive the Next Oil Supercycle – American Consequences

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