MK: No. No new wells coming on produce as much as Ghawar produces per day. With North American shale, you have to pop out so many more wells and perform many multifracks to produce even a fraction of what a superwell in the Middle East does.
RR: Marin makes an important point that warrants emphasis. My father worked in Saudi Arabia in the 1970s, and they'd drill a 1,500-meter well that would produce 50,000 barrels per day with no water at Ghawar. This was truly a spectacular business, when a well that cost maybe $1 million (M) to drill would make something like $4,500/day. That's about as good as it gets. The industry talks about the recycle ratio, which is the amount of new oil that can be discovered and developed on the operating margin from a barrel produced. The wells that we're replacing those wells with – a very good well today might have a 2x recycle ratio, whereas those wells had maybe a 15x recycle ratio. So the industry has become much more capital-intensive than it was, and the recycle ratio is lower.
Furthermore, the social take from global energy production, which includes taxes, royalties and regulatory burdens, is much higher: The rate per barrel climbs each year. In many jurisdictions around the world, the game is over – they take 100%. And for years, governments in countries like Mexico and Venezuela have diverted a substantial amount of free cash flow from their domestic oil industries to subsidize spending programs.
In an industry as capital intensive as oil and gas, starving it of sustaining capital impairs its ability to exploit assets for much-needed oil. The catch-up spending necessary is truly spectacular.
TER: So in an increasingly politicized industry, is there any investment opportunity? Is this the time for North American companies to shine in comparison to cash flow-strapped producers in less friendly jurisdictions?
MK: It's always the time if you find the right companies. This is why I urge people to be very careful and patient and to do their homework. The sectorwide bull is not here right now. It's company specific. Rick and I have talked about Africa Oil Corp. (AOI:TSX.V) for the past four years. We were the first ones to talk about it publicly, finance it and recommend the company to investors. But while Africa Oil has done fantastically well, the other juniors in the East African rift are at the same price they were a year and a half ago, at the peak of the junior energy market. This is why it's important to understand that we are currently in a "Pick Right, Sit Tight" energy market.
TER: But oil has really been bouncing along pricewise in the same band for a couple of years. It sounds as if it's about to break out of the band.
RR: I don't think it will break out anytime soon. There is a dichotomy between domestic natural gas, which is keeping energy prices moderate as regional crude oil markets are developing. We hadn't seen such wide differentials before. For example, the market for Brent, for international light sweet crude is quite high, particularly relative to the price being paid for light sweet medium crude, which is becoming landlocked and doesn't sell. You have a series of regional markets.
MK: There are price differentials even within the regional markets. As a result, producers in the Bakken get a different price than producers of the same type of oil in Eagle Ford. The discount differential for Canadian oil is even larger. Distribution is another factor. So just because oil went to $120 per barrel (bbl) doesn't mean the oil company you invested in is getting $120/bbl; what matters is what the company is getting on its netback. Again, it's very company specific and more regionalized than people realize.
LJ: One more point – the speculative component to energy prices goes away if the global economy visibly tanks. So the near term certainly presents plenty of opportunities for lower prices, and this should be seen as a buying opportunity for the very best picks.
TER: Marin, last time we talked, you said that risk mitigation is the key to success, but in a risky market like this, how do you do that?
MK: Many factors come into play. Louis and I have had the advantage of working very closely with and being mentored by both Doug Casey and Rick Rule, so I think the key thing is to first look at areas that interest you. At that point, determine your risk appetite as an individual investor and start doing your homework. It always starts with the people. That's the most important "P" of the eight Ps. You also have to look at what type of investments a company is doing, its stage of development, its financial metrics and so forth. Risk mitigation is complicated, but those are some quick and easy places to start.
RR: Another thing that many people can do to mitigate risk is hire help. For instance, if you can have 40 people in the Casey organization working for you six or seven days a week, and you get that help for the price of a $1,000 subscription that you can leverage against a $1M portfolio. It's pretty stupid not to do it.
I agree with Marin that people are the most important factor, but another key concern is balance sheets. In a capital-intensive business, if you don't have any capital, you don't have any business. That's it. Stop.
Beyond that, strong due diligence comes down to traditional securities analysis. It's pretty simple in the case of oil and gas juniors. You look at three things:
- Recycle ratio, or the amount of new production you can bring on with the margin from prior production
- Reserve life index, meaning how many years of production you'll get from a deposit
- Ratio of proved undeveloped to proved developed producing conversion ratios
If you have those three things down, I wouldn't say it gets easy, but it gets doable. You don't even necessarily have to get them right – just closer to right than your competitors. Risk mitigation just requires knowing more than the people you're bidding against in the market.