Oil Prices: Is $70 Going to be the New $90?

By Markets Fool.com

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Photo credit:Flickr user William Gray.

The dramatic drop in the price of crude oil over the past few months has sent shockwaves throughout the energy industry. It has upended long-held beliefs, including the assumption OPEC would defend a $100-per-barrel oil price because its member states needed that level to balance their budgets.

Also called into question is whether American oil companies need a triple-digit oil price to make money drilling shale wells. Instead, these companies are finding that drilling costs are deflating along with the price of oil, so they'll soon be making the same return on oil at $70 per barrel as they did when oil was $90, but that still might not be enough to reboot the oil boom

Letting out the air on oil-field service prices
DuringAnadarko Petroleum's quarterly conference call a couple of weeks ago, CEO R.A. Walker said the U.S. onshore drilling industry has changed dramatically over the past decade. He noted that 10 years ago 70% of drilling costs were the actual drilling of a well and the other 30% were the costs to complete a well. However, the actual drilling costs have fallen dramatically over the years; they now represent just 30% of the cost of drilling a well, with completions being the other 70%.

Those completions, however, are very service-intense, and costs had remained elevated until recently due to high demand for services. But demand has dropped alongside the price of oil, pulling oil-field service feesdown, too. Those reduced expenses change the return potential of drilling new wells. Walker noted that a 20% savings in service costs gives a driller such as Anadarko the same return at $70 oil that it had enjoyed when the oil price was $90: "$70 could be the new $90 or $90 could be the new $70, however you want to look at it."

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While those cost savings will be good news for oil producers, its lousy news for oil-field service companies. Halliburton , for example, has already said that it expects 2015 to be a painful year as its margins will be compressed because producers are demanding that it reduce its fees. This margin compression has already taken a toll on Halliburton's workforce as it recently announced that 6.5%-8% of its global workforce would be cut, which is about what we're seeing from other major oil-field service providers. Suffice it to say those jobs won't come back if $70 is the new $90 because that would reinflate oil-field service fees.

Good, but not great news
Moreover, even if $70 soon becomes the new $90 it doesn't necessarily mean the oil boom will resume its prior pace of growth. This was noted duringPioneer Natural Resources' recent conference call, as an analyst asked whether the company was seeing the same development cited by Anadarko. Pioneer CEO Scott Sheffield agreed that companies "probably could get the similar results in a $90 environment, you get at 20% [of cost reductions] at $70 [oil]." However, he cautioned that oil companies wouldn't grow productionas fast at $70 oil because margins overall would still be lower. That is due to legacy oil production from previously drilled wells that would not generate the same cash margin at $70 oil as those wells would at $90 oil, according to Sheffield.

He said the bigger picture is that OPEC is trying to slow down the U.S. shale boom, but not completely upend it. The only way to do that was to drive the oil price low enough that U.S. producers can't grow as fast. Sheffield suggested that:

In my opinion, the bigger picture, is that the U.S. has been growing a million barrels a day per year. The world on the demand side, most people will agree, will be adding 1.2 million barrels a day. The Saudis want to find a price, long-term price, that will keep U.S. growth somewhere down between 300,000 and 500,000-barrels a day. Until demand significantly picks up. And so long term, I feel like we are in a $60 to $80 price world, instead of an $80 to $100 price world, so we are probably, once this thing settles out, we are probably going to be in the $60 to $80 for a while until we see conflicts in the Middle East, or see demand pick up significantly.

As Sheffield notes that the way things were prior to the price collapse have changed. OPEC doesn't want U.S. oil production growing at its previous rate and that means the price of oil could stay at a level that will keep growth tame. So, what this means is that while drilling itself might be as profitable at $70 as it was at $90 the overall margins earned on oil won't be enough to spark a new production boom. The industry simply will need to see demand for oil, and therefore its price, start to increase meaningfully to justify a reacceleration of U.S. production growth.

Investor takeaway
Rates of return and cash flow are two totally different things. So, while the returns from drilling new shale wells could mean that $70 is the new $90, the actually cash flow from oil production will still be less at that level. Because of that the industry won't grow as fast as it had been, however, it could be moving to what looks to be a much more sustainable grow rate in the future. That means industry profits should be decent, but certainly not as robust as before.

The article Oil Prices: Is $70 Going to be the New $90? originally appeared on Fool.com.

Matt DiLallo has no position in any stocks mentioned. The Motley Fool recommends Halliburton. 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.