How to Use Exploration and Development Costs to Evaluate Energy Stocks

By Markets Fool.com

Unlike price-to-earnings ratios, exploration and development costscan't be shifted around by energy companies for appearance's sake.

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In this clip from Industry Focus: Energy, Sean O'Reilly and TaylorMuckermanexplain what investors need to know when they're evaluating a company's exploration and development budgets. Also, they look at why the entire oil sector has been drastically cutting its exploration budgets, and what that will mean a few yearsdown the line.

A transcript follows the video.

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This podcast was recorded on July 28, 2016.

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Sean O'Reilly: One thing that cannot be really fudged for an oil and gas producer is exploration and development costs. Walk me through what that entails, and maybe some companies that investors looking to get invested in this space might look at that are doing really well based upon this metric.

Taylor Muckerman: Yeah, so they generally break out costs in two different brackets. Exploration and development, [which] is sometimes termed as finding and development, [and] the second half is production and completion.

O'Reilly: The former, the exploration and development cost: That's the thing that's been cut a lot?

Muckerman: A lot, yeah, yeah. You look at a company like Marathon Oil(NYSE: MRO), to take their exploration budget for conventional oil over the last couple of years. In 2014, it was $500 million a year. 2015 cut it in half to $250 million a year. 2016, $30 million a year.

O'Reilly: Where is that $30 million going?

Muckerman: There's a few longer-tail projects that they just have to put money into.

O'Reilly: What do you even get for $30 million?

Muckerman: Not much, and that's [what] one of the big worries in the industry is. These are the projects that are going to deliver oil production years down the road, and that is why companies have decided to cut back on that in the last year or two -- because they need cash flow now to pay for those dividends I had mentioned a little earlier, and to just keep the lights on. They've been pulling back on these long-term investments. ConocoPhillips(NYSE: COP) as well, [is] pulling back a lot in the Gulf of Mexico. They plan to completely exit exploration drilling in the Gulf of Mexico by 2017.

Offshore is definitely a little bit more of a coin flip, and it's definitely more expensive from top to bottom: exploration, drilling, and completion. That being said, there's a lot of reserves supposedly out there. They could be missing a big heap of oil reserves, but onshore, they've got a pretty decent portfolio.

O'Reilly: Yeah. Obviously, with exploration and development costs on planet Earth, you've got a pretty wide range, because you go over to Saudi Arabia's Ghawar Field and you stick a straw in the sand, and you've got oil.

Muckerman: Yeah, that's what we call a conventional oil. Easier to find, easier to drill for, versus unconventional, which is offshore and shale.

O'Reilly: Obviously, at the other end of the spectrum is deep-sea offshore stuff, Antarctica, all that stuff. What kind of cost per barrel -- just give me ranges, I mean, you don't have to be exact -- what's good for conventional? What's normal for offshore? I mean just anecdotally spitball. I did want to get an idea.

Muckerman: When you're looking at capital spending, which generally includes this exploration, the one-time costs, you're looking at some of these areas around the world, you look at Norway, it could be 65% of the cost of a barrel. It could be 51% in the U.K. Then you get into, like we talked about, Saudi Arabia and their fields, you're looking at some of these costs are below $5 and $10 a barrel.

O'Reilly: Yeah, I saw this one number, it was like $7 or $8 a barrel.

Muckerman: Yeah, so it's very regional. The U.K. is dealing with the North Sea, turbulent water. They're kind of removed from a lot of the transportation options. You've got some exploration and development costs there, which as I mentioned, is a little over 50% and you're looking at maybe $20 to $25 a barrel.

O'Reilly: Got it. Which is, ironically enough, where crude bottomed out earlier this year.

Muckerman: Yeah, exactly, and that's why exploration was one of the first things to go for a lot of companies.

Sean O'Reilly has no position in any stocks mentioned. Taylor Muckerman has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. 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.