How to Use Production Costs to Evaluate Energy Stocks

By Markets Fool.com

In this clip from the Industry Focus: Energy podcast, Sean O'Reilly and Taylor Muckerman explain why production costs are one of the most important numbers for potential investors to understand before buying shares of an oil company.

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Listen in to hear what factors get covered under that metric, how the industry has been getting so much better at reducing those costs year after year, and learn about a few companies that are doing especially well. Also, the hosts look at how location affects the costs of production, which ranges most companies are looking at, why so many companies have been talking up the Permian Basin lately, and more.

A transcript follows the video.

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This podcast was recorded on July 28, 2016.

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Sean O'Reilly: Moving on to production costs. This is really where especially onshore conventional producers have been focusing, because they've been cutting exploration and development costs. They're not finding more oil, but they've really been getting more efficient. They've been trying to -- and they've had to -- because of this downturn. You see these estimates where most producers I've seen that are just onshore shale producers, their production costs come down 20%, 30%. Walk us through that.

Taylor Muckerman: Almost sometimes on an annual basis.

O'Reilly: Yeah, it's crazy. Walk us through what production costs entail, how they're getting better at it, I guess, and maybe a few more names that are doing well.

Muckerman: Yeah, so you're looking at ... You've got the drilling activities, which is basically setting up shop, drilling the wells; and then the completion aspect, which is the majority of the cost. You're looking at generally 60% or above for the completion side, and that's the fracking and the extracting. What you've seen over the last year or so is companies do everything but the completion stage, because it is the most expensive and it can be done relatively quickly. It's just very capital intensive, very labor intensive, and very resource intensive, because you're dealing with proppants, you're dealing with all the fluids, the sand, the silicone, whatever they might be using. That does vary by field. If you're looking at some of the drilling costs across the four major basins in the U.S., [in] the Bakken, drilling cost is $1 million.

O'Reilly: For a well?

Muckerman: For a well, it's about $2.5 million in the Bakken, Marcellus, just under $2 million, Eagle Ford, right around $2 million, and Permian right around $2 million. This all comes with different depths, different horizontal lengths. By depths and horizontal lengths, I mean the depth straight down that these wells are being drilled, and then the lateral and horizontal length is basically the length of the frack stages that they're drilling out, which are getting several thousand feet now. And then within that several thousand feet, you've got several fracking stages that they go through to access multiple different portions of this well. The Bakken is the deepest and the longest generally, with the Marcellus being the shallowest, and less long underground horizontally, left, right, north, south, east, west, wherever the heck they're trying to get this oil from. Then, on top of that, you've got the profit, fluid and completion costs that are different.

You might expect, because the Marcellus is the shortest and less deep, that it would be the cheapest, but no: It's actually the most expensive when it comes to proppant and fluid costs. It just varies quite widely, which is why you see companies choose to specify in certain basins ... You've got some companies like an EOG (NYSE: EOG) that spreads itself all around.

O'Reilly: They're mostly in Eagle Ford.

Muckerman: Yeah, they're the largest producer in Texas. They're one of the largest producers in North Dakota. They've got a small percentage of assets they're trying to grow internationally, but for the most part, they're the largest domestic oil producer in the U.S.

O'Reilly: I see a lot of players -- in their latest quarterly earnings, they're talking up ... Just focusing on the Permian. Why?

Muckerman: Well, compared to the Bakken and Marcellus ...

O'Reilly: This is West Texas, for everybody that doesn't know.

Muckerman: Oklahoma as well. What you're looking at here is a field that's kind of been looked at last, but it has supposedly tremendous reserves. The Marcellus got tapped very heavily for some oil, but mostly natural gas. The Bakken and Eagle Ford have just been the darlings of the shale energy revolution, with Harold Hamm basically pioneering up in the Bakken and a little bit into southern Alberta. The Eagle Ford was just a rush. Everyone wanted in on that. The Permian has kind of been one of the last low hanging fruits to be discovered, and it's just got multiple different layers to it. They can tap a well, drill a little bit deeper, tap another whole resource formation. They call them a stacked play, basically, where you see these wells stacked on top of each other where you can access them at different depths.

O'Reilly: Before we move on, how have companies been able to drop these production costs so much, like you just said, like 30%? How are they doing that?

Muckerman: One thing is you've been seeing greater wells drilled per rig, so you've seen "pad drilling" is what they call it. Rather than having to completely disassemble a rig, move it to a new well site and then reassemble it and drill again, these rigs are basically movable. In some instances, they'll just basically put them on tracks almost like ... not like a railroad, but the same general idea.

O'Reilly: Like excavator tracks.

Muckerman: Yeah, yeah, exactly. You've got these rolling wheels on basically a bulldozer track that they can move those in quadrants around a well site. You're drilling multiple wells with the same rig, so it shortens the time frame and the manpower that you need to disassemble and reassemble. And then [there are ] the longer laterals with more fracking stages in those laterals, so you don't have to ... You're just drilling that one well and then accessing many, many, many more points within that well and then you've obviously got optimization with the proppants and the fluids that they use just in testing.

In the major fields in the United States, the Bakken, the Eagle Ford, the Permian, and offshore Gulf of Mexico, drilling and completion costs have come down roughly 25% to 30% since 2012. That's basically the bread and butter of the United States. If you stripped out those four basins, we're not producing hardly any oil.

Sean O'Reilly has no position in any stocks mentioned. Taylor Muckerman has no position in any stocks mentioned. The Motley Fool owns shares of EOG Resources. 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.