The whole energy sector has been absolutely punished by the freefall in oil prices. Investors are acutely worried that the downdraft in prices will make it impossible for companies to make any money drilling. However, one of the reasons for this worry is because investors are focusing on break even costs that were projected when oil prices were a lot higher. The problem with those breakeven costs is that they're not exactly set in stone.
A history lessonAn example of these breakevenpointscan be found on the slide below, which I pulled from an Emerge Energy Services L.P. investor presentation.
Source: Emerge Energy Services L.P. Investor Presentation.
As that chart shows there are several shale plays that need oil well above today's current prices of around $60 to make money. However, what some are missing is that these break even costs tend to drop when oil prices fall. The drop isn't as deep, but it does change the economics of some plays rather substantially.
We've seen this a number of times throughout the energy industry's history. Most recently, however, was the deep drop in oil prices due to the financial crisis. At that time the operating costs of energy companies also dropped, which helped to mitigate some of the plunge in oil prices. This historical reference was pointed out at a recent investor conference when BreitBurn Energy Partners LP's CFO Jim Jackson made the following comments,
As Jackson points out the company's costs dropped by 20%, which can make a very big difference when we're talking about breakeven points or cash flow. A similar drop in costs could push a breakeven point from say $70 per barrel down to $56 per barrel, which could be the difference between making money and losing money for some drillers in today's environment
Jackson, however, isn't the only energy executive to point this out. Kinder Morgan Inc's COO Steve Kean pointed out the same thing when talking about his company's oil business. He noted that while the company's returns will be affected by lower oil prices, that impact won't be as great as the full drop. He noted that,
He notes that while costs don't drop lock-step with oil, they do fall and that helps to partially mitigate the impact of the drop in oil. Further, it doesn't take all that long for these lower costs to show up.
We're already seeing this happenThis fact that costs are already falling was quite evident by statements made by Halliburton Company's CFO Mark McCollum at a recent energy conference. The oil field service company is already making adjustments due to the current market environment to bring its costs down so that it can pass those reductions on to its customers to keep its assets fully utilized. He said that,
Unfortunately, this particular cost reduction resulted in 1,000 jobs being eliminated in the Eastern Hemisphere. However, in terms of costs for the company it's taking the upfront charge of $75 million so that it can see the longer term cost savings from those eliminations. Those longer term savings will allow the company to keep its fees low enough to continue to stay busy. McCollum noted this when he said,
Basically, he's saying that the company will underprice its competitors if necessary to keep its assets fully utilized. Not only will this enable the company to take market share from weaker competitors, but the lower prices will drop the break even points for customers drilling new wells. That will help to keep everyone busy and making money, even if it's not as much as before.
Investor takeawayThe energy industry will adjust to the new reality of lower oil prices. This is why the models that told us that the breakeven prices for drilling were in the $70s or $80s are likely no longer accurate because costs will come down, which will move those breakeven points lower as well. So, while lower oil prices will slow the oil boom, it won't necessarily end it all together.
The article Why $60 Oil Isnt as Big a Worry as You Might Think originally appeared on Fool.com.
Matt DiLallo has the following options: short January 2016 $32.5 puts on Kinder Morgan and long January 2016 $32.5 calls on Kinder Morgan. The Motley Fool recommends BreitBurn Energy Partners, Halliburton, and Kinder Morgan. The Motley Fool owns shares of Kinder Morgan. 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.
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