US State Government Declares War on OPEC

Back in November I wrote why OPEC would not cut oil production. At the same time, I also stated that we would see US government tax breaks for certain US producers.

It’s now official. Tax breaks are about to start.

If the shale revolution is in a 12-round boxing match, then we are barely through the first few rounds. In the first round, OPEC came out swinging with haymakers as they declared war on US shale and said they would not cut production.

Many US exploration and production (E&P) companies’ share prices took a beating as the price of WTI tumbled over 50%. Supported by the ropes and holding on for dear life, round one ended with the US E&Ps looking to their corner for help.

And help has come.

The oil patch has always tried to distance itself from all forms of government, but it is the government that is coming to their rescue.

And because of the US government’s assistance, the US E&Ps are able to throw a couple of uppercuts back at OPEC.

Why?

Tax breaks, which have helped increase US oil production.

OPEC took round one, but round two goes to the US E&P sector.

US oil production has increased even under a crumbling oil price. How?

For one thing, lower production costs. As drilling and service companies are forced to undercut each other to compete for business, the cost of production per barrel decreases.

Another and now very crucial element is the support from state governments.

State Governments backing the US oil patch

For every $1 spent on Texas’s oil and gas industry, $2 of additional business is generated in other industries, and for every $1 spent on North Dakota’s oil and gas industry, $1.60 of additional business is generated, according to both Texas’s and North Dakota’s own government websites.

Texas and North Dakota are the largest oil producing states, and they are more than aware that their economies depend on oil production. Texas and North Dakota produce 3.5 and 1.2 million barrels per day of oil, respectively, which is over 50% of total US oil production. (To put things in perspective, one in every four drilling rigs on the planet is in Texas.) Thus, for their states to do well, it is essential for the oil and gas industry to continue to thrive.

The way Texas and North Dakota have dealt with the issue of low oil prices is by providing oil and gas companies with tax incentives.

The most effective tax incentive will come from North Dakota’s tax program on new and old oil wells. If oil drops below $55.09 for five consecutive months, all wells will be exempt for 24 months from paying a 6.5% extraction tax on oil produced. After the 24 months, if oil prices have not increased above $55.09 for a five-month period, the extraction tax will increase to 4%. However, if oil prices rise above $55.09 per barrel for five consecutive months, the extraction tax exemption will become inactive.

The WTI price in January, February, and the first half of March 2015 have remained below $55.09, which means that if oil prices remain below $55.09 for the next 2½ months, we could see this tax incentive kick in as early as June 2015.

The incentive trigger for a price under $55.09, plus the existing tax incentive trigger for a price between $55.09 and $57.50, will reduce North Dakota oil-driven tax revenue by $100 million per month, provided oil stays below $55.09 per barrel for the entire 24-month period. Tax incentives in both Texas and North Dakota provide oil and gas companies with a saving grace of last resort. But just as oil companies can benefit from incentivized regulation from state governments, there are certain regulations that may hinder the profitability of oil and gas companies, while simultaneously leading to another unwarranted flood of US oil production.

Mick, Cut me

One of my favorite scenes in Rocky is where Rocky asks his manager, Mickey, who is in his corner, to cut open his right eye just before the 15^th round. Apollo Creed had cut and bruised Rocky’s eye so badly that Rocky couldn’t see out of his right eye.

Time will tell how the US oil patch will look by the time this battle with OPEC is over.

Rocky is one of my favorite films of all time. Chuck Wepner is regarded as the “real life” Rocky, as it’s Chuck’s career that people most believe Stallone used to create Rocky.

But I believe it was based on a hybrid of both Chuck Wepner’s and my favorite boxer “Mr.Canada,” George Chuvalo’s, careers. Chuvalo, like Rocky had very little time, exactly 17 days to prepare for the world title bout against Ali, and like Rocky, Chuvalo went the distance with Ali. Also, like Rocky, Chuvalo came from an ethnic background.

Muhammad Ali, stated of Chuvalo, “He’s the toughest guy I ever fought,” and Chuvalo, whom many believe had one of hardest punches in boxing history, happens to be of Croatian descent. Even Stallone made a remark about Chuvalo, calling him, “My hero.”

Chuvalo’s post-ring life has been a nightmare, with his first wife and a son both committing suicide, and two sons who died from drug overdoses. Trying to make the best of a horrible experience, Chuvalo has dedicated his life to trying to teach kids the dangers of drug abuse. Chuvalo, you’re a world champ in my books!

Back to the oil patch.

Should the government create tax incentives for the US E&Ps?

Answer: They have no choice. But the governments will actually add to the problem and here is why.

The state governments of Texas and North Dakota have additional legislative measures that will promote oil production through force.

Under Texas and North Dakota oil well abandonment laws, any well that remains inactive and unproductive for more than a year must be plugged. North Dakota, in addition to plugging, the well site must be reclaimed to its original landscape. The reason this is particularly important to the current US shale oil industry is due to the increased amount of oil wells that have been drilled and left uncompleted in North Dakota and Texas. The costs of reclaiming certain wells is actually higher than the NPV of the well, thus the companies will continue to produce because it’s cheaper than reclaiming the well.

The reason oil and gas companies are leaving wells uncompleted is to prolong their production until a higher oil price is realized. These companies are essentially storing oil in the ground in hopes that within a year, oil prices will appreciate.

Large producers such as EOG Resources, Apache, Anadarko Petroleum, and Chesapeake have added over 3,000 US shale wells that remain uncompleted and unable to produce. I wrote about this in 2011, calling them “phantom wells” in the gas sector. The phrase being used today is “fracklog.”

If oil prices remain low for the rest of 2015, it is likely that many of these wells will be forced into production or required by state regulations to be plugged and, for North Dakota wells, reclaimed.

According to the North Dakota Industrial Commission, Department of Mineral Resources, there are 825 North Dakota wells that were drilled and uncompleted as of January 2015, compared to October when 650 were left uncompleted and 150 were left uncompleted in June 2014. If we just focus in on North Dakota production, by June 2015, oil producers will be forced to either plug and restore their well sites or bring on at least 37,500 barrels per day of additional production over the next two months. As October 2015 approaches, an additional 500  wells will be forced to either plug the wells and restore the land, or produce a minimum of 150,000 barrels of new oil production per day.

Ding, Ding, Ding; Round Three. Who Will Take Round Three?

Unfortunately for this fight, there will be no scantily clad models walking the ring between rounds. No ring girls in this fight. Just investors, speculators, traders, E&P’s, NOCs, and now governments.

Round three is likely going to be a long and bloody round as both sides (OPEC and US E&Ps) begin to suffer from the previous rounds of the fight. The Saudis have publicly stated they have produced 350,000 more barrels per day than reported to OPEC, while also suggesting they could increase production further if there was demand. This is not a knockout punch but a definite body blow to the North American shale industry.

The US tax incentives are not going away and will drive production higher into 2015 and early 2016. Furthermore, the backlog of thousands of wells (fracklog) that can be completed in a matter of days will force down any short-term increase in the price of WTI.

Round three will extend throughout the majority of 2015 as OPEC and the United States circle each other, leaving everything in the ring.

What about Russia?

For all the Rocky fans, don’t worry, I didn’t forget about the greatest Russian boxer, Ivan Drago.

In Rocky IV, Ivan Drago easily took down Apollo Creed.

Rocky turned to unconventional training methods to take down Ivan Drago.

Interesting metaphor (unconventional, as it’s unconventional technologies that will save the US E&P sector) I’m jabbing with here, but it’s an appropriate one, as the Russians have increased their oil production, as have the US and Saudi Arabia.

And just like in boxing, it is important to not be caught standing still.

Iran?

Yes, Iran also might become an issue because of the potential increase of Iranian oil exports. The P5+1 countries have come to a framework agreement with Iran regarding the nuclear issue. Part of this agreement would lead to the sanctions against Iran being removed, including oil sanctions. Iran has the ability to increase production and the existing infrastructure to bring this oil to the international markets. All of this would increase the global supply of oil. Bearish for oil.

This means as an investor, you have to be on your toes at all times, stick and move, as Ali would say. If you’re caught flatfooted or get hit on the chin, it could be lights out for your portfolio.

Oil Prices around the World

How Do You Make Money from the Evolving Shale Revolution?

The current energy markets are volatile, but a speculator must use volatility to his own advantage to build positions in companies that have suffered as a result of the current market correction.

I follow a very disciplined approach and use very advanced mathematics and technical knowledge to position myself in the best energy companies.

If you’re looking for in-depth research, experience, and exposure to my vast network in the resource sector, then you may want to pay attention to what I’m doing. If you believe that in order to be successful in the resource sector, one must be a contrarian—as I do—now is the time to become engaged.

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I plan on writing a weekly missive on whatever I find interesting in the resource world. I will also attempt to make this the one stop.

K-Man’s Resource Financial Tip of the Week: Price per Flowing Barrel

If you’re wondering why this portion is K-Man, it was my nickname back when I was a teacher. Though I left teaching years ago, some people still call me K-Man, including Casey Research’s Louis James. In the spirit of learning, and as a flashback to my old teaching days, this section will be called “K-Man’s Financial Tips.”

Over decades of practice, valuation experts have derived industry specific multiples to determine the intrinsic value of companies. Investing is not easy and requires hard work and a lot of time. Thus, any tools to make things simpler is definitely welcome, and multiples are just that: tools to help in the process of buying and selling stocks.

For example, social media stocks have been on everyone’s radar: companies with absolutely no earnings are raising billions upon billions of dollars from a more-than-eager investment community. However, traditional valuation methods, especially the price-to-earnings ratio, are thrown out the window, and investors must somehow quantify what is merely an idea. This is where the industry specific multiple comes in.

The only thing that can be quantified in the case of Twitter, WhatsApp, Snapchat, etc., are the users of the application. And as it turns out, you and I are worth roughly $100 each. So, if a new social media company is launched and 1,000 users sign-up, the company is worth $100,000 to the market.

Let’s look at a real life example. According to their last financials, Twitter, who had a loss of $578 million in 2014, has 288 million users and market capitalization of approximately $34 billion. So, each user is currently being valued at $118. Your tweets about the weather and how long your coffee is taking at Starbucks are worth roughly the cost of Netflix for a year. Feeling used?

The price per flowing barrel is just another multiple, but used in the valuation of oil and gas. It is calculated as:

If this multiple is higher than its peers, the company is trading at a premium, and if it’s lower, the company is trading at a discount. Now let’s use it in a real life example like we did with Twitter. In one of the most recent transactions in the oil patch, Whitecap Resources (WCP.TO) acquired Beaumont Energy, a private E&P, for $587.5 million. At time of acquisition, Beaumont had production of 5,100 barrels of oil equivalent per day, so Whitecap paid $115,196 per flowing barrel. Historically, companies operating in the same light-oil play sold for $100,000 per flowing barrel, so initially we can conclude Whitecap overpaid for Beaumont.

This metric is easy to use, but we emphasize that it is just one tool to use in the valuation of an oil company. And it comes with several shortcomings. One is that the metric does not take into account the reserves of a company or the future growth from undeveloped fields. So, while it may look like Whitecap overpaid for Beaumont, we are not taking into account the 27.2 million barrels of 1P reserves Beaumont also comes with. Which is why the price per flowing barrel metric is often used in combination with the enterprise value to 1P Reserve ratio. It helps investors understand how well a company’s current production is supported by what is in the ground.

Remember, these metrics will differ due to location and oil/gas mix, but it’s a great starting point if you have a group of similar companies.

Interesting Resource Data

Below is the data showing the current oil storage, capacity, and daily production. This past week was the first week of the year that had a production decrease. US crude oil production is at 9.386 million bopd, down 37,000 bopd from the week before.

What’s Next in the Energy Sector?

In the past four months, I have personally invested more cash in speculations than I have in the last four years. Could I be wrong? You bet I could, but this is not my first downturn. I’ve seen this rodeo before.

I also do not have many positions personally, nor does the Casey Energy Report portfolio. I follow a very disciplined approach, and my style isn’t for everyone. I’ll be the first to acknowledge that fact.

If you’re looking for a newsletter that recommends a stock every month, I’m not your guy. I only recommend stocks that I’m willing to put my own money in.

If you’re looking for in-depth research every month, experience, and exposure to my vast network in the resource sector, then you may want to pay attention.

There’s blood in the streets in the energy sector right now—and I love it!

If you believe that, as I do, to be successful in the resource sector, one must be a contrarian, now is the time to become engaged.

So how can we profit from the blood in these markets?

Take me up on my “Katusa Challenge.”

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As a subscriber, you’ll receive instant access to our current issue, which details how to protect yourself from falling oil prices, plus our current top recommendations in the oil patch. Do your portfolio a favor and have me on your side to increase your chances of success.

I can’t make the trade for you, but I can help you help yourself. I’m making big bets—are you ready to step up and join me?

Below are the US natural gas storage levels.

Hard Rock Data

Here are the five-year storage and price decks for some of the more popular metals. I have put this info together for you so you can quickly see the price and LME inventory levels all in one place.