The Work Horses of the Oil Patch

The Daily Reckoning PRESENTS: This won’t come as a surprise to our long-suffering readers, but things have changed a lot for the world’s most voracious energy consumer since the days of Col. Edwin Drake. In fact, oil production in the United States is about 37 years past its peak. Dan Amoss explores…

THE WORKHORSES OF THE OIL PATCH

Imagine an army of “nodding donkeys” scattered across windswept plains. These pumping units toil without fanfare. Up and down, day and night, most draw less than a dozen barrels daily from wells long past their prime. Yet combined, they account for a shockingly high percentage of the oil produced in a country that was once the world’s top producer.

This is a picture of a country 37 years past its peak in oil production. Yet our reliance on this army of machines to produce the most precious commodity in the world remains a little-known secret.

It is a picture of the United States of America.

The United States – the world’s most voracious energy consumer – now heavily relies on an army of worn-out machines to supply much of its oil and gas.

Yet as far as the public is concerned, oil and natural gas reserves float around in giant swimming pools a few hundred feet underground, and if only those greedy oil executives would turn up the production nozzles, we’d have all the affordable energy we need.

The challenges posed by declining oil supply and rising prices are not as simple as most imagine. Entrepreneurs have scoured nearly every square inch of promising hydrocarbon basins since Col. Edwin Drake successfully drilled that famous Pennsylvania well in 1859. We are now in a situation in which small independent operators are responsible for maintaining older wells – and they increasingly rely on this month’s recommended company to keep their wells from drying up.

As far as the big oil companies are concerned, it’s pretty telling that they’re exploring in harsh, remote environments like offshore Kazakhstan and Sakhalin Island, rather than right here in the good old U.S. of A. This is a very clear signal from the free market that the size of potential future U.S. oil discoveries are not worthy of large-scale investments.

In The Future of Global Oil Production, Roger Blanchard explains how the U.S. has reached this state:

Once oil production starts declining in a mature oil-producing region such as Texas, the easily extractable oil has been extracted, and it requires an increasing amount of work to extract the remaining oil. Wells that once required no pumping because high reservoir pressure forced the oil out ultimately require pumping as the reservoir pressure declines. Over time, the wells pump less and less oil. A substantial increase in the price of oil will have little effect on the declining production trend unless there are previously undeveloped oil fields to exploit. The U.S. now has approximately 500,000 low-production stripper wells (wells that produce less than 10 barrels/day) with an average production rate of ~2 b/d.

You read that figure correctly. That’s 500,000 “stripper wells” currently in operation. Even more shocking is the fact these mom and pop wells account for about 18% of U.S. oil production. Tiny natural gas wells provide about 10% of U.S. gas supply. Moving a little further up on the size scale, the latest EIA numbers show that about 50% of U.S. oil supply originates from wells producing less than 100 barrels per day. No wonder so many nodding donkeys dot the landscape!

You might say that a couple of states would have to go without modern transportation or winter heating if not for the industry that supports this production. This is an industry that will hardly blink an eye as an estimated $1.5 trillion worth of mortgages rolls past the “teaser” stage, or flinch at the growing glut of chips in the electronics supply chain. This industry will go about its business through bull market and bear market, through boom and bust. I’m talking about the well service industry.

A well service rig generally has fewer capabilities than a typical land drilling rig. They are normally smaller and more mobile, mounted on trucks operated by three-four man crews. Most well service rigs also typically don’t have the drill pipe, mud pumps, and rotary tables necessary to drill new wells. But these rigs can perform workover drilling, recompletions, and horizontal re-entries – all drilling-related tactics an operator may use to offset depletion after a well has passed its peak production rate. Service rigs are truly the “workhorses” of the oil patch, often the first to arrive and the last to leave the well site.

Well service companies charge by the hour. During the last industry downturn, in 2001-2002, the drilling rig count contracted by 37%, but well service hours declined only 25%. Each newly drilled well creates an annuity for the well service industry; maintenance work must continue to some degree, even through the worst industry slowdowns (see “Typical Oil Well” chart).

Here’s the key difference between the traditional land drilling business and the well service drilling business: Exploration and production (E&P) companies will acquire drilling rigs only if they are optimistic about oil and gas prices. But if they want to remain in business for more than a couple of years, they need to spend on well services. Otherwise, their production would fall off a cliff. As you’d imagine, rates earned by well service rigs are far less volatile than rates earned by exploration-focused rigs.

Another reason why pricing in the well service business is less volatile than pricing in the drilling business is a more consistent balance between supply and demand. When investing in companies supplying services with a fleet of capital-intensive assets, capacity utilization is the most important factor to monitor. This applies for oil tankers, offshore drillers, land drillers, and well service drillers. Competition is not limited to existing competitors; it includes new equipment coming online in the future.

In the well service industry, business was horrible in the late 1980s. Bankruptcies eliminated about 65% of well service capacity over the following 20 years. The industry is now operating with only about 2,800 well service rigs left in working condition.

Now that the industry has worked through the huge glut of well service rigs, service companies are finally starting to order new rigs. However, even after this long, painful attrition process, the average age of the well service rig fleet is still about 25 years. This gives us reason to expect that for every two new rigs constructed and put to work, roughly one old one will be scrapped.

Regards,

Dan Amoss, CFA
for The Daily Reckoning
April 3, 2007

Editor’s Note: Dan Amoss, CFA is managing editor for Strategic Investment and a contributing editor for Whiskey & Gunpowder. Dan joined Agora Financial from Investment Counselors of Maryland, investment advisor for one of the top small-cap value mutual funds over the past 15 years.

Dan brings to Strategic Investment the unique experience of an institutional background and a drive to seek out the most attractive investments within favored “big picture” trends. He develops investment ideas for SI readers with a global network of geopolitical and macroeconomic analysts. Dan holds the Chartered Financial Analyst designation, a professional designation widely recognized within the investment community.

T for Texas
T for Tennessee
T for Thelma
That gal made a wreck out of me
– Jimmie Rogers

Yesterday, we noted that thousands of people are leaving Michigan. Jobs are disappearing. House prices are falling. The place is having a ‘one state recession,’ say the news reports.

But when they’ve loaded the Chevrolets, where do they go?

Ask the movers. According to Atlas Van Lines, Texas is the top destination for Americans who’ve pulled up stakes. And they come from all over – not just the Rust Belt. In fact, many are leaving the hurricane coast of Louisiana and Mississippi to take up residence in Texas. And if this continues, Texas could be home to about 25 million people by the year 2010; and by 2040 the state’s population could hit 51 million.

We once lived in Mineral Wells, Texas, as a small child. That was in the days before universal air-conditioning. All we remember was that it was hot, which is such a strange thing for a child to remember that we suspect we are just making it up.

The big financial news yesterday was that New Century Financial finally went broke, owing $100 million, according to the bankruptcy filing in Delaware. One hundred million is chump change, of course. But we continue listening for other shoes to drop. When standards fall, shoes hit the floor.

New Century’s stock traded at more than $30 a year ago, and as much as $66 two years ago. Yesterday, you could buy a share for $1…which makes us wonder: What’s wrong with Mr. Market? Is he blind? Deaf? Or just dumb?

In Malcolm Gladwell’s defense of Enron’s managers in the New Yorker in January, he points out that all the data needed to figure out that Enron was a house of cards was readable in the company’s various filings. If investors didn’t bother to read them, he says, well, it’s no reason to send the Ace of Spades, CEO Kenneth Skilling, to jail for 24 years.

And, it shouldn’t have taken Sam Spade to figure out that the House of New Century was not exactly as stable as the Pyramid of Cheops. We said as much right here in the pages of The Daily Reckoning: As a business model, lending money to people who can’t pay it back has a serious flaw.

And so now…the poor people who took out loans to buy houses in Michigan…and then lost their jobs to Koreans or Pakistanis…have to move on.

But what can they do with their houses? “U.S. workers saddled by”, (they must mean ‘with’), “houses that won’t sell,” says the Christian Science Monitor.

What can they do? It’s simple – pull down the shades, pack their bags, pour motor oil on the carpet to teach the mortgage company a lesson, and head for Texas.

“Loan delinquencies soar,” reports Bloomberg.

And so the poor people who bought New Century at $66…or lent it money when it was in the chips…are counting their losses.

But among those NOT yet headed for Texas, are New Century’s three founders. Who says you can’t still get rich in America? These guys took out $40.5 million in profits – selling their shares to the lumpen between 2004 and 2006. But now (oh ye wicked Fates!) the feds are on the case and the whole affair threatens to go a little sour, like Enron before it.

More news:

————–

Chuck Butler, reporting from the EverBank world currency trading desk in St. Louis…

“What, do the markets believe the discussion will involve? Exchanging cookie recipes? Not hardly! They are going to discuss why the currency is still crazy after all these years…I mean still the most undervalued, and manipulated currency!”

For the rest of this story, and for more market insights, see today’s issue of The Daily Pfennig

————–

And more thoughts:

*** We admire the resilience of the Get-Rich Economy. All you need to be a success in today’s America is to have money – or appear to have it. And all you need for that is credit. And when one credit-puffed bubble blows up…along comes another one…even bigger.

It’s a bit like those old Whack-A-Mole games. You whack one mole down…and another pops up somewhere else. You smack the dotcoms…and up comes housing. You bash the subprime lenders for being reckless with other people’s money…and lending standards continue to fall elsewhere!

Margin debt on the NYSE is up to a new record – $285 billion. Global mergers and acquisitions activity – funded with debt, of course – has just passed a milestone…reaching more than $1 trillion in the last three months. Global debt issuance overall is increasing five times faster than the world’s GDP. Corporate bonds are increasing at a 22% rate. Junk bonds are up at a 30% rate. Leveraged buyouts, according to Bloomberg, are up 40%…with the financiers collecting $2 billion in fees in the first quarter alone.

Sam Zell is taking his money from Blackstone’s real estate group and using it to buy the Tribune Co. for $8 billion. KKR is putting $39 billion into First Data. Deals-on-Wheels!

Where does all this money come from? Are people stashing away so much in savings that banks have an extra trillion dollars to lend to these money shufflers?

Of course not. Three quarters of the junk bonds, for example, are taken up by hedge funds.

And now we come to something interesting. The world’s credit system is no longer controlled by banks, and thus, no longer under the control of bank regulators. Instead, there is a huge pool of liquidity outside of the banking system. A news item last week spoke of giant “dark pools” of liquidity that “do not publish quotes on the open market.” But how much bilge is sloshing around in these dark puddles? How do they work? Where does the money come from?

We don’t know. But we know that pools of liquidity do not really make the world a richer place. They just increase the odds that you will step into something…like Enron or New Century…and sink.

*** While dark pools flood the world’s markets and let speculators frolic…the actual, real-world experience of the average American is getting more and more grim. The latest figures show him driving more – even though oil has climbed back over $65 and gasoline is at record prices. Nor does he show much hesitation to borrow and spend – even though the latest polls show him losing confidence. And get this: The state of Florida reports declining tax revenues for the first time in 32 years!

We opined the other day that it is not absolute wealth that the average man cares about, but relative wealth. A man in an Indian village doesn’t envy the American with air-conditioning and two cars in his garage. He envies the man down the street with a half-acre more of garden space.

An American may be perfectly content to vote Republican when Ronald Reagan is in the White House and he thinks everyone is getting rich. But when the slump comes, he looks around and sees things differently. He begins to look for a New Deal. Not since the ’20s, in America, have so many people had so little while so few others have had so much. The many, pressing their noses to their television screens and gaping at their rich neighbors like the mob facing Marie Antoinette…are likely to want a change.

Then, the scoundrels and scalawags will have their day at last. The old politics of envy will make a comeback. “Soak the rich,” they will say. “Hang the profiteers”… “Power to the people…”

Envy does not permit a free society. People say they value liberty, but they can’t stand what it produces. They can’t stand the fact that – left to their own devices – some people will have more than they do and some will struggle to survive. Redistribute income, tax, control, regulate – they will support almost any measure that promises to make the outcome more to their liking. They will ask (and in some cases demand) that their leaders control everything – income levels, interest rates, health care, parking, handicapped access, what the schools teach, what language people speak, who can marry whom, what goes into the sausages – even the weather!

The rascals in every major political party all share the same basic opportunistic creed. They differ in style, not in substance; one clown wears patrician blue…the other a plebian red. One favors a plan whereby government pays all medical expenses. Another offers reimbursements. Still another offers subsidies and tax incentives to various favored projects. Every one of them believes in taking something from one citizen and giving it to another.

But envy is not the only reason for the triumph of collectivism. We are, by nature, collective animals – like our monkey relatives. We may no longer live in trees, but we still live in groups. And we look to our neighbors – not to ourselves alone – for food, shelter, comfort, companionship, direction, religion, opinions, and much more.

Yes, in theory, all of these relationships could be managed in a free, consensual, collegial and civilized way – in which persuasion and honest trade are used instead of violence and force. Most of our private lives are run that way. We do not threaten the baker for a loaf of bread. Nor, for the most part, do we take our wives like Sabine women; we are taken by them…seduced, not stolen.

But public life is different. Without the iron hand of the state behind him, mass man feels a little lost…vulnerable…and lonesome. How will he eat, unless his neighbors are forced to give him bread? Who will look out for him in his retirement, unless the younger generation is forced to pay into Social Security? Who will protect him from terrorists, if his armed forces are not properly locked and loaded? A little bit of humble reflection might show him that he would be better off by relying on his own wits…but not one man in ten is prepared to do it.

The world might be a better place if people were free…but it would not be the place it is.

*** Yesterday…it was April in Paris. Flowers in bloom. Freshly mown lawns. The sun shone down warm. The cafes spilled out their tables onto the sidewalks. Couples cooed in the parks…in the streets…in elevators…on the Eurostar!

But what is this? We arrived in London this morning. It is gray and cold. The wind is blowing. What is it with this London weather? Today might as well be a day in January…or July.

Relief is on the way. According to a map published in today’s “Liberation” the climate of Europe is changing rapidly. You wouldn’t guess it from the weather in London today, but the whole place is warming up. In a few years, London is expected to have the same climate as…say…Bordeaux today – with hot, dry summers and mild winters.