Profit Opportunities in US Oil Production Decline

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 USD$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 utilisation 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.

Dan Amoss, CFA
for The Daily Reckoning

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