Investment U Explains: Who Wins With Cheap Oil?

by Ryan Fitzwater, Director of Research, The Oxford Club

Editorial Note: Cheap oil is just the beginning. To find out more about  “one of the most improbable and important American business stories of the past decade”, click here.

Oil prices have been tanking, down from $105 a barrel in mid-June to around $80 today.

And you have probably seen the impact at the pump.

As you can see in the chart, the average price of gas has dropped $0.32 over the last month.

Today, the average price for a tank of gas across the U.S. is $2.96.

South Carolina has the lowest average price - there you can fill your tank for $2.70 per gallon - while Hawaii is still the most expensive at $4.03 per gallon, since it has to import all its crude.

Why has the price of oil been dropping so much?

I tapped our in-house Energy and Infrastructure Strategist Dave Fessler and Resource Strategist Sean Brodrick to get the inside scoop on oil’s plummeting prices.

Turns out, the biggest culprit is Saudi Arabia. The Saudis have decided that they will try to stomp out their competition by cutting prices for exports.

In private meetings, they have stated they are willing to accept oil prices around $80 per barrel for the next year or two, right around where it is trading today.

The reason the Saudis are doing this appears to be due to a direct battle among the biggest OPEC members for market share in a pricing environment that is increasingly becoming more influenced by unconventional methods, like hydraulic fracturing, also known as fracking.

Sean and Dave have covered the current shale boom taking place in American extensively in Investment U Daily. There is no doubt it is one of the biggest profit opportunities of the 21st century. Thanks to the horizontal drilling and hydraulic fracturing of oil shale formations, the U.S. is swimming in oil.

As a result, last month, the U.S. replaced Saudi Arabia as the world’s largest exporter of oil products. And there was no apology letter. At the same time, the U.S. is no longer the largest importer of crude oil, now China is.

Our insiders expect the U.S. to be the top exporter for years to come, and this has the put the Saudis on the defensive.

Right now, Saudi Arabia would need to reduce output by around 500,000 barrels a day to eliminate the supply gut caused by the highest U.S. output in over three decades.

This is a surprising move. Usually, the Saudis act in the opposite manner; they normally look to stop plunging prices by cutting output. Clearly, the game has changed for them.

Facing more competition from other producers and, more importantly, American shale oil, the Saudis have realized that if they cut prices, they will lower the revenue for other producers and discourage further shale development in the U.S.

And they can afford it. Saudi Arabia’s cost of production is extremely low, averaging around $25 per barrel. This hurts other countries like Iran, Venezuela and... Russia.

There are talks that the Saudis are doing this to hurt Russia as well. In fact, they might be the main target. Having Russia in their cross-hairs does make sense, considering China and Russia penned a 30-year, $400 billion gas deal back in May.

Oil is vital to Russia’s global power, which is dependent on oil sales around $100 per barrel; any decrease in price hurts that power.

But there is no denying the Saudi price cut is also a direct shot at the American shale revolution.

And the current situation recently led Goldman Sachs to cut its 2015 West Texas Intermediate Crude target to $75 from $90. And in 2016, it has a price target of $80 a barrel. Oil in this price range means some current and new shale plays will become unfeasible.

Cheap oil is great if you are a consumer, and I’ll touch base on the companies benefitting from this in a moment. But for shale producers, it is not good news.

Lower prices will squeeze sales and profit margins, and will also suspend drilling projects. This will also affect jobs in one of the fastest-growing industries in the U.S. over the last decade. But it isn’t all doom-and-gloom for the industry. Even if prices continue to drop, a majority of shale producers have plenty of wiggle room to stay in the black.

What is crucial for them is the breakeven oil price per barrel. That is the point where today’s price per barrel matches the cost to produce it.

But not every producer and not every region will be affected the same. And unfortunately, analysts’ estimates are all over the place on the subject.

First, let’s look at it from a regional perspective.

As you can see in this table, according to Credit Suisse, the breakeven oil price per barrel varies per region.

The Marcellus Shale region (located in Ohio, West Virginia and Pennsylvania) has the lowest breakeven point, ranging from $24 to $25. Clearly producers there won’t be shutting down rigs anytime soon.

But in the Barnett Shale (located in Texas), the breakeven price is well above $80. And remember, this is the breakeven point; to turn a profit, prices need to trade above it.

If you want to take a step back and look at just an average breakeven price across the board, this is where the numbers really vary based on the research house.

KLR Group commented that to maintain the current oil rig count of 1,500 to 1,600 rigs in the U.S., the Exploration and Production industry needs more than $90 in NYMEX and about $100 in Brent. They also believe $90 NYMEX is needed to maintain the projected pace of Canadian oil sands development.

Bernstein Research chimed in, stating it estimates about a third of U.S. shale production is uneconomical at $80 per barrel WTI. And it disagrees with other estimates, including the IEA’s - that the majority of shale oil production is “robust at such prices.”

According to Morningstar, the breakeven point is around $70 per barrel.

Meanwhile, Robert W. Baird Equity Research estimates $73 as the weighted average breakeven point for U.S. supply.

Morgan Stanley is claiming that cash breakevens in some major U.S. shale plays are hovering around $30. That is much lower than all the prices everyone else is quoting, and surely means shale producers won’t be curtailing production anytime soon.

Morgan Stanley also stated the Eagle Ford region in Texas has a breakeven price of $60 to $80 a barrel.

As you see, no one can agree on a precise breakeven number. It depends on the region, the company and the technology it is using.

What matters is that most shale producers need an internal rate of return above 20% for a field to be viable. If the cost of oil keeps dropping, certain drill sites will become unfeasible.

So what shale producers have the most wiggle room?

Most firms have the Bakken Shale region breakeven point priced around $60 to $65, so shale producers in the region, like Continental Resources (NYSE: CLR), Whiting Petroleum (NYSE: WLL) and Kodiak Oil & Gas (NYSE: KOG), have the ability to produce oil in the region at today’s current oil prices and still turn a sizable profit.

Then you have the Eagle Ford, which had estimated breakeven prices ranging from as low as $43 per barrel all the way up to $60 to $80. Apache (NYSE: APA), Marathon Oil (NYSE: MRO) and Cabot Oil & Gas (NYSE: COG) are big operators in that region.

Those operating in the Marcellus Shale have the largest wiggle room. As I already mentioned, its breakeven price of $24 to $25 is the lowest out of all the shale formations. Shale producer Chesapeake Energy (NYSE: CHK) is the largest driller in the Marcellus. Then you have Anadarko Petroleum (NYSE: APC), EOG Resources (NYSE: EOG) and Range Resources (NYSE: RRC), which are also major drillers in the region. With a breakeven price in the mid-$20s they can easily compete with the Saudis’ cost of production of $25 a barrel. Expect profits to flow steadily from the Marcellus for a long time to come.

The shale producers I just mentioned look safe for now, but clearly shale producers are not happy nor are they benefitting from lower oil prices. You, on the other hand, are, and you see that benefit every time you head to the pump.

In general, a small $0.01 drop in the retail price of gasoline puts about $1 billion back into American consumers’ pockets. Over the last three months, prices are down about $0.52 a gallon, equaling $52 billion in savings for motorists.

More good news. Winter is coming. Heating oil is also going to be cheaper. The EIA expects homes that use heating oil to save an average of $362 this winter.

Cheaper gas at the pump and heating at home means more moola for consumers. And remember, we have the holiday season approaching.

Combine that with the fact that most businesses outside the oil industry benefit from lower oil prices since they rely on oil to transport goods and provide services, and you have a recipe for increased consumption and profits.

So what specific sectors will really benefit from low gas prices?

Resource Strategist Sean Brodrick recently penned the “Four Big Winners” that will benefit from lower gas prices.

First up are discount retailers like Wal-Mart (NYSE: WMT), Dollar General (NYSE: DG) and Target (NYSE: TGT). As Sean notes, low-end consumers feeling relief at the pump will probably spend that money at their favorite stores.

Next up are restaurants. Families feeling flush with cash can directly translate into a night out at family-style restaurants like Red Robin (NYSE: RRGB) and Famous Dave’s (Nasdaq: DAVE), along with multi-restaurant operators Darden (NYSE: DRI) and Brinker International (NYSE: EAT).

Darden owns popular restaurants like Olive Garden and Longhorn Steakhouse.

And Brinker International operates chains such as Chili’s, On the Border, Macaroni Grill and Maggiano’s.

Then there are online retailers, an industry already expecting sales to rise this season.

Those sales could kick into overdrive for ecommerce sites like Amazon, and eBay.

Another sector salivating over cheaper oil is transportation companies.

UPS (NYSE: UPS) and Fed-Ex (NYSE: FDX) will be able to rake in a lot of extra dough as the cost of fueling their truck and plane fleets falls through the floor.

And the same goes for passenger airlines like American Airlines (Nasdaq: AAL), Southwest (NYSE: LUV), and Delta (NYSE: DAL).

Any transportation company with a large fleet is a no-brainer pick for outsized profits in a cheaper oil environment.

All the companies I just mentioned are primed to profit from lower oil prices.

But Sean Brodrick recently made an exclusive presentation on one little-known company that is perhaps the most astonishing gasoline story for the next decade.

Let me explain...

Today it costs giant energy companies like Exxon Mobil (NYSE: XOM) an average of $77 to create a barrel of GASOLINE, that's 42 gallons.

But this little-known Louisiana-based company creates it for just $25 a barrel. This allows it to create gas for, get this, $1.71 a gallon, one of the lowest production costs in the U.S.

That's over three times cheaper than Exxon... and it's a lot of wiggle room to profit.

AND it isn’t using petroleum.

One Pulitzer Prize-winning journalist who just picked up on this breakthrough calls it “one of the most improbable and important American business stories of the past decade.”

Unfortunately, I don’t have time to cover the whole opportunity in this video. But Sean goes over all the details in his special presentation. You can view that by clicking here.

Until next time, enjoy those lower gas prices at the pump and good investing.

Ryan Fitzwater

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