The U.S. oil industry has taken a beating from the recent drop in oil prices, which have plunged more than 25% since the summer.
Oil and oil service stocks across the board have been bruised… but none more so than those related to the fracking industry.
You see, fracking is an expensive process compared to conventional oil extraction techniques – a situation that became grave three weeks ago, when Saudi Arabia decided to try to run U.S. oil out of business by dropping the price of its crude oil.
Now, it looks like fracking may be the first casualty in this worldwide oil war.
An Expensive Target
In conventional oil exploration and production, most of the cost is incurred before the first barrel of oil is even extracted. But in fracking, the cost is upfront for both the land and the operation of each well.
Fracking also requires chemicals, vast amounts of water, and power to release oil from shale. The more complex the shale formation, the more expensive each barrel of oil is.
And unlike conventional drilling, which looks for vast oil reservoirs that can be exploited for decades, fracked oil formations yield big returns for just a few months before they’re quickly used up.
Thus, resources are frequently moved to new wells in order to keep production flowing.
Generally, fracking operations can be profitable. But it does depend on their location and whether oil stays above $65 per barrel. Some fracking operations can make money below this number, but the vast majority would break even or lose money.
Now, when oil prices were high, the high cost of fracking wasn’t an issue. But now, the Saudis’ low-price tactics are threatening to crush U.S. fracking.
Picking off the Weakest in the Herd
The Saudis, who are conventional drillers, are deathly afraid of fracking and its promise to deliver greater energy independence from OPEC – the oil cartel that’s dominated global oil pricing and supply. You can see why, given that its members produce more than one-third of the oil used worldwide.
The Saudis are able to produce oil for less than $30 per barrel and have ample cash reserves to wage a price war for six months to a year before they retreat.
But it’s not the cost of production that matters in the long term, it’s how much revenue is generated per barrel of oil.
The Saudis run a regime that cannot survive in its current despotic form if oil stays below $90 indefinitely.
It seems, their plan is to inflict severe damage on the U.S. fracking industry as quickly as possible in order to drive out competition and force future explorers to think carefully before engaging in high-cost operations.
But, in the end, the Saudis will fail.
U.S. Oil’s Granite Chin
Fracking stocks in the United States – like Pioneer (PXD) and Continental Resources (CLR) – have seen their share prices hammered, for sure. But the hammering is beginning to wane, as more people see the bright future of fracking.
Need proof? Well, look no further than the massive acquisitions that have taken place in the past year by the likes of Encana (ECA), Devon (DVN), and Southwestern Energy (SWN). These three have spent $18 billion combined on three acquisitions.
Most importantly, this indicates that, thanks to technology and the lower cost of land purchases, oil producers using fracking can turn a profit even at today’s depressed oil prices.
I’m inclined to agree.
In the short term, it may seem like the Saudis are gaining ground and that fracking isn’t sustainable at current prices.
But we could see a sharp upturn in oil prices as this battle plays out over the course of the next 12 months.
So how should you play this situation?
Well, first, we may see oil prices dip below $70 per barrel. That’s your signal to buy the companies I mentioned above.
Fracking is not dead and has yet to hit its peak, in terms of production. So bet on the big, low-cost producers, as they’ll emerge victorious, while smaller producers will likely get squeezed out of the business.
And “the chase” continues,