Oil and gas drilling: how to harness the extreme volatility*

Oil and gas drilling provides rigs for E&P companies exploiting offshore fields. Their development and subsequent extraction are often cheaper than onshore fields (shale gas and oil or oil sands). We are entering a new bull cycle for the oil and gas industry, and, with a few charts, I will argue my hypothesis.

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Forecasts for the next ten years are that gas and oil production from ultra-deepwater and deep water (UDW and DW) fields will increase significantly.

The following image shows future oil production from the primary sources:

This is due to two factors:

·??????The discovery and consequent depletion of shale fields in the US and Canada were at the heart of the last oil boom in North America. These fields have made the US the world's largest oil producer. Their depletion will open up a large hole in supply that must be filled. UDW/DW is proving to be the optimal solution.

·??????Significant technological advances have made production from UDW/DW fields significantly easier, affecting the ultimate cost of production per barrel. Innovation is at every level, from the equipment used to drill and extract the oil to artificial intelligence analyzing the field's geologic potential. So the breakeven, the minimum spot price of oil that makes the area economically viable to develop, is falling significantly.

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The last point makes a transition to the following chart. It compares the main types of oil fields and their economic parameters.

As you can see, UDW/DW (yellow bars) have several advantages:

·??????Lowest price of extraction, i.e., break-even cost 40 $ per barrel;

·??????Payback period, average payback time of about five years, significantly superior to other fields. The only exception is tight oil;

·??????The average internal rate of return (IRR) of a project is 30%, second among the others;

·??????Average CO2 intensity, average CO2 intensity, is the lowest among all fields.

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CAPEX spending has been increasing over the last year. That is a leading indicator often heralding the growing utilization of oil rigs.

?Utilization rates in the industry were, until recently, at a record low of 45% over the last 25 years. They are now rising steadily to 55%.

The bottom graph shows equipment costs as a percentage of gross profit margin and rig utilization.

Investments are still at deficient levels, which visibly affects utilization.

The following chart illustrates the day rates of an oil rig (Ultra deep water oil rigs). From a low of $180,000 per day in 2018, prices have reached $450,000 per day in recent months. And that figure is far from the previous peak 2007 of $620,000. Moreover, this price is not adjusted for inflation.

In the coming years, we will see a cost per day for UDW in the range of $750-800,000 per day.

These prices result from a lack of oil rigs, which in turn is a consequence of a lack of investment:

Investment in new rigs is at a record low, impacting their supply and day rates long-term. The graph shows something else too. In 2010-2013, there was a peak in investments; the CAPEX cycle was at its peak.

High oil prices have motivated increasing investment in the sector, leading to an ever-increasing supply of oil outstripping demand. The consequences were visible - from 2014 to 2020, we had a bear market.

During this time, many companies that had invested with the thought that oil would only go up went bankrupt. The final nail in their coffin was the Covid 19, the start of which drove oil prices below $0. Many companies were forced to sell assets for cents on the dollar. The few survivors restructured and focused on reducing their liabilities.

The following chart shows what the balance sheets of the major firms in the industry look like as of Q2 2023:

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Debt levels today are significantly lower than in 2019. Transocean is the exception.

The oil rigs deficit is rising due to demand and supply pressures:

·??????Demand will rise due to the increasing economic viability of extracting oil from UDW/DW fields.

·??????Supply - the lack of investment over the last eight years is bearing fruit

A new bull cycle in Oil and Gas drilling industry is one of my investment ideas with the highest conviction, along with the looming uranium deficit and LATAM revival. I expect in the next 12-24 months to see a significant revaluation of the drilling stocks.

* One of the most cyclical businesses is that of oil rigs - shares of companies in the industry reach extreme peaks and lows. And they do so with immense volatility. The CAPEX cycle of oil is between 3-6 years, making investments for more than four years risky. They can turn a 10x gain into a loss in months. Following the above features, investing in oil and drilling companies requires diligent risk controls and active position management.