It is a simple formula…when oil prices rise oil companies prosper. This past week the energy sector continued a month long winning streak posting its biggest weekly gain for this year. Given the modest increase in crude a more likely market motivator is geopolitical risk. Several oil producers are at risk including Venezuela where their political climate threatens their 2 million barrels of oil production per day, Mexico looks weak, Azerbaijan production has declined 9% year-on- year and China’s production is declining rapidly. With production capacity threatened and demand increasing the simple result is higher oil prices. The next question is where will the slack in production come from and where do we invest?
The U.S. is poised to take a lead role and exploit their vast reserves via hi-tech shale oil drillers. However, even slightly higher oil prices still remain too low to entice the drilling of fresh wells needed to fill this production gap. The U.S. shale oil and gas industry, which uses expensive drilling methods to extract oil and gas from rock formations, typically rely on debt to expand. This expansion comes with a price typically in higher servicing costs. Analysts say those expenses are capitalized or spread out over the life of the asset. However, by doing so makes it difficult to create sizable returns to investors as companies constantly reinvest in new wells to replace cash flow from depleted ones. This should prompt investors to take a more serious look at big oil accounting.