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The greatest challenge to oil stocks that Wall Street isn't talking about

The Motley Fool logo The Motley Fool 7/8/2018 Tyler Crowe

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One of the narratives that is prevalent in the U.S. is that we are awash in shale oil. Producers in places like the Permian Basin are tapping oil sources we once thought were unextractable and are unlocking billions of barrels of oil. The amount of oil American producers have found, and the amount they are pulling out of the ground on a daily basis, have undoubtedly created a tectonic shift in the global market.

One thing that all this shale oil has done, though, is cover up one of the largest concerns that the oil industry will face over the next several years: the sheer lack of investment and lack of new oil discoveries over the past half-decade. Let's look at this issue and what it could mean for investors down the road.

Not exactly the age of discovery

The concept of the oil and gas business is pretty simple. Companies explore for new sources, evaluate the economics of their find, and develop the best opportunities to produce at the best rate of return possible. Those oil reservoirs have a shelf life, though, so producers need to consistently replace that produced oil with new developments and discoveries.

This is never a one-for-one situation, as some years a company will find more or will come up short. A year or two of the latter situation isn't necessarily a bad thing since most producers have large portfolios of prospective assets to tap. If there is a prolonged period without adequate replacements, though, then things could become a little more troublesome.

To make discoveries, a company needs to spend large sums of money on exploration. Over the past several years, though, that hasn't been the case. When oil prices started to fall off a cliff from 2014 to the nadir in early 2016, companies slashed exploration budgets to the bone because they are the easiest costs to cut when times get tough. 

According to research group Rystad Energy, the rate of conventional reservoir discoveries in 2017 was the lowest since the 1940s, at less than 7 billion barrels of oil equivalent. By comparison, that same year, the world consumed approximately 36 billion barrels of oil, according to BP's Statistical Review of World Energy. Now, if this were a one-off situation, then it might not be too much of a concern because producers can draw down their portfolios. Unfortunately, though, conventional discoveries over the past half-decade have come up woefully short of consumption. In fact, Rystad says that the last time total discoveries were greater than consumption was in 2006.

Data source: Rystad Energy. BOE = barrels of oil equivalent. © Chart by author Data source: Rystad Energy. BOE = barrels of oil equivalent.

OK, so there is one corollary to this chart. This only includes conventional discoveries, which means that it doesn't account for all that shale oil we have found or made economically viable. Some optimistic evaluations put total available shale resources in the Permian at 160 billion barrels of oil equivalent (BOE), which would cover up years of discovery deficits.

Also, the Permian isn't the only shale formation. According to the U.S. Energy Information Administration, there are approximately 418 billion barrels of unproven, but theoretically technically recoverable, shale oil resources globally. Proven reserves and unproven, theoretically recoverable oil are two completely differen things. And it will take billions in exploration and assessment expenses to determine the viability of these resources.

What's an investor to do?

From the business side of things, there is pretty much only one way that we can close this discovery deficit: Companies need to spend money on exploration and assessment of new sources. If not, they will have to rely on developing assets that may not have great rates of return, which of course would hurt profit margins. Also, putting off exploration and development now means that much more in spending down the road, which will almost certainly put a dent in rates of return.

There could be some implications for oil prices (more higher-cost sources could mean higher prices), but there are so many factors influencing oil prices at any given moment that it's hard to point to one single factor that could significantly swing that market one way or the other.

Overall, though, it will be important for investors to watch what kind of spending levels companies are dedicating to new sources and replacing existing ones. Companies that are trying to juice their returns today by skimping on exploration could end up paying a heavy price down the road.

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