This Might Be The World’s Lowest-Cost Oil

Quick, what do the following three events from last week have in common?

1)    Shell warning on lower-than-expected profits for the past quarter

2)    India raising its domestic natural gas price to $8 per mmbtu

3)    Malaysia bringing online one of its newest offshore oil fields

Any guesses? The answer, as it turns out, comes down to one single word—which might be the most important issue facing the entire energy industry today. As well as the biggest opportunity for foresighted companies in the sector right now.

Costs.

It’s simply getting very expensive to operate in the oil and gas business.

Just ask Shell shareholders.

They watched their holdings in the petro-major plunge 4% in a single day last week. After the company issued a warning that its fourth quarter financials would be “significantly lower than recent levels of profitability.”

Why the fall in profits? Shell cited a number of factors—disruptions in Nigeria, maintenance work, and falls in currencies like the Australian dollar.

But there was one cause the company said was chiefly responsible for the underperformance. Higher exploration costs.

This isn’t a new story. Rising rates for drilling rigs, parts and services have been pinching corporate profits across the E&P sector of late. Ernst & Young recently warned that such increased expenses are one of the biggest challenges facing the oil and gas industry—with margins having contracted significantly over the past two years.

The numbers from individual oil firms confirm that profits are slipping. Even amongst the best companies in the business. An outfit like Occidental Petroleum (NYSE: OXY) is one of the most savvy drillers on the planet. And yet saw its return on invested capital plunge to just 20% in 2012, after running over 300% during the previous three years. We’ll see soon what the 2013 figures looked like.

Governments Not Immune to Costs

It’s not just corporate players that are feeling this impact. Governments are also starting to feel the bite of higher costs and lower profitability.

That’s the main driver behind a high-profile legislative move we saw in India last week. With the nation’s petroleum regulators doubling the domestic natural gas price, to $8 per mmbtu.

That’s a big jump. And is actually the second such doubling of the natgas price in as many years.

The interesting thing is that India’s new $8 gas rate is being echoed in other parts of the world. Argentina also recently boosted its domestic prices to near this level—at $7.50 per mmbtu—to spur needed exploration and development activity in the country.

This global jump in prices is striking. Given that a few years ago, $4 was generally considered a very decent price—one where the majority of producers could make good profits.

But based on events like India’s price hike, it appears we’ve blown through that level. With gas developers now needing significantly higher price levels in order to keep natgas flowing.

This of course makes perfect sense amid all the news about higher costs across the business. If drilling and services rates are spiking, it’s no surprise that producer profits are tight under the old pricing regimes. We’ve entered a new world order of energy—one where $8-ish is the new price needed to insulate producers against rises in their underlying cost structure.

This is worrying, to say the least.

In the commodities business, rampant cost inflation is often the precursor to stalled growth—and an eventual crash in a sector. We saw this move in the mining business over the last few years: costs blew up (for example, driving the construction price tag for Barrick Gold’s Pascua Lama mine in Chile from $3 billion to over $8 billion in a matter of months), corporate profits fell, and share prices eventually collapsed.

News like Shell’s recent profit warning seems an eerie echo. The oil and gas sector is admittedly orders of magnitude larger than the mining business—and so can absorb more capital inflows without burning out. But there comes a point when inflation catches up even here. And we may be getting close.

Beat Costs With These Unusual Asian Contracts

What should investors do then? Is the energy business a complete write-off as we wait for Armageddon to fall?

Not necessarily. As least, not everywhere.

One bright point on the cost front came last week from Malaysia. Where state oil firm Petronas announced it has brought on first oil from its offshore KBM cluster of fields.

That’s significant. Because KBM is no ordinary project.

These fields are some of the first in Malaysia (and indeed, in the world) to be developed under “Risk Service Contracts”, or RSCs.

These unique development agreements may be some of the most attractive globally in today’s rising-cost environment. Because they remove the element of cost from the equation for operating companies.

Unlike more-standard production sharing contracts, operators of RSCs don’t actually own or sell the oil they produce. Instead, they simply service the field—drilling wells and operating field equipment to bring production onstream.

In return, the Malaysian government pays the operating company a fixed fee per barrel of oil produced.

The beauty of this arrangement is there is zero cost exposure for the operator. All costs for drilling, development and maintenance are paid by the government. And margins are not affected one bit by rising operating costs—the operator receives the same per-barrel fee whether the pumping costs run $10 or $100 per barrel.

KBM is one of the first test cases on just how profitable RSC contracts will be for producers—with the project being operated by Houston-based Coastal Energy (TSX: CEN). But it appears this contract structure might be an ideal way for producers to get pro-active with managing their cost exposure.

Beyond this, I’d strongly recommend avoiding any energy investments with the following cost-unfriendly aspects:

•    High land acquisition costs, such as we’re seeing in U.S. unconventional plays like the Marcellus and Bakken.
•    Competitive services markets like deepwater drilling, where prices are being squeezed upward by short supply of specialized rigs and operators.
•    Frontier exploration areas where high costs are the name of the game at the best of times. The Arctic, the Caspian, the Falklands—you don’t want to be heaping on more exploration costs when things are already getting tight.

I continue to believe there is still good upside in cheap, basic plays. Such as shallow-water development in the U.S. Gulf Mexico and increasingly in places like the North Sea. By using affordable, established technology like jack-up rigs, developers can keep things affordable—and survive the tight times that seem to be the way of the world in today’s petroleum business.