I'd never say "forget about the price of oil" when you're thinking about buying oil and natural-gas stocks. The price of oil is the tide that lifts all boats -- or leaves them stuck in the muck.
But, increasingly, the difference between a good oil and natural-gas stock and a bad one isn't the price of oil or even how much oil or gas the company has on paper or in the ground.
The "decider" these days is cost: the amount of capital the company has to spend to explore, discover and develop oil and natural gas.
Costs have become so critical that one oil and natural-gas producer, Devon Energy (DVN, news, msgs), recently announced it would sell off its very promising Gulf of Mexico and international oil reserves in order to concentrate on expanding its onshore natural-gas production in the United States.
The vast majority of Wall Street analysts cheered the move, even though natural gas seems stuck below $5 per million British thermal units (Btu) and doesn't look likely to go higher anytime soon. The International Energy Agency recently projected a global natural-gas glut that would persist through 2015.
On Nov. 23, the December contract for natural gas closed at $4.45 per million Btu. At that price, many, and perhaps most, natural-gas producers aren't breaking even. A back-of-the-envelope calculation says it requires a commodity market price of at least $5.25 per million Btu to break even.
So why would Devon Energy, with a reputation as one of the sharpest pencils in the box, decide to focus on a depressed natural-gas market with dismal long-term prospects, and in which almost no one is making money? And why would Wall Street cheer?
Costs.
If you understand the Devon Energy move, you'll understand what is driving energy company profits these days and understand how to tell a promising oil and gas stock from an also-ran. After I've sketched out the logic of costs for you, I'll run through how a few of the big international oil companies stack up.
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Crude calculations
Here's what Devon Energy announced it was going to do.The company plans to sell its Gulf of Mexico offshore assets. These consist of about 1.5 million acres. Most of that (87%) is undeveloped, but Devon's acreage includes some of the most promising recent deep-water discoveries in the Gulf of Mexico. The company has one of the largest deep-water inventories in the gulf, and Devon Energy and its partners have done enough exploratory drilling to project the existence of sizable recoverable reserves. Chevron (CVX, news, msgs), one of Devon's partners, projects that the St. Malo and Jack drilling blocks, for example, hold 500 million barrels of recoverable reserves.
The company is also selling off 9 million acres, again mostly undeveloped, in Azerbaijan, Russia, Brazil and China.
What's the matter with these assets? They'll cost a whole lot to explore fully and then develop. Especially in comparison to their contribution to the company's overall production.
The Gulf of Mexico and international assets combined equal just 7% of the company's proven reserves of 2.8 billion barrels of oil equivalent. In 2009, they'll contribute just 11% to the company's estimated 248 million barrels of production.
And yet the company's capital budget shows that the Gulf of Mexico and international assets will eat 29%, or $1.2 billion, of the company's $4.1 billion annual capital spending.
Video: Is a sell-off in crude oil ahead?
The cost picture for these assets gets even worse if you look at how long it takes for production from these assets to pay back that capital investment. Investments in developing deep-water or overseas fields can take five years before they generate significant cash flow. That means Devon would have to go out into the capital markets to raise cash to invest in developing these assets and then pay interest for five or more years waiting for cash flow from these fields to come in the door.
None of this would matter a whole lot if Devon Energy didn't have an investment opportunity that required less investment, that took less time to pay back or that, because of its quick payback, could largely be funded from internal cash flow.
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