Price of Oil – Winners and Losers

I’m sure you’ve noticed prices at the pump have been dropping. This is a good thing for the U.S. since over 65% of our economy is consumer driven. Some estimates say the drop in price will free up about $137 billion this year in money than can be used for investment and purchases. However, as the consumer benefits, the shale oil industry potentially loses.

We have been amazed by the Domestic boom in shale oil as it has increased U.S. oil production by 50% over the past 3 years to a 30 year high. We are now the largest producer of oil in the world. In the past few months however we have seen oil prices drop 28% putting a strain on the shale oil industry as the cost of extracting oil from shale is quite expensive.

Shale wells have a very short shelf life, so new wells must be drilled to keep production flowing. Prices must stay high for well drilling to remain profitable. Lower prices of oil will ultimately reduce supply and hurt profit margins of the drillers.

Drilling new wells has been made possible mostly through raising capital from high yield debt and private equity. Any hiccup in the capital markets will stop the flow of capital. High Yield bond issues from energy companies now represent 16% of the entire high yield debt new issuance. The annual average is 11%, an almost 50% increase. High yield is usually the first shoe to drop in any debt speed bump.

We receive a lot of calls from brokers selling private equity oil and gas partnerships which usually require the investor to tie up their investment for 7 years. For these investments to be profitable, they require the partnership to be able to drill for new wells. For the reasons listed above, you can easily see the huge risks involved. This is another reason why our investments at Parallel are liquid and do not have any lock up periods. Ed Hirs from Hillhouse Resources sums it up best by saying, “There’s a lot of ways to make money in the oil and gas business, and not all of them involve drilling for oil. You just drill investors’ pocketbooks. When investors are willing to throw money at you, you can just make money on that. It’s a time-honored tradition.”

So for now the consumer wins and the shale oil industry loses. However, as with the laws of supply and demand, less wells are drilled going forward, less supply will be available, which could bring prices back up. (Click to Expand)