Let's invert and try to justify the purchase of oil producers. Most exploration & production (E&P) oil companies in the usa have grown due to the development of "tight oil" reserves. These reserves (e.g. e.g. Bakken Shale, Eagle Ford) have become viable due to the development of techniques such as hydraulic fracturing & horizontal drilling. These techniques, which have now become widespread in the United States, have led to thousands of new drilling sites and large increases in production:
Source: http://www.eia.gov/dnav/pet/hist/LeafHandler.ashx?n=PET&s=MCRFPUS2&f=A
Great - looks like the potential revenue is there. However, what about cost? Looking at fast growers such as CLR, we see that growth requires very high capital expenditures. In fact, CLR's free cash flow has been negative for the past four years. As a result, we can say that the growth in CLR has been essentially debt-financed. Now, it is possible that investments in tight oil require large upfront contributions which taper off, but that is not the case for fracturing, where continued production requires continued capex.
Okay, so may be E&Ps as a whole may just be break-even and not make "excess" profits. If crude oil prices rise, couldn't they make more money? In the short term, sure, but how easy is it for others to look for new wells? In short, it takes less than a month from start to production, so barriers to entry is easy for those with capital. Capital in no short supply given high levels debt issuances for energy producers. As a result, competition is high and always waiting in the wings to drive down prices quickly, similarly to gas shale. This is makes investing in E&P's a tough business, at the very least.
This is just the beginning, however. E&P's may do okay with flat to rising oil prices near $100, so what would drive a panic-driven sell-off of both futures & equities? One possible answer, which I'll dig into will be in part 2.
Disclosure: short CLR & other oil E&P company equities
