Rick took at a stance in January that went against many investors’ contrarian instincts. He said to stay away from oil and gas for the time being.

However, Rick has been discussing oil and gas drilling lately in internal broker meetings, as well as conferences.

Does he now think there’s an opportunity in oil and gas?

I met with him about it for Sprott’s Thoughts.

I asked: Should we be looking at oil and gas drilling? What may make it appealing right now?

“Precisely because the oil price has declined, the odds have shifted in investors’ favor,” he replied.

“Over the last eight years, there was more demand for participation in oil and gas drilling than there was supply. The companies had the upper hand over investors.

“Now, capital is once again in shorter supply in the oil and gas business, and so the terms are beginning to favor the investors.

“In terms of participating in drilling, the general choices available are to take a working interest participation or to participate in drilling through a joint venture or a partnership.

“Most of what we’re going to talk about today is in the context of partnerships, which represent about 75% of private capital for drilling.”

So we’re looking to take advantage of a lower supply of capital for oil and gas?

“Correct. For the eight years prior to the recent price decline, the oil and gas industry funded operations from capital they raised in the stock market, money contributed from other companies, from cash flow, and from debt.

“Each of those four sources of capital is much less available now and is much more costly. Yet the need for capital in the industry is serious and is becoming acute.

“This seems to happen about once a decade following an oil price decline and we are in the midst of such a period now. Note, Henry, that a shortage of capital is likely to cause a decrease in drilling activity which ultimately leads to decreases in supply and to higher product prices (market prices for oil and gas).

“It’s ironic that a set of circumstances where the terms for investments are more favorable can also cause a rise in product prices – leading to a potentially ‘virtuous circle’ for investors.”

What detracts you from investing in oil and gas drilling when prices are higher?

“In good times and bad, you need to look at the front-end load of a partnership (expenses that aren’t tied to producing oil and gas). Too often, partnerships are merely a way to drill investors – not oil and gas wells,” Rick reveals.

“I have seen offering memorandums (laying out the terms of investment) where the front-end expenses exceeded 20% of the total capital raise. Only 80% of the money went into the ground, and the rest went into things like partnership organization, lawyers, or broker payouts. That’s just criminal.

“You need to get as much of the money as possible into the ground. I would say that any offering memorandum that involved less than 95% of the capital raised going into the ground is one you should shy away from.

“A second thing you need to look at, in good times and bad, is the structure of the partnership. Too many partnerships are structured on a ‘turn-key’ basis. That means the general partner guarantees that drilling operations will be completed for a certain amount of money.

“This is seductive, but they do this by turning a well that should cost $1 million to the partnership for $1.35 million. They absolutely guarantee that they won’t exceed a cost for the well that’s already 35% above what it should be.

“A well-constructed oil and gas drilling partnership will have between 8 and 12 wells – maybe more – so that overruns on some wells will be offset by more efficient operations on others. When you notice the financial statements of public companies that sponsor drilling funds, you often see that they make most of their money from drilling and service operations and very little from oil and gas production.

“This tells you that the mark-ups for their drilling and production services are above market rates.

“The structure of the partnership needs to reflect accurate provisions for costs of third-party drilling and production service providers. Those should be billed at actual market rates.”

Why do investors accept these kinds of terms? Did it have to do with the high oil prices we had before last year’s price collapse?

“There’s really a whole panoply of drilling partnerships out there. What makes them particularly attractive now in North America is the conjunction of technologies that we’ve talked about before.

“The ability to extract oil and gas from shales, limestones, sandstones, and basic-centric ‘tight’ formations means there is less and less exploration risk in oil and gas drilling. There is more completion and production risk. What makes these drilling participations attractive now compared with 15 years ago is that the rates of production are fairly predictable, at least relative to 15 years ago, when there was more exploration risk involved.

“As a result, if you model out your production costs, your production volume -- which you can do reasonably accurately (within a 15% or so) -- and you model out your product price over five to ten years, the certainty of your financial returns is much greater today than ten or 15 years ago.

“The second thing that’s interesting about drilling now relative to ten or 15 years ago is that, in drilling these horizontal development wells, the payoffs come much sooner. The production profile today is a high initial production, a fast decline, and a very long tail at lower production rates.

“Thanks to the very low absolute failure rate in oil and gas drilling, a highly predicable type-curve, and a fairly rapid recovery of capital, drilling returns to investors are much more predictable than at any other time in my 40-year history in the oil and gas business.

“If you combine that with low availability of capital right now, it becomes potentially very attractive.”

Why do investors, and the shale industry generally, focus almost exclusively on the United States and Canada?

“For my own, and Sprott’s, purposes, we focus on the US and Canada first of all because we know them better than any other jurisdiction. It’s convenient for us that the technology for development drilling in shale basins is focused 95% in the US and Canada.

“This occurs for a variety of reasons, the most important being the preponderance of private ownership of minerals in the United States and Canada.

“In most of the world, minerals are reserved for the governments. The local people that bear the costs of development (like having to live near an oil field) have no particular interest in the revenue from development. As a consequence, there is a lot of local opposition to oil and gas operations. In the United States and Canada, local parties usually participate as landowners, or in other shapes and forms, and so oil and gas is much more popular.

“The second reason is that capital markets in the United States and Canada are much more developed than in other countries. Having 30 or 40 different participants focus on a basin and enhance the technology through the trial and error method is much more effective than having a state oil and gas company, like in many countries. The technology is then imposed from above without market feedback.

“The third reason is that the United States and Canada, relative to the rest of the world, have very mature oil and gas servicing, gathering, processing, and storage infrastructure. So the incremental production from shale assets in mature basins is much more economic to produce than it would be in other basins with less mature servicing, gathering, and processing infrastructure.”

Why weren’t people in the oil and gas sector more aware that the oil price would need to come down, seeing the vast increases in production from shale?

“Well I think we should have been, myself included. I think we should have been aware of the fact that markets work, and that eight or nine years of high product prices do two things: they increase supply and limit demand. When supply increases and demand is limited, obviously prices collapse. The tagline is that ‘markets work – the cure for high prices is high prices.’

“As for me, I missed the decline because, at the same time that US and Canadian production was increasing thanks to new technologies, production was decreasing in some OPEC countries where production was run by national oil companies. I’m speaking about Mexico, Venezuela, Peru, Ecuador, Iran, and Indonesia. My assumption, which turned out to be true, was that the increases in US and Canadian supplies would be offset by decreases in other countries.

“The rub was that the recovery, which many people expected in global economies, including the Chinese economy, didn’t materialize. Production has grown, on a worldwide basis, faster than consumption.

“Despite the fact that US and Canadian production increases were offset by decreases in some OPEC countries, the return to the market of Iraqi crude and increasing levels of Russian production, in the face of low global demand, allowed markets to work.”

Has the US shale industry become the new ‘swing producer’ in the world, replacing Saudi Arabia?

“That’s exactly what happened. Traditionally, the swing producers were the Saudis, increasing and decreasing supply to meet market conditions.

“The Saudis worked very hard in the last ten years to improve their ability to produce oil. They invested $100 billion to maintain and increase their production capabilities. As a result, they no longer wanted to provide a ‘pricing umbrella’ for oil. They didn’t want to reduce their production in order to subsidize less efficient producers, in particular North American shale producers, but also Iranian producers across the Persian Gulf. They obviously have a historic antipathy with Iran.

“We can also assume that they did not want to aid the Russians, who are sometimes antithetical to their interests in their view.

“I think that now, the swing producers will be the United States and Canada. We know that we can increase production by increasing investment. We also know that if investment is constrained – as it will be in the next 2 or 3 years because of low product prices – the production profile of shale operations, with rapid decline rates, will cause production to come down. In periods of high product prices, it’s easy to start up again.

“So, as you suggest, the United States and Canada will emerge as the true swing producers.”

The oil and gas exploration and production industry is less gorged with capital right now. We may be able to find opportunities in oil and gas drilling, according to Rick, as constrained capital markets tend to favor investors.

Rick has promised to do a webinar specifically on oil and gas drilling. Express your interest in a webinar from Rick on this topic by e-mailing me at hbonner@sprottglobal.com. Please include specific questions for Rick.

Generally, natural resources investments are more volatile on a daily basis and have higher headline risk than other sectors as they tend to be more sensitive to economic data, political and regulatory events as well as underlying commodity prices. Natural resource investments are influenced by the price of underlying commodities like oil, gas, metals, coal, etc.; several of which trade on various exchanges and have price fluctuations based on short-term dynamics partly driven by demand/supply and nowadays also by investment flows. Natural resource investments tend to react more sensitively to global events and economic data than other sectors, whether it is a natural disaster like an earthquake, political upheaval in the Middle East or release of employment data in the U.S. Low priced securities can be very risky and may result in the loss of part or all of your investment. Because of significant volatility, large dealer spreads and very limited market liquidity, typically you will not be able to sell a low priced security immediately back to the dealer at the same price it sold the stock to you. In some cases, the stock may fall quickly in value. Investing in foreign markets may entail greater risks than those normally associated with domestic markets, such as political, currency, economic and market risks. You should carefully consider whether trading in low priced and international securities is suitable for you in light of your circumstances and financial resources. Past performance is no guarantee of future returns. Sprott Global, entities that it controls, family, friends, employees, associates, and others may hold positions in the securities it recommends to clients, and may sell the same at any time.