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Is the Oil Sector Overheating Again?

Reuben Gregg Brewer, The Motley Fool

The oil and gas industry is highly cyclical, with the downturn that started in mid-2014 simply the most recent example of the extremes that take place. But after oil plummeted from more than $100 a barrel to around $30, the energy industry, looked at as a whole, seemed to suggest that it had finally been chastened and would live within its financial means. Only that resolve may not be realistic, with recent results from Pioneer Natural Resources Company (NYSE: PXD)Helmerich & Payne, Inc. (NYSE: HP), and Noble Corporation plc (NYSE: NE) all suggesting that you'll want to start paying close attention to costs again.

A changed industry

The cyclical nature of the energy industry isn't hard to understand. When oil prices are high, companies are willing to fund just about any project because just about any project can turn a profit. But huge investment inevitably leads to huge supply, which swamps demand and leads to falling prices. When prices are low, very few investments get made because low energy prices make it hard to turn a profit on new development. Once the excess supply from the upturn gets absorbed, though, the lack of investment during the downturn leads to a supply/demand imbalance that pushes prices higher again. And the whole cycle repeats.

A man with a notebook standing in front of an oil well

Image source: Getty Images.

The industry pull-back after oil prices started to fall in mid-2014 was severe, particularly in the U.S. onshore market, an increasingly important source of global oil supply. To give you an idea of how big of a drop-off there was, consider this: Helmerich & Payne, a drilling services company, watched its active onshore U.S. rig count decline from a peak of 297 to just 87 in an 18-month span. Clearly, oil companies, which are Helmerich & Payne's customers, pulled back hard and fast.   

In fact, many in the energy industry have declared that their wild spending days are over. For example, industry giant Chevron (NYSE: CVX), which has drilling assets around the world, has cut capital spending by more than 50% since 2014. But more notable is the fact that it doesn't have any plans for a material pick-up in the foreseeable future. It's pegged capital spending at $18 billion to $20 billion through at least 2020.   

The pressure is building

However, there are signs that energy companies may not have a choice but to raise their capital spending plans, and that they may not get much benefit for that added spend. Helmerich & Payne, for example, has seen its active rig count rebound to 189 rigs, and it's expecting drilling rig rates of $23,000 per day in the fiscal third quarter, up from $22,400 in the first quarter and roughly $22,000 in the year-ago period. Rising prices are generally a function of strong demand, which the company's rising active rig count highlights.   

HP Revenue (Quarterly) Chart

HP Revenue (Quarterly) data by YCharts

So, costs are going up, but what about the benefit to customers? This is where the problem lies. For example, Pioneer Natural Resources started 2018 with plans to spend $2.9 billion on capital projects. It recently upped that number to as much as $3.4 billion, based on its intention to expand its drilling activities and the impact of higher costs. At the midpoint of the year, this U.S. onshore driller is expecting to increase production in 2018 by 19% to 24% -- the same goal it had at the start of the year despite the fact that its spending plans have increased by as much as 17%.   

The onshore U.S. market isn't the only place where costs are heading higher. For example, Noble Corporation, a drilling services company that serves the offshore market, saw the average rig rate for its portfolio of rigs jump nearly 10% year over year in the second quarter. The company's earnings release included a positive outlook for contracting opportunities, backed by an expectation for increased customer spending. Once again, increasing demand tends to lead to higher prices.   

Start paying more attention now

It is unlikely that participants in the oil and natural gas industry will suddenly turn into spendthrifts, jacking up production at any cost. So, the industry isn't overheating...yet. However, recent pricing strength at Helmerich & Payne and Noble Corporation suggests that demand for drilling continues to build as oil prices have recovered from their lows. Investors should keep an eye on these costs. They could be a leading indicator of an oil industry that's starting to heat up again. And, at the very least, higher costs are a potential negative for oil company margins.

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Reuben Gregg Brewer has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.