People tend to think of California as a bit “hippy-like” when it comes energy. It’s no secret that the state is hotbed of renewable energy, green technologies, and a favorite stomping ground for solar stocks like SolarCity (SCTY).
But the truth is California has a long history of pumping out old-fashioned hydrocarbon. And the hope is that the state can once again become a serious contender in terms of growing U.S. production. Plans are in the works to begin fracking in California’s various shale fields and off its coast.
However, there is a potentially big issue that was exacerbated by the recent weather problems in the state. This issue could throw a huge wrench into California’s plans to regain its energy mojo and could spell trouble for the firms planning on tapping that potential — especially Occidental Petroleum (OXY).
The vast Monterey shale is being seen as the solution to helping California once again regain its crown as the leading energy producer in the United States. The field — which is roughly the size of Delaware — is estimated to be twice as big in terms of reserves as both the Eagle Ford and Bakken.
According to analysts at IHS CERA, the Monterey holds more than 400 billion barrels of oil. That’s enough to meet the United States’ complete energy needs for the next 57 years. Meanwhile, the Santa Barbara Channel is once again seeing activity. That’s a big deal as new oil leases in the region have been prohibited since the 1980s.
All of these recent moves are designed to help California reclaim its former status as the nation’s biggest oil producer. Oil production in state peaked back in 1985 at roughly 1.2 million barrels per day. In practice, fracking should be the state’s savior in terms of rising productions and potential tax and royalty receipts.
In particular, that’s big news for OXY stock.
The firm is California’s largest producers of oil — around 154,000 barrels per day — and is the largest stake-holder in the Monterey with 1.2 million acres. In fact, OXY so confident in its California operations that it recently made plans to split itself in two distinct firms.
The OXY stock spinoff will be an independent E&P firm solely focusing on its vast California operations. OXY expects that business will generate about $1 billion in free cash flow this year and be worth around $19 billion.
Naturally, investors cheered the potential split and shares of OXY stock have surged over the last few months.
A Major “Liquidity Issue”
However, there is a big “liquidity” issue to contend with.
In order to frack a well, you need water. Lots and lots of water. Top natural gas producer Chesapeake (CHK) estimates that it takes, on average, 4.5 million gallons of water to drill and frack a single horizontal well using traditional fracking processes. That amount can reach nearly 13 million gallons in places like the Eagle Ford and Bakken.
With its complex geology — it’s folded similar to an accordion, creating more shale “layers”– the Monterey is estimated to be on the high side of those water requirements for fracking. The problem is that California is essentially a desert. The state basically pumps in all of its required water needs from various out-of-state aquifers and reserves.
Those aquifers and man-made lakes have been running dry as of late. California experienced a record dry year during 2013 that continued the low rainfall trend from the previous year. Gov. Jerry Brown was quoted as saying this is “perhaps the worst drought that California has ever seen since records (began) about 100 years ago.”
The issue is made worse by the fact that the majority of our fresh produce here in the U.S. is actually grown in California. The drought has left many areas fallow, and the California Department of Water Resources said it would halt distribution of state supplies this year to nearly a million acres of agricultural land for the first time ever.
Basically, there may not be enough water to split between rising energy production and growing tomatoes, lettuce or other crops in the state.
A Huge Problem for OXY Stock
Investors may not be fully taking into account the water requirements for fracking and California’s penchant for environmentalism. Already, many producers have struggled to find a foothold in the high cost Monterey. Add in the potential higher costs for water or perhaps the complete ban of its use in the state for energy activities, and that spin-off becomes a lot less attractive.
If you think people are fanatical about the TransCanada’s (TRP) Keystone XL pipeline, try jacking up everyone’s weekly grocery bill by about $100 and then telling them it’s because an oil company like OXY stock is using that water.
There are plenty of reasons to believe that Californians would take to the streets and protest. The previous mentioned Santa Barbara Channel drilling ban was due to a spill that happened in the 1960’s. Already, lawsuits have been planned in order to prevent its reopening as well as the fracking plans in the Monterey.
Keep in mind this isn’t a generally energy-friendly populace. There’s a good chance these lawsuits might actually work in Cali, which could be devastating for OXY stock.
While Occidental isn’t a bad firm — and OXY stock isn’t a bad investment otherwise — the effects of the California drought are beginning to work through the system. It’s a risk that no one is considering.
But the California drought is something investors must think about when buying OXY stock to cash in on the spin-off.
As of this writing, Aaron Levitt did not hold a position in any of the aforementioned securities.