From the April 2012 issue of Research Magazine • Subscribe!

March 26, 2012

Compelling Dynamics

Experts point to shifts in the oil and gas industry that are altering the exploration and production landscape, while providing investors with attractive long-term opportunities.

Technological innovation has played a prime role in America’s economic success, and current developments in oil and natural gas drilling techniques are no exception. Beyond the enormous production boom they have created for the energy industry, experts say, the developments provide far-reaching ways for the country to solve some of its most-pressing economic concerns.

“The growth in production has caused the United States to become arguably the low-cost supplier of energy globally. We’re now growing oil and natural gas faster than just about any country in the world,” says John Dowd, a research analyst with Boston-based Fidelity Investments, in an interview. “We’re seeing massive amounts of job creation in the industry. It’s a boon for America. And, yes, there are some amazing investment opportunities.”

From 2008 through 2011, the United States recorded the single-biggest increase in the global oil supply. What was responsible for the turnaround, which followed a 30-year decline? The new drilling techniques, industry experts note.

As a result, America has become less dependent on foreign oil. Imports dropped from 60% in 2005 to 47% now, thereby shrinking OPEC’s importance while reducing the U.S. trade deficit.

“There are a few compelling dynamics underway in the energy sector that have the potential to significantly alter the landscape and provide attractive opportunities for long-term investment,” explains Dowd in a recent report.

 Key Producers, Production Methods

Leading the way in the production renaissance are America’s small and independent oil and natural gas exploration and production (E&P) companies. They produce 68% of the country’s oil and 82% of its natural gas. With energy stocks poised for gains this year, investing opportunities abound.

At the heart of the production advances are two techniques: horizontal drilling, in which the drill bit curves and becomes horizontal underground, and hydraulic fracturing (fracking), a process that breaks up rock formations with chemicals and water pressure. These techniques allow E&Ps to recover oil and natural gas in places that were previously inaccessible or too expensive to capture — most notably, shale rock. This, in turn, has meant decreased costs for E&P firms and a production bonanza in crude oil and natural gas.

“The industry has been able to crack the code of drilling unconventional oil fields,” says Pavel Molchanov, energy analyst with Raymond James & Associates in Houston, in an interview. “Between 2008 and 2011, the country that provided the biggest contribution to increased global oil supplies was the United States. Its oil supply should continue to increase” well into the future, he adds.

Some domestic E&P companies responsible for this mega-trend include Denbury Resources (DNR), Hess Corp. (HES), Marathon Oil Company (MRO) and Whiting Petroleum Corp. (WLL), Molchanov says. “We generally think that now is a good time to invest in these companies,” the analyst explains. “They are on the cusp of a multi-year up-cycle in North American oil production growth.”

Other analysts, such as Brian Youngberg of St. Louis-based Edward Jones, also stress that now is an opportune time to consider investing in energy. Since the sector underperformed the broader market last year, “many stocks are quite attractively priced” and below their historical averages, Youngberg notes.

There are also analysts, such as Jason Stevens, associate director of equity research for Morningstar in Chicago, who look for opportunities to “build positions in quality exploration and production firms with large drilling inventories and low-cost production,” according to “Energy Outlook for 2012,” a report he authored in December 2011. Some of “the deepest values,” Stevens shares, are “among our U.S. E&Ps,” including Ultra Petroleum Corp. (UPL), a producer of natural gas.

“There is a credible scenario that by 2020, the United States together with Canada will be essentially oil-independent,” Molchanov says. “We’re already importing a third less than in 2005.”

 Unconventional Growth

The technology for recovering unconventional oil and gas has put America at the forefront of oil shale development worldwide. Some analysts estimate that there are trillions of barrels of potential North American oil shale resources — far more than OPEC’s Saudi Arabia claims to have.

Unconventional drilling techniques have made possible the spectacular oil recovery in the Bakken area in North Dakota. About 510,000 barrels a day are produced there; and within five years, daily volume is forecast to rise to one million.

“The growth opportunities are significant for companies involved in the Bakken [area],” notes Daniel Pratt, director of E&P coverage for the research firm IHS Herold in Norwalk, Conn., in an interview.

Eagle Ford in South Texas is another major play, or area, of vast oil shale resources. The next hot oil shale, analysts say, is Utica in Eastern Ohio; and companies are preparing to ramp up activity there. “This is going to be a key play going forward,” Pratt points out. “The talk is that it looks like it could be the next Eagle Ford — if not better.”

Moreover, as a result of unconventional production techniques, Colorado has been pegged as a big, new oil frontier. The state isn’t altogether new to oil reserves, of course; but now its tight oil — inaccessible before — is thought to be recoverable.

 Oil Prices

The key driver of most energy stocks is the price of crude oil, and some analysts foresee prices remaining strong throughout 2012, increasing 10%-15% and higher from their 2011 Brent average of $95 per barrel. In late February, oil rose to a 10-month high to top $125 a barrel.

“We see global crude oil prices generally trading in the $80 to $120 range as far as the eye can see,” says Molchanov. “Day to day, of course, there will still be plenty of volatility. For example, prices are currently higher than supply/demand fundamentals would warrant due to the Iran-related ‘fear premium’.”

He and other Raymond James analysts have “long been bullish on oil prices based largely on the perception that non-OPEC supply has been in the process of flat-lining and that OPEC producers have minimal excess production capacity. We still believe OPEC’s excess capacity is well below the cartel’s official estimates, but our outlook for U.S. oil supply growth has forced us to completely change our tune about non-OPEC supply,” they explain in a recent report.

“Although geopolitical events and potential supply disruptions would provide upside to our oil prices estimates, our global oil supply-demand model is simply too loose to support our current rising oil price deck …,” the report continues. “Thus, we are lowering our 2013 forecast from Brent $110/barrel to $95/barrel. We are also lowering our long-term oil forecast from Brent $125/barrel…to $95/barrel ...”

In the short term, these analysts believe that full-year U.S. crude production will grow 20% by the end of 2012, which puts it seven years ahead of EIA projections.  And, “barring any significant supply interruptions in the Middle East, we think there is more downside to our long-term forecast than upside,” they state.

Oil prices, which have tripled since February 2009, will likely remain volatile this year, other experts say; and this will influence energy stocks, since oil is the main driver for most of their movement. Demand growth for oil is being spurred mainly by developing areas: China, India, Brazil and Southeast Asia. If China’s huge demand continues, “expect oil prices to stay relatively high,” Pratt says.

 Natural Gas Developments

In the natural gas sector, the United States has become the world’s largest natural gas producer since 2009. Some 20% of domestic production entails the extraction of natural gas from shale rock formations. 

Unconventional natural gas is a “game-changer for the future energy supplies of the U.S.,” shares Youngberg, in a December 2011 report. There are “enough recoverable unconventional natural gas resources to serve U.S. demand for roughly a century.” This excludes resources “not yet deemed recoverable or discovered,” he adds.

The largest unconventional gas fields include Marcellus, in the Appalachian Mountains from West Virginia to New York; Haynesville, in Northwest Louisiana and East Texas; and Barnett, in North Texas. Last year, Pratt says, “a few [U.S. E&P] companies with exposure to the Marcellus Shale — such as Cabot Oil & Gas (COG) and Range Resources Corp. (RRC) — did quite well.”

As little as six years ago, conventional wisdom said that America would need to import natural gas. Now, with the development of shale gas fields, that outlook has been turned on its head. In fact, E&P companies have become so good at producing natural gas, there are plans to export it.

Some companies are looking into re-developing import terminals for use in exporting gas in the form of liquefied natural gas (LNG), which requires gas to be frozen and condensed into a liquid to reduce its size for cheaper transport. The first export terminal could be completed by 2016, according to Youngberg.

“Exporting natural gas makes sense,” Pratt shares. “Gas in North America is now [mid-February] at about $2.50 [per thousand cubic feet]. In some areas of the world, it’s priced at $9. So, there is opportunity to export it and get a higher price elsewhere.”

U.S. demand for natural gas in 2011 was up 2%, while production continued to grow at about 6-7% year over year. Prices dipped but have bounced back a bit.

“Exporting should help push prices up, because it will open new markets,” says Youngberg. He expects to see both exports and increased natural gas usage for power generation by the decade’s end.

Shifting Production

Stimulating the modest natural gas price rise earlier this year were announcements by some E&P firms that they were scaling back gas production somewhat to improve the supply/demand situation. The shift emphasizes oil production, with companies drilling for “wet” gas, which contains oil (while “dry” gas does not). Such liquids-rich plays often have a fairly high gas component, as well. Several natural gas producers remain profitable below a $3 price, because most gas they produce is wet, according to Youngberg.

“If companies, such as Goodrich [Petroleum] (GDP) and SM Energy Corp. (SM), which primarily produce more natural gas than oil, focus more on liquids-rich gas at low cost and without leveraging up their balance sheets, they’re going to do pretty well regardless of how low gas prices go,” explains Kevin Cabla, an analyst with Raymond James in Houston, in an interview.

“Even if there’s a deceleration in gas activity, the flip side is that you’ll start to see oil activity accelerate,” Cabla adds. “So net-net, they’re still increasing overall activity in the U.S. [E&Ps] are spending more money and making good money, with 99% of their profits re-deployed back into the ground and the economy.”

This year, natural gas prices are expected to increase to $3 or $3.50. By 2014, they should return to $5 or $6, which analysts consider to be a good price.

Obviously, with a significant rebound in the economy, demand for natural gas should increase. Meanwhile, several companies are set to benefit from unconventional gas production, including EQT Corp. (EQT) and MDU Resources Group (MDU).

Deep Water

Technological breakthroughs are pushing open even more American energy frontiers. One is deep-water natural gas and oil drilling: With improvements in seismic wave techniques, companies can now discover new resources below the ocean floor.

“Many [U.S.] energy producers view deep-water drilling as a relatively untapped frontier that could provide a source of production growth over the next several years and are investing in resources that will allow them to tap into [it],” Dowd writes in a recent energy report.

Apache Corp. (APA), for instance, is testing deep-water drilling in the Gulf of Mexico. Also, McMoRan Exploration Co. (MMR), targeting natural gas, was set to test shallow-water ultra-deep gas exploration in March 2012.

Another valuable new technique is tertiary recovery, an enhancement process that makes the flow of oil easier by injecting liquid carbon dioxide into rock formations. With it, companies can recover 10% more oil. Some domestic E&P firms are already involved in this; others are expected to follow suit.

While the energy industry will likely soon see new regulation relative to fracking, firms may welcome at least some of it. “I believe companies will embrace a lot of the regulation. The industry wants the public to get more comfortable with fracking,” Youngberg says.

The big picture is that, with its unconventional drilling methods, the energy sector is turning “a resource-constrained world,” as Dowd puts it, into one with potential to be energy production-rich. In another positive for the industry, in mid-February of this year, the House of Representatives passed a bill to expand offshore oil drilling and take control of the permit for the Keystone XL oil pipeline — from Canada to the Gulf Coast — away from President Obama, who put the project on hold.

When it comes to investing in the energy sector, as J.P. Morgan analysts note in a recent report: “Global production and trade patterns in oil and natural gas [among other commodities] are undergoing historic changes that will likely not reverse and will offer a number of novel and attractive opportunities.”

Thus, unconventional oil and gas production is emerging as a major advancement that ultimately will affect energy markets, producers and consumer across the globe. Already it is a clarion wake-up call for investors.

“Unconventional production techniques have been great for job creation and wealth creation in energy-producing areas of the U.S.,” Dowd explains. “The E&P companies who have the right technology, management and expertise to successfully execute the strategy of growth and have figured out how to drive their costs down further than their peers will benefit to an extraordinary degree.”

Page 1 of 3
Single page view Reprints Discuss this story
This is where the comments go.