Compelling Dynamics

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.