On the Road to Independence

The dream of energy independence for the United States of America is fast becoming a reality. And indeed, the energy sector’s oil-and-natural gas exploration and production companies are unequivocally responsible for this major milestone in the history of our nation, industry experts say.

Using advanced technology—horizontal drilling and hydraulic fracturing—to extract natural gas and oil from non-porous shale rock, the E&Ps have launched a true production renaissance over the past decade.

America is growing unconventional oil and natural gas production faster than any other country in the world, many energy analysts point out. Just how close is our nation to energy independence?

“The U.S. is already natural gas independent,” says Pavel Molchanov, an energy analyst with Raymond James & Associates in Houston. “When it comes to oil, in 2005 the U.S. was importing 65% of our crude oil. In 2012, that number was 46%. So, in just seven years, it dropped by almost 20 percentage points. That’s a very big deal. Our forecast for this year is 39%. We think that by 2020, imports will fall to less than 10%. And that’s not too far away.”

Molchanov is certainly not alone in his forecast for oil independence. “Most of the data that we’ll see over the next two to three years will be consistent with the U.S. moving toward energy independence,” says John Dowd, research analyst and portfolio manager with Fidelity Investments, based in Boston. “So from an investing point of view, the idea of energy independence is going to gain credibility pretty consistently over the next several years.”

In an in-depth February 2013 report, “Energy 2020: Independence Day—Global Ripple Effects of the North American Energy Revolution,” Citigroup analysts declare that “a move over the course of the decade in which the United States is transformed from the largest hydrocarbon producer and exporter in the world to self-sufficiency or close to it and in which North America becomes an exporter is big news and transformational.”

The report explains, “A half-decade from now, combined U.S. and Canadian oil output could be in surplus of projected needs. And over the next five years, demand for natural gas in the U.S. should catch up with supply, opening up unexpected opportunities in transportation and igniting a re-industrialization of the country. The probability of North American energy independence is extremely high, and even the prospects of energy independence for the U.S. alone are real. It provides unexpected opportunities for the country’s foreign and trade policy.”

Solid E&P Outlook 

Not surprisingly, the outlook for E&P stocks in 2013 is positive and upbeat. After lagging the overall market last year, the E&P Index is now up 8% year over year.

“Investors are seeing the E&Ps provide some long-term value, and we’re seeing a big increase this year in some of them,” says Brian Youngberg, a senior energy analyst with Edward Jones, who is based in St. Louis. “Some are already up double-digits. The E&Ps, especially those focused on shale and with good growth prospects, can be very good investments now.”

In general, E&Ps are clearly demonstrating not only increased efficiency at extracting oil and gas but improvement in their business models and cost structures, analysts note. 

“What is new is that the E&Ps are able to deliver significant volume growth and in some cases, figure out ways to do it profitably, and in most cases, figure out ways to reduce their overall cost structure,” Dowd says. “When you fast-forward three to five years, I expect the cost structure to be materially improved and the profitability to be materially higher.”

For the past year, firms have been focusing more on oil production, since oil prices are higher than prices for natural gas. “Firms that produce more oil have greater cash-flow margins than those who do not,” says Jim Dean, vice president of corporate development, Penn Virginia Corp., in Radnor, Penn.

Gas, Shale Growth

In natural gas, the Marcellus area in the Appalachian Mountains from West Virginia to New York has seen the most production growth. The biggest, most successful oil shale areas are the Bakken in North Dakota, the Permian Basin in West Texas and the Eagle Ford in South Texas, which is “the hottest” right now. E&Ps also are ramping up activity in the promising Utica area of Eastern Ohio.

Penn Virginia has been drilling oil wells in the Eagle Ford since 2011.  The wells are about 95% oil and liquids. “With oil prices remaining high since 2011 and low operating costs, the economics of the wells are among the best in the U.S.,” Dean says. The firm has quadrupled its original positions in this play and at the same time “steadily improved [its] financial leverage and liquidity metrics.”

The unconventional drilling techniques, pioneered by a small drilling company in the 1980s in the Barnett shale region of North Texas, are responsible for today’s E&P impressive performance. The technology has been continually refined, and now there is another exciting development. 

Up until recently, companies have been tapping only one layer of oil. Now, in the Permian Basin, they’ve begun drilling into two or three.

“This is brand new,” says Parag Sanghani, a senior analyst with Salient Partners in Houston.  “There is talk that the Eagle Ford has potential for multiple layers, and the Utica looks like it will have at least two to produce from.”

E&Ps have been so successful at producing natural gas—leading in fact to an oversupply—that last year they began focusing more on oil, at the same time, drilling for so-called associated gas, or “wet” gas, which contains oil. (“Dry” does not). These liquids-rich plays have proven to be the right strategy to maximize E&P efforts.

If you visit one of the busiest, most successful shale plays, the upbeat spirit would likely be contagious, industry experts share. At the Eagle Ford, for example, you’d see a multitude of rigs and trucks in motion—a bustling, noisy and industrious scene.

“There is a sense of optimism about what these companies are doing for the county, what they’re doing to help others,” Dowd says. “Most people look at the production growth as something very beneficial for the United States, and there’s a legitimate pride in that. There’s a lot of optimism about the future. They’re excited at what they’re able to do to help U.S. growth. All of this has not been an insignificant contribution to employment in the U.S.”

Stock Selection

Last year, the E&P stocks that performed the best were, generally, the more oil-focused securities. Bright spots this year are likely to be those companies that can live within their means. Analysts say that selectivity is paramount when investing in E&Ps.

“We’re focusing on the E&Ps that can stay disciplined with capital and can fund all or most of their capital spending with internal cash flow instead of having to borrow or issue stock,” Molchanov explains.

For 2013, the biggest driver will be the location of shale plays, says John Freeman, a managing director with Raymond James & Associates, in Houston.  “You will see producers who are drilling in the Eagle Ford realizing better returns than producers drilling in the Bakken or the Niobrara plays. You’ll see some exploration in the Utica, as that play develops—and it could be really big.”

Location is important, Freeman adds, because of the cost of drilling. “The Eagle Ford is highly economical because of the amount of oil and gas that’s produced, its proximity to the marketplace and its interconnectivity in terms of pipelines,” he says. “It’s just more cost-effective to drill in the Eagle Ford today, and as a producer you receive more dollars per barrel there than drilling in the Bakken or the Niobrara.”