Drilling for Profits: The Bakken Shale

Although the Macondo oil spill and consequent political and regulatory uncertainties have plunged the US offshore drilling industry into chaos, onshore producers have adopted the “Drill, baby, drill” mantra as their own. In fact, the US oil-directed rig count more than doubled in 2010, reaching record highs along the way.

In addition to the disaster in the Gulf of Mexico, the shale gas revolution also has contributed to the surge in onshore oil production. Horizontal drilling and hydraulic fracturing, two innovations that enabled operators to access gas reserves trapped in massive shale deposits, can also be used to extract oil from liquids-rich bedrock.

A horizontal well branches off laterally from an initial vertical drill hole, exposing more of the productive layer to the well.

Fracturing, or stimulation, increases the permeability of the reservoir rock, allowing natural gas to flow from the reserve rock into the well. This process involves pumping large quantities of water and a small percentage of chemicals into the rock formation at high pressure, producing a network of cracks. The inclusion of a proppant–typically sand, sand coated with ceramic material or ceramic material–ensures that these passages remain open.

Depressed natural gas prices and a strong recovery in the value of crude make onshore oil plays an enticing proposition, especially given oil’s long-term fundamentals. In fact, rising activity in oil and natural gas liquids-rich shale should offset weakness in the Haynesville Shale and other dry gas plays. Halliburton (NYSE: HAL) CEO David Lesar indicated as much during the company’s third-quarter conference call:

The shift to oil and liquids-rich plays has been persistent, boosted by stable oil prices. We believe that this shift will continue as evidenced by operator interest in acquiring additional acreage in the oil and condensate basins that have outpaced the dry gas regions.

We anticipate that incremental capital spending will continue to drive increased rig counts in oil, in liquids-rich plays like the Eagle Ford, Niobrara, Granite Wash, Bone Springs and other emerging basins in the Permian Basin over the next year and we are, of course, well positioned in these plays.

Although increased activity in emerging liquids-rich plays enumerated by Lesar should absorb much of the rig capacity, investors shouldn’t overlook North America’s most active and well-established unconventional oil play.

The Bakken Shale occupies the Williston Basin, a vast area centered in North Dakota and Montana. The play also extends into Saskatchewan, though the US portion is generally considered to be more prospective for oil.

Source: Energy Information Administration

The Bakken comprises three layers of shale–an upper, middle and lower Bakken–located at a depth of between 8,000 and 11,000 feet in the play’s most productive areas. Drilling activity targets the Bakken’s middle layer, a naturally fractured shale rock that contains a light, sweet high-quality crude oil.

Some parts of the play include another productive formation, the Three Forks-Sanish. Operators initially characterized the Three Forks as an area where oil that spilled out of the Bakken collected. But drilling results increasingly suggest that the Bakken and Three Forks are actually separate plays; activities in the Three Forks formation don’t sap production from nearby Bakken wells.

The Williston Basin and Bakken Shale aren’t new discoveries–the first wells were drilled back in the 1950s. Technology and techniques were the real discovery.

The simple vertical wells sunk in the 1950s failed to produce oil at high rates. A vertical well travels straight through the Bakken formation, but the only productive part is the 50 to 100 feet of the shaft that touches the middle Bakken. In contrast, a horizontal well drilled along the productive layer exposes thousands of productive feet to the well. In addition, hydraulic fracturing supplements the middle Bakken’s natural fractures, further enhancing productivity

In 2000 Lyco Energy was the first company to drill horizontal wells in the Bakken. Since then, several major producers have ramped up activity to the point that the Bakken has emerged as the leading onshore oil play in the continental US.

Source: Energy Information Administration

This graph tracks crude oil production in Montana and North Dakota from 1981 onward. Output from the Bakken area is expected to have topped 350,000 barrels per day in 2010. Given that these states produce roughly 370,000 barrels per day, the data serves as a good proxy of total production from the Bakken.

Estimates of the basin’s potential production growth vary widely. Conservative estimates put the figure at 500,000 to 750,000 barrels per day over the next five years. Aggressive estimates suggest that the Bakken could yield 1 to 1.5 million barrels per day in a half-decade. Based on recent well results and comments from producers, production should approach the high end of these estimates–assuming oil prices remain strong.

As for recoverable reserves, in 2008 the US Geological Survey (USGS) estimated that the field contained 3.65 billion barrels of oil, 1.85 billion cubic feet of gas and 148 million barrels of NGLs. Investors should note that this estimate fails to reflect the increasingly productive Three Forks-Sanish play. Initially regarded as a gross overestimate, the USGS figure is now regarded as quite conservative. Continental Resources (NYSE: CLR), the leading player in the field, pegs the region’s recoverable reserves at 24 billion barrels.

But don’t get vertigo from these dizzying reserve estimates; what really matters is production, how many barrels of oil per day the play generates. Under the most optimistic assumptions, the region could produce about 1.5 million barrels per day by 2015, a drop in the bucket compared to US oil consumption of 20 million barrels per day.

Don’t believe the hype about the Bakken enabling the US to become energy independent or an oil exporter. That being said, the field is large enough that it will have a meaningful and lasting impact on US oil production growth.

Do believe the hype about the Bakken providing attractive opportunities for investors. Low production costs ensure that, at current oil prices, many producers are generating returns in excess of 100 percent for each well drilled. Most wells pay for themselves in 1.5 to 3 years. The economics become even more attractive in the event of higher oil prices. Companies with attractive acreage positions in the Williston Basin should be able to grow profits significantly in coming years.

These growth prospects explain why the Bakken remains the most active liquids-rich shale play and the rig count increased by roughly 110 percent over the course of 2010. (See graph below.)

Source: Baker Hughes

Integrated oil company Hess Corp’s (NYSE: HES) 2011 capital budget and recent acquisitions in the Bakken underscore the opportunities for producers. Hess hiked its overall capital budget 44 percent from a year ago to $5.62 billion, while US-directed spending will increase substantially to $3 billion. The company will allocate a significant amount of this money to increasing its output in the Bakken; management plans to up the number of rigs it has operating in the region from eight to 15 and expand its support infrastructure.

In the back half of the year, Hess acquired American Oil & Gas and purchased acreage from TRZ energy, boosting its leasehold to more than 750,000 and making the company the second-largest acreage in the Bakken.

Although Hess Corp’s position in the Bakken and exciting plays offshore Brazil and Ghana make it an attractive investment from a production standpoint, the stock is hardly a pure play. For the best returns, investors should focus on some of the smaller names that are de-risking areas outside of the Bakken’s core. Not only is it easier for these companies to grow production meaningfully, but also a slew of expected drilling results should provide plenty of additional upside catalysts.

Elliott Gue recently profiled his favorite small-cap play in the Bakken, a name that trades at an attractive valuation relative to its peers and is poised to outperform in 2011. For details on this pick and other opportunities in the shale oil plays, sign up for a free trial of Elliott’s paid advisory, The Energy Strategist. Click here for more information on this offer.

These fundamentals explain why the Bakken remains the most active liquids-rich shale play and the rig count increased by roughly 110 percent over the course of 2010. Check out the growth in North Dakota’s rig count.