Of Bull Runs and the Next Hot Shale Plays

During last week’s investor chat, a subscriber asked a very good question: “You seem to favor energy stocks that have had huge moves to the upside, situations where the good news is already well known and factored into the price. Isn’t this approach quite risky?”

Let’s address these concerns one at a time before diving into the particulars of some new energy plays and technologies that may not yet be priced into share prices.

First, a rising stock often reflects the simple truth that the underlying business is doing well, an attribute worth seeking in investments. Stocks can make huge moves in response to favorable long-term trends, and focusing on a numerical percentage from an unsustainably low number may obscure the positives that stand to make those impressive early gains look small by the time the bull market is over.

It’s impossible to know, except in retrospect, how widely a given story is disseminated and to what extent fully reflected in the share price. Our job is to provide intelligent analysis on this score based on the known facts and numbers. And we must judge these not against the extent of the prior run but against the price of a stock, and the available alternatives, today.

We’re in the midst of a four-year bull market that’s just made a powerful run to all-time highs, so no surprise that the stocks of the best-run companies have seen impressive gains. They’re arguably not expensive relative to very modest growth expectations, and were almost certainly unjustifiably mispriced at the recent lows.

Here at The Energy Strategist, we’re looking for trends with legs and stocks with excellent fundamentals. And if we find some that we believe have been punished unfairly we won’t hesitate to recommend them, though we might temper our enthusiasm until the downtrend has clearly run its course.

Today, instead of bottom-fishing beat-up stocks, I want to touch on several new energy plays, technologies and trends that have not yet captured the public imagination and therefore may not be fully reflected in the share prices of related companies.     

One I’ve covered here in the recent past is the growing acceptance of natural gas as a transportation fuel. I believe oil prices are going to be high for the rest of this decade, but that natural gas prices will be moderate. So there is money to be made from an oil/natural gas price ratio that I expect will be higher than the historical norm. Companies that facilitate a shift to natural gas-based transport have the potential to profit enormously if my hypothesis is correct.

One we’ve recommended already is Aggressive Portfolio holding Westport Innovations (NASDAQ: WPRT). Energy infrastructure builder Chicago Bridge & Iron (NYSE: CBI), profiled elsewhere in this issue, would be another beneficiary.

Another major trend transforming the energy industry is the development of continental US shale plays. As we all know, oil production has been increasing in the US, primarily driven by expanding tight oil production from the Bakken Shale Formation in North Dakota and the Eagle Ford Shale in Texas. Natural gas production has surged as well, with major contributions from the Barnett, Haynesville and Marcellus shales.

The operators in the Bakken and Eagle Ford are such familiar names as EOG Resources (NYSE: EOG), Continental Resources (NYSE:CLR) and Anadarko Petroleum (NYSE: APC). Major operators in the shale gas fields include Chesapeake Energy (NYSE: CHK) and Cabot Oil & Gas (NYSE: COG).

The booms in these formations have been underway for five years. Oil production in the Eagle Ford Shale has grown from 352 barrels per day in 2008 to 363,000 bbl/day in 2012. Gas production in the Marcellus Shale grew from 2 billion cubic feet in 2008 to 2.3 trillion cubic feet in 2012.

There will be enormous potential as the shale revolution starts to unfold in other countries, but there are still shale plays in the US that are largely undeveloped. Let’s look at two.

Two Up and Coming Shale Plays

Many industry experts believe that the Niobrara Shale located mostly in Colorado could be the next Bakken. The play is in an early state of development relative to the Bakken and Eagle Ford. Still, since 2008 oil production in Colorado has risen by an impressive 63 percent to a 50-year high. That growth has been driven largely by production from the Niobrara. While this trails the near quadrupling of oil production in North Dakota and the thousand-fold increase in oil production in the Eagle Ford formation over the past five years, it represents the strongest oil production growth over the past five years of any Rocky Mountain state.

Anadarko and Noble Energy (NYSE: NBL) are already two of the most active companies in the formation. Noble estimates its Niobrara reserves at 2.1 billion barrels of oil equivalent. Anadarko estimates are 1.5 billion barrels of oil equivalents in the formation. Both of these companies have announced that they will spend at least $1 billion this year to develop these reserves.  Other active operators in the formation of potential interest to subscribers include Chesapeake, EOG and Whiting Petroleum (NYSE: WLL).

The Monterey Shale in California is at an even earlier stage of development than the Niobrara. However, the US Energy Information Agency (EIA) has estimated that 15 billion barrels of oil can be recovered from the Monterey using current technology. This is more than double the US government estimates of Bakken and Eagle Ford reserves combined.

The oil in the Monterey is more difficult to produce than that in the Bakken, for reasons political as well as geological. California’s environmental lobby is very strong, and is already gearing up to fight fracking in the state.

But California isn’t quite as anti-oil as many people presume. While the state’s oil production has been in decline for nearly 30 years, California is still a major oil producer. In 2012 it was the third-largest producer in the US, trailing only Texas and North Dakota, but coming in ahead of Alaska.

While some have suggested that a Monterey Shale oil boom could solve California’s budget crisis, opinions are mixed on the potential of this play. California-based Chevron (NYSE: CVX), for instance, has been skeptical about the Monterey because “we have not been encouraged by the results of the wells we have drilled into the formation.”

But some companies are more optimistic. Growth portfolio holding Occidental Petroleum (NYSE: OXY) is the biggest player in the formation, and has developed a deep acid injection technology that is an alternative to fracking. Should that approach prove successful, Occidental will be in the driver’s seat in the Monterey Shale.

Other publicly traded companies with interests in the Monterey include Berry Petroleum (NYSE: BRY), National Fuel and Gas (NYSE: NFG), and Plains Exploration & Production (NYSE: PXP).     

California’s budget problems will make development of this formation a very attractive revenue target for the state government, and the technology is improving every day. I expect a full-blown shale oil boom in California by the end of the decade.   

One Preposition Makes All the Difference

While oil from shale has been a huge moneymaker, beware a distant cousin known as shale oil. While oil that is produced from shale formations is often called that, the more accurate term is tight oil. Tight oil formations contain oil, but the formations are composed of shale, which is of low porosity. Horizontal drilling combined with hydraulic fracturing has opened up tight oil formations to commercial production. Even though the oil in the Bakken and Eagle Ford is being extracted from shale formations, the term shale oil has been used for more than 100 years to refer to something entirely different — something investors should avoid.  

If you hear talk of trillions of barrels of US oil resources, this most likely refers to the oil shale in the Green River Formation in Colorado, Utah, and Wyoming. Some have assumed that since shale oil formations have been developed in North Dakota and Texas, the Green River Formation and its roughly 2 trillion barrels of oil resources will be developed next. But this is a very different resource.

The oil in the Bakken Formation is a liquid — it just doesn’t flow very well. The oil shale in the Green River looks like rock. Unlike the hydrocarbons in the tight oil formations, the oil shale (kerogen) consists of very heavy ydrocarbons that are solid. In this way, oil shale resembles coal more than oil.

Oil shale is essentially oil that Mother Nature did not finish cooking, and thus to convert it into oil, heat has to be added. The energy requirements — plus the fact that oil shale production requires a lot of water in a very dry environment — have kept oil shale commercialization out of reach for the last century.

The surge in tight oil production from shale shows that new technologies can convert formerly uneconomical resources into valuable reserves, so it isn’t out of the realm of possibility that this could also prove the case with kerogen. Companies have worked to commercialize the production of oil from kerogen for many years. For example, Shell has conducted experiments in the Piceance Creek Basin in Colorado for more than a decade.

Nevertheless, I view the near-term potential of the commercialization of kerogen-to-oil processes as very low, and I would recommend avoiding companies heavily involved in this space.

Oil Sands in the US?

Mention oil sands production to someone, and the immediate association is with the Athabasca oil sands in Alberta, Canada. But there are oil sands in the US as well, and a small Canadian company called US Oil Sands (CVE: USO) plans to exploit them via bitumen leases covering 32,000 acres of land in Utah’s Uinta Basin. The company received a groundwater discharge permit in 2008, and a large mine permit for the development in 2009. But in 2011 U.S. Oil Sands requested a change to the permit and legal challenges ensued on the basis of potential groundwater contamination. That challenge was recently turned down by a judge in Utah who found in favor of the company.

US Oil Sands claims to have a unique extraction process that does not require high water usage and does away with the notoriously polluted tailings ponds. The process is based on a biological-based solvent that is used to extract the hydrocarbons.

I can’t speak to the company’s claims regarding its technology, and so can offer no informed opinion on its prospects. Suffice it to say it has a penny stock listed on the small-fry TSX Venture Exchange in Toronto, and a $37 million market capitalization. I expect the company will continue to face opposition, and it presently don’t have the financing to complete the mine.

Still, I believe this is a development worth watching because the upside of such a technology is tremendous and because commercial oil sands development in the US would set an important precedent.

Stock Talk

George Mateyo

George Mateyo

Berry Petro-thought that it was taken out by LNCO/LINE????

Igor Greenwald

Igor Greenwald

Yes, Berry is merging with Linn Energy, and if that transaction closes as expected by end of June Linn would then own all of Berry’s assets.

Geoffrey Brown

Geoffrey Brown

What is the best stock in shale oil in the USA?? The stock likely to
appreciate the most over next 2 years??

Gary Leonardo

Gary Leonardo

What are your favorite refiners?

Robert Rapier

Robert Rapier

I like Valero quite a bit, and of course we have MPC in the portfolio. I also own legacy shares of PSX from when I worked for ConocoPhillips, and they have performed well.

Robert Greenwa.d

Robert Greenwa.d

How do you liike Conoco Phillips for covered option calls. I also am looking at Exxon, GE and VZ

Robert Greenwa.d

Robert Greenwa.d

Is SDRL still a long term buy and will the dividend stay as of last Dec.

Igor Greenwald

Igor Greenwald

Thanks for reading, Robert. I’m not a frequent options trader, so can’t really comment on calls. On Seadrill, we continue to recommend it and expect no changes in dividend policy in the near term. I did a recent portfolio update on SDRL here: http://www.energystrategist.com/energy-strategist/articles/17458/game-over-for-opec/

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