Don't put all your investments in one stock, warns S&A Resource Report Editor Matt Badiali. In this interview with The Energy Report, he shares a basket of companies that are extracting higher margins with ever-evolving shale drilling methods. Find out about his top tenbagger opportunities at home, in the so-called new science and factory shales, as well as his favorites in the far reaches of Kurdistan, where an eventual takeover draft looks likely.
The Energy Report: In a recent Daily Resource Update, you wrote a piece called, "Here's How Russia's Invasion of Crimea Could Benefit Some U.S. Oil Companies," and it wasn't the oil producing companies I assumed from the headline. Tell us, what companies could benefit.
Matt Badiali: The companies that can refine crude oil here in the U.S., put it on ships and send it abroad are the ones benefitting from the spread between Brent crude and cheap domestic West Texas Intermediate prices. I was actually surprised with the results of this research, too. Giant companies like Exxon Mobil Corp. (XOM:NYSE) and Chevron Corp. (CVX:NYSE) had record years for their refining arms.
Refining is a terrible business. It's notorious for single-digit profit margins. The price of oil fluctuates globally, but the price the refiners can sell it for in the U.S. is limited by consumers. Back in 2008, when the price of oil hit $140/barrel ($140/bbl), the price of gasoline increased, but it certainly didn't go up in the same magnitude as the price of oil.
Since exporting raw crude from the U.S. is illegal, refined product is leaving the country at record levels. The Energy Information Administration (EIA) has tracked export data since the early 1980s. We are orders of magnitude higher today in export volume than we have ever been. It's going to Mexico, it's going to Canada, it's going to South America, it's going to Asia. We're putting it on ships in Houston and sending it everywhere. These refiners are making a ton of money.
TER: Also, didn't the U.S., for the first time in a long time, sell crude oil from the strategic reserve as a way to punish Russia?
MB: That was a warning shot. Russia's economy is based on energy sales. It sells natural gas and oil to Europe and it is starting to develop a bigger sales arm to China. If you can undercut Russia's oil price with higher-quality crude oil, then it really hurts Russia economically. That's what broke the U.S.S.R. in 1991. Back then it took Saudi Arabian involvement. This recent strategic reserve sale increased the supply on the market, thereby lowering the price, which threatened Russia and made refiners at home even more profitable.
TER: Do the actions in Ukraine have an impact on European oil and gas companies?
MB: There is a fear premium built into Brent crude, and producers like the Italian oil company, Eni S.p.A. (E:NYSE) will benefit from that. However, Europe's refineries, which are paying the significantly higher price of Brent, are losing their profit margins. That is why companies like BP Plc (BP:NYSE; BP:LSE),Royal Dutch Shell Plc (RDS.A:NYSE; RDS.B:NYSE) and Total S.A. (TOT:NYSE) are shedding European refineries.
Total is in big trouble with a couple of refineries in France. Repsol-YPF S.A. (REPYY:OTCPK), the big Spanish oil company, has invested billions of dollars in retrofitting older refineries and it's making about $1/bbl. It will take a long time to pay off that investment at that rate. So it's kind of a mixed bag right now.
TER: Back in the U.S., we're coming off one of the coldest winters most people in the Northeast can remember. Is demand for natural gas going to bring the price back up long term or is $6 per thousand cubic feet (Mcf) a temporary blip?
MB: It is a temporary blip. The price spike is due to a transportation problem. We just don't have the right plumbing in place. There are not enough pipes to get the natural gas to the Northeast. And we did have a record drawdown of natural gas from storage. But there is too much natural gas for the prices to stay high.
If the natural gas price held at $6/Mcf, supply would skyrocket as well. There would be a mass mobilization of drill rigs into places like the Fayetteville Shale, the Haynesville Shale, the Barnett Shale and the western part of the Eagle Ford Shale. It would be like printing money at those prices, but at $4.50/Mcf that natural gas isn't economic. There is an enormous amount of natural gas waiting to be tapped.
TER: What is your estimate for the price of natural gas for the rest of 2014?
MB: I've seen some pretty smart people putting their estimates around $4–4.25/Mcf for the average for this year, maybe a little higher because of that $6 hit we took early. But I suspect that you're going to see prices fall substantially into the summer.
Natural gas and coal are competitors because of electricity. Energy breaks down to fuel energy—which is usually oil—and power plant fuel, the stuff that powers our electrical grid—that means coal and natural gas. When natural gas was really cheap, around $2/Mcf, many power plants switched to natural gas.
The new Environmental Protection Agency (EPA) pollution controls on coal plants also sped up decommissioning of old coal power plants. That decrease in demand drove the coal price down. Then when natural gas prices rose again, the plants that could switch, went back to coal. It is a delicate dance between supply and demand for these two fuels.
TER: The shale plays you mentioned earlier are not all producing the same thing. Some are oilier than others, some more advanced. How does an investor gain exposure to projects in the Bakken and Eagle Ford differently than the new science shales in the Tuscaloosa, Utica, New Albany or Cline?
MB: When George Mitchell first started experimenting with cracking shale in Fort Worth Texas, the target was natural gas. At that time, natural gas prices had spiked to more than $14/Mcf. The thin layers of shale rock he was observing weren't thick enough to hold a conventional well. He started exploring methods for drilling horizontally and opening up those rocks.
Fast-forward over 20 years and we know a whole lot more about shale and how to make it produce.
Each shale requires a slightly different approach depending on the geology. This is the science stage of shale fracking. The Bakken Shale up in North Dakota is well past that stage. Companies like Continental Resources Inc. (CLR:NYSE) went through the science part of that shale in the mid-2000s. Today there are some really interesting new shales, including the Tuscaloosa Marine Shale in Louisiana, the Cline in West Texas and the Utica in Ohio. They are all in the science stage.
Once operators understand how deep and in what direction to put the wells for the best yields, they go into the development stage. This stage is all about making the best well at the cheapest cost. They experiment with fracking. Back in the 1990s, they might have divided the well into two stages. Now drillers do 30 or more stages.
As the operators figure these techniques out, production rises. This is when you see a massive increase in production. The Eagle Ford is just finishing up the development stage. It is moving into the factory stage.
During the factory stage, companies drill three, four, five wells from the same location, going out like bird feet. Or they drill them in parallel. Shale wells can be drilled very close together (called downspacing) by this point. That's where the Bakken is now. The Bakken is an oil and gas factory. You're seeing dramatic increases year after year in oil and gas production in North Dakota.
TER: Are the improvements in the development stage and increasing the number of frack stages helping with the decline rate problem?
MB: Absolutely. The decline rate in an oil well is a natural progression. A conventional oil well in sandstone is like a 2-liter bottle of soda. When you shake it and poke a hole in the side of it, cola or, in this case, oil gushes out because of the natural pressure in the rock. As that pressure declines, the production of the well does too. That's decline rate.
In shale wells, the decline rate is much steeper than in conventional oil wells. Analysts that don't understand shale use that data to predict a bad end for the shale revolution. However, that's wrong. And the reason is that the decline rate of a single well doesn't matter. . .it's the number of wells we can drill in shale that matters.
Let me explain the difference: Conventional oil fields are geologic anomalies. That's why it was getting harder and harder to find them. A conventional oil field is made up of three things. You have to have a source, which is the shale.
You have to have the reservoir rock. It has to have something like sand grains in it to hold the thing open with lots of space to allow the oil and gas to get in there. That is called permeability and porosity. That's what allows you to put a well in and suck the liquid out.
Then you have to have a seal, something on top to keep the oil and gas trapped. A good example would be throwing a handful of Dixie cups in the air. The ones that land open side down are conventional oil fields. These perfect situations aren't common. Giant ones are incredibly rare.
On the other hand, shale is like the carpet under the cups. It is the source rock, so it is full of oil and gas already. It covers an enormous area, much larger than the area of the conventional oil fields. That's what's so critical. The volume of oil and gas in shale is much larger than in the conventional fields.
That's why individual well results don't matter. Because the amount of oil available in shale is an order of magnitude larger than what was trapped in the conventional oil fields. And we're just starting to crack these rocks.
The Eagle Ford Shale was the source of oil for the largest oil field in the lower 48, and it still has billions of barrels of oil in it. That's what's exciting. Most investors just don't realize how gigantic shale fields are. We're just getting good at making them produce oil right now.
When shales get to the factory stage, companies maximize the amount of oil and gas coming out of the ground and minimize the cost to do it. I'm a huge fan of this.
TER: Is there still money to be made in the Bakken and the Eagle Ford?
MB: There's absolutely money to be made. I like to find small companies doing something different in those established shale areas. One example is Penn Virginia Corp. (PVA:NYSE) in the Eagle Ford Shale. This is a company that is pushing the boundaries of what we considered the Eagle Ford to be. As the price of land in the heart of the shale play got more expensive, some companies moved to the periphery. That's where they can get a big position without spending a lot of money. Many of these smaller explorers do great work and take what they've learned from the heart of the play and expand it. That's what Penn Virginia did.
By October of 2013, the Eagle Ford was an old story in the eyes of most investors, and Penn Virginia was a $6.73 stock. It saw an opportunity to move into the area, changed its business model, sold off assets and focused on the Eagle Ford. Shares are over $17 today. George Soros is an owner, and he significantly increased his position in the company. There is a Buy target on this from some analysts, up to $25/share. So, yes, there is absolutely still opportunity in the old shales.
Companies like Continental Resources kicked off the Bakken, but you don't buy them expecting to make 150%. I want to find the next Continental. I want to buy the billion-dollar company that goes to $23B.
TER: Where are you looking for the next Penn Virginia?
MB: I think the next big shale plays are probably the Tuscaloosa Marine Shale, the Utica Shale or the Cline Shale. We're digging very hard into companies working on these.
However, I like several companies that work multiple shales right now. Sanchez Energy Corp. (SN:NYSE) is a peripheral Eagle Ford player, but it's also in the Tuscaloosa Marine Shale. It's a small cap run by a really smart management team. It's a $1.3B market cap. This is a stock that I think has that potential.
Another one I really like in the Eagle Ford, Marcellus, Utica and Niobrara in Northeastern Colorado isCarrizo Oil & Gas Inc. (CRZO:NASDAQ). It's the same thing—small cap, moving into the new shales and with a lot of upside potential.
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