Seeking Alpha
Profile| Send Message| ()  

Shale plays have gotten a lot of attention lately, as more and more news articles focus on the importance of U.S. shale in helping reverse the 40-year decline of U.S. domestic oil production. "Hubbert's Peak" has ruled as production fell to under 5 mmboe/d from a peak double that in 1970. Outside of a rise in the late-1970's/early-1980's brought on by a 12-fold increase in the price of oil in 7 years, production had been in a multi-decade steep decline - until the U.S. shale revolution:

Merrill Lynch is looking for shale production to hit 3.2 mmboe/d by 2017, with a chance of an upside surprise to 5 mmboe/d:

Many companies have experienced phenomenal production growth in recent years from shale basins, like Continental Resources (CLR) and EOG Resources (EOG), dominant in the Bakken and Eagle Ford shales, respectively. But the shale story is not new, and while some companies have and will experience outstanding production growth, for many companies that growth is already discounted in the stocks. For others, the cost of acquiring the gas and/or oil is prohibitively high in terms of extraction costs or costs to shareholders via equity dilution or debt financing. U.S. natural gas prices are depressed, making 'dry gas' drilling uneconomical in most areas. Shareholders may or may not benefit, depending on events outside their control, namely the price of natural gas and domestic/international oil benchmarks.

Analysis of shale oil & gas profitability is highly-complex and dependent on many variables. The initial cost of the well - much higher for horizontal than for vertical wells - is a huge determinant of the ultimate profitability of even prolific shale basins. The difference in profitability with a well costing $7 million vs. $10 million is tremendous. Check out this sensitivity analysis for the Haynesville Shale for various well costs and natural gas pricing, profitability/(losses) are in millions of dollars:


(Click to enlarge)

Note that even at super-high natural gas pricing ($10/mcf) a well costing $10 million is barely profitable on an NPV basis. Similar economics come into play with the ultimate recovery of oil and gas and the lifespan of the field: higher EUR and long-life is more important than a bump in natural gas pricing.

This ties into energy stock returns because minimizing CAPX and depletion are key to generating higher returns. Aside from volatile energy prices, the reason that energy stocks have traditionally sold at discounts to the market multiple is the huge amounts of money that must be continually spend on CAPX to fund E&P projects to maintain production and reserves, let alone grow them. With conventional producing assets subject to rapid declines, companies need fields with either very large quantities of oil and gas (shale) or low decline-rate assets (LDRA). Either way, the goal is to recover the high initial fixed costs and keep CAPX in the future as low as possible.

Shale gas is CAPX-intensive, but at least you know the oil & gas is there. You have years - often decades - of drilling targets. Future dry holes are minimized since you know the target area has the oil or gas. Geopolitical concerns are also minimized: no expropriation, changing tax or PSC schemes, etc. This is the attraction of shale assets. Low-decline rate assets are even better, like oil sands or LNG. Several of the companies I list below have exposure to these complements to shale assets.

An energy analyst I spoke with recently told me that much of the core shale oil is economic at $60 barrel oil, but that non-core acreage is 80% of the total and the marginal cost for much of this acreage is closer to $80 before taking into account cost of capital and required return for shareholders. The top 10% of producing wells are almost 800x as productive as those in the bottom 10%, so simply buying into a story that a certain company is in a certain shale play tells you nothing about their prospects. A lot of the best acreage has already been milked, so don't believe the extrapolations or past growth trajectories from some of the spottier players.

What is the best way to play the shale boom at this point? There are plenty of articles talking about some of the smaller 2nd or 3rd tier players but that to me is speculating, not investing. Some may turn out to be good investments, some will not. I believe a better way for conservative investors to play the shale boom is to focus not on pure-plays in the sector, but rather on diversified, larger companies with multiple levers that can move their stocks of which shale is one. Obviously, the larger the company the less a given shale exposure will be able to move the needle, but that allows you the investor to choose the level of exposure/risk that you desire.

Below are 5 energy stocks that are not often considered shale plays - indeed, one is a supermajor and another an ex-supermajor - that give you leverage to the burgeoning U.S. shale plays but in a diversified, conservative, and prudent manner:

Anadarko Petroleum (APC): Anadarko is one of the largest E&P companies in the world, and has exposure to numerous U.S. shale regions. Anadarko is active and ramping up in the Marcellus and Eagle Ford shales and also has a presence in the Haynesville, Permian, and Niobara (Wattenberg/Rocky Mountains) shale regions. Anadarko also has non-producing acreage in the emerging Utica Shale play in central Ohio. Anadarko had been concentrating her efforts in the Gulf of Mexico and overseas, so it hasn't spent as much of her CAPX money building out the U.S. shales and being forced to take reduced WTI spread and depressed natural gas prices while waiting for transportation, infrastructure, and logistical solutions to catch up. U.S. shales, notably the Wattenberg fields in the Rockies, are now being ramped up in 2013 and 2014. Rates of return are 100%-plus in this area though depressed NGL pricing out West and infrastructure takeaway bottlenecks will constrain growth somewhat going forward.

Anadarko has a world-class overseas portfolio of deep-water assets led by her 36.5% position in the mega-gas field off Mozambique. The Mozambique field size has been upped from 6-10 trillion cubic feet (TcF) originally to a recent 30-60 TcF, with a possibility of additional gas taking the total to 100 TcF (potentially 15 billion boe). This acreage is likely to be monetized in 2013 and is worth $16/share or $8 billion at recent transaction prices (neither the reserves nor much of that per-share value is in the stock currently). Anadarko has far-flung deep-water and on-shore operations, holding exploration acreage and conducting extensive exploration in the deep-water Gulf of Mexico, Brazil, Ghana, China, Sierra Leone, and Liberia as well as other countries.

APC's stock has been held back by a legacy lawsuit with Tronox regarding environmental liabilities dating back to the old Kerr-McGee spinoff. The lawsuit has been a damper on the stock in recent quarters but a trial decision should be forthcoming in Q1 2013 with the judges 'body language' indicating a judgment no worse than what the stock is currently discounting, and possibly less. Anadarko has been a terrific wildcat operator with a success rate close to 70% compared to an E&P average closer to 40%. APC is cheap on proven reserve and NAV calculations, and new management is keen to unlock value in 2013. If they are unsuccessful for whatever reasons, a sale of the company should not be discounted. While it would be a sizeable acquisition, any of the large integrated companies would welcome APC's East Africa gas assets (a key LNG hub to Asia within a few years), U.S. shale assets, and Gulf of Mexico operations. Royal Dutch Shell, Chevron, and possibly even Total SA would be good fits for Anadarko and could afford the hefty price tag which would probably cost at least $110/share - or more. APC has 2.5 billion boe in proved reserves, 45% oil and 55% natgas, and produces about 740kboe/d.

Hess Corp. (HES): Hess Corp. is one of the larger players in the super-prolific Bakken Shale, a growing production presence in the Eagle Ford, and is performing appraisal activity in the Utica Shale. HES's strategic infrastructure in North Dakota significantly enhances the value of its oil and gas resources there. The gas in the Bakken is very rich in NGLs and LPGs, and the completion of the Tioga gas processing plant should enhance the value of its production. Even with Bakken oil fetching less than WTI (which is less than Brent or LLS pricing), the Bakken is rich in overall oil and NGLs relative to other shale plays, as this chart from Sanford C. Bernstein highlights:


(Click to enlarge)

Net production from the Bakken Shale averaged 62 kboe/d in Q3 2012 for Hess, up 94% year-over-year. Because HES has multiple production and exploration activities scattered geographically, it tends to not get full value for many of her key assets. This includes the Bakken assets, which are trading at a steep implied discount in HES shares relative to Bakken pure-plays like Continental Resources, to whom Hess has comparable acreage and production. But CLR trades at a huge metric premium to HES despite producing 1/3rd the cash flow and trading at a steep premium to proven reserves. Merrill Lynch estimates that the hidden value of the Bakken assets in Hess could be worth $20-$24 a share that is not currently being recognized in the stock. Check out the respective production profiles of the two firms; not only do both companies have similar acreage and proximity to the Bakken core, but the actual production forecasts look similar through 2017:


(Click to enlarge)

Hess is also a small producing player in the Eagle Ford and new entrant in the Marcellus and Utica Shales. But the entry into these shale plays was late and whether the plays will prove productive let alone economically beneficial to HES shareholders remains to be seen. This could exacerbate an old problem of Hess, one of too many drilling opportunities and spreading herself too thin. This has resulted in CAPX funding deficits, with asset or debt sales needed to bridge the gaps. Hess is trading below book value, pays a dividend of 0.8%, has a 75% oil/NGL weighing (25% natgas), and has 1.6 billion boe in proven reserves. Annual oil and gas production is about 425kboe/d. Nearly two-thirds of Hess revenues are from overseas.

Hess has been perennially mentioned as a takeover candidate, but as long as patriarch Leon Hess ran the company that was never a likely option. Son John Hess is now in charge, has significant holdings in HES stock, and is much closer to retirement than when he took over running the company in 1999. It would be a stretch to say that Hess is hot to sell itself, but if the company is unable to realize value in the next 2-3 years, the shares - once selling for $140 in the oil bubble of 2008 - could be attractive to a larger E&P or a supermajor.

ConocoPhillips (COP): Once one of the integrated supermajors, ConocoPhillips spun off its refining assets last year. Some would say that is par for the course - another misstep, this time unloading refining assets just when the refinery sector is on fire - but COP felt it would stand out more as the largest E&P rather than in the shadows of ExxonMobil, Chevron, and the rest of the supermajors. COP never fully recovered from its purchase of Burlington Resources at the natural gas peak (a $35 billion boondoggle with natural gas selling for $12/mcf after Hurricane Katrina). A series of asset sales, share buybacks, and dividend boosts were implemented to appease angry shareholders before the separation of the refining and E&P divisions.

COP has multiple unconventional drilling activities in the U.S. including the Wolf Camp, Avalon, Lewis, Bakken, Niobrara and Mancos shales. But it is the Eagle Ford where COP is starting to get recognition as production averaged 76 kboe/d in Q3 2012 compared to 61kboe/d in Q2 2012. ConocoPhilips has 230,000 net acres in the play, one of the larger holders. Total shale production was 102 kboe/d in Q3 2012, up 100% from Q3 2011 levels. Total oil & gas production is just under 1.6 mmboe/d and COP has 8 billion boe in proven reserves.

ConocoPhillips has an annual CAPX budget of $15 billion, double that of most E&P's. Dividend coverage, share buybacks, and CAPX will be tight if oil stays under $90/bbl. for any length of time. ConocoPhilips yields 5.2% and the dividend yield is by far the highest among E&P companies, topped only by a few international majors. Management has said that the dividend is to be prioritized above virtually all CAPX projects, probably to appease shareholders for previous management snafus.

Marathon Oil Corp. (MRO): Another E&P that separated from her refining assets, Marathon Oil has operations around the globe in over a dozen countries. Marathon also has growing production in the Bakken and Eagle Ford oil shale plays in the U.S. Rounding out her shale portfolio, MRO has acreage positions in the Anadarko Woodford, the Powder River Basin, Piceance Basin and Niobrara/DJ Basin in the Rockies, and the Marcellus in Pennsylvania (which may be up for sale).

Marathon is not a high-producing oil company, but it has a history of being acquired going back to the late 1800's when it was known as The Ohio Company and was bought by John D. Rockefeller's Standard Oil Co. We would not be surprised to see Marathon kick off a wave of consolidation by being acquired, much as it kicked off a similar M&A boom 30 years ago when it was bought by U.S. Steel. The separation from the larger Marathon incentivizes management to deliver for shareholders after years of lackluster results. But the emphasis on shale production is the key current driver to have the company's P/E ratio revalued upwards after years of MRO selling at a discount to peers.

MRO's key shale asset is the Eagle Ford Shale with her high liquids production and close proximity to Gulf Coast refining and processing stations. This avoids the WTI-minus discounts to LSS and Brent pricing and ensures premium pricing for oil and NGLs. Eagle Ford production nearly doubled sequentially in Q3 to 40kboe/d, due to an acquisition and organic growth. MRO is currently producing over 60kboe/d and recently raised production guidance in the Eagle Ford for 2013 by 15 kboe/d to 85 kboe/d.


(Click to enlarge)

Eagle Ford well costs for Marathon are around $8.6 million currently (down from $10 MM in 2011), and MRO is intent to continue improving performance to lower than $8 MM (EOG is the leader at under $6 million per well). The same well costs apply to Marathon's Bakken acreage, too. But in the Eagle Ford production is 900 kboe estimated ultimate recovery (EUR) and pricing is at Louisiana Light Sweet (LLS) minus ~$6 per barrel, while the Bakken yields 500-600 kboe EUR and prices at WTI minus $6-$9/bbl. That's a huge pricing discount that Eagle Ford oil avoids.

MRO is in discussions regarding the potential sale of a portion of her 20% interest in Canadian tar sands assets which could unlock $5 - $10 per share in value. Elsewhere, Marathon has a strong relative presence for a company her size with diversified assets around the globe in Angola, Canada, Equatorial Guinea, Indonesia, Iraqi Kurdistan Region, Libya, Norway, Poland, and the U.K. Total global production is just over 500kboe/d and total reserves were 1.8 billion boe at year-end 2011. MRO is paying a dividend of approximately 2.7%.

Royal Dutch Shell (RDS.B): Royal Dutch Shell the 3rd largest oil company in the world, as a way to play U.S. shale? Well, different companies will have shale move the needle different levels and this is definitely among the most conservative. But that doesn't mean investors shouldn't look to RDS as a way to get shale exposure, both in the U.S. and possibly in Europe or other countries where Shell has operations and acreage. RDS acquired about 618,000 acres in the Permian Basin from Chesapeake Energy Corporation (CHK) for a price of $1.94 billion back in September. Royal Dutch plans to add more drilling rigs to the site, according to its head of Americas operations, and anticipates "years and years" of output from the oil and natural gas acreage.

Gas drilling is being limited to the lowest breakeven price acreage in Western Canada and the Marcellus play in Pennsylvania. Production from liquids rich plays averaged 16 kboe/d, which will increase with additional gas-processing facilities in the Eagle Ford, and including the recently acquired Permian Basin assets production should reach 50 kboe/d early in 2013. Certain shale areas have NGLs in addition to dry gas and this helps increase profitability since just drilling for (depressed) natgas is not very profitable.

Royal Dutch Shell has additional acreage in British Columbia, in Kansas' Mississippi Lime, and the Marcellus Shale. Smaller acreage plays are also located in Ohio, Wyoming, Colorado and California. The company is also drilling in oil-rich shale in Egypt and Oman, and it aims to drill in similar plays in Turkey and Russia in the future. The goal is to help the company meet its target of producing 250,000 barrels of oil equivalent a day world-wide from oil-rich shale by 2017, an amount representing 6% of the average daily production of Shell's total production for that year. The shale, LNG, and other low-decline assets combine to give Royal Dutch Shell a standout total reserve resource life compared to her peers:

RDS did the heavy CAPX lifting years ago while others lagged behind and now is in a position to reap the rewards. RDS will be generating lots of free cash flow while her peers catch up and are forced to increase CAPX spending. Royal Dutch's production should increase by 800 kboe/d over the next 2-3 years, almost 25% of recent production levels. If oil prices hold at current levels, Royal Dutch's cash flows from her U.S. shale and global LNG assets will enable her to boost the dividend and commence share buybacks (Dutch tax law changes permitting). Shell has operations in 140 countries with total proved reserve of 12 billion boe and daily production in excess of 3.4 mmboe/d. RDS pays a 5.3% dividend, one of the highest dividend yields among the large supermajors.

If you decide to speculate, Eagle Ford shale exposure is probably the best shale to focus on for 2013-14. It is already one of the most prolific-producing shales and geographic areas in the history of the United States, despite its relative youth. With a potential 100,000 drilling locations and 10 million acres, we are talking about decades of drilling inventory. IRRs are among the best for all the shale plays, as can be seen in this chart below:


(Click to enlarge)

The Eagle Ford is on the verge of producing 1 MM boe/d by 2013 and could hit 1.7 MM boe/d by 2017. Besides lots of oil, you have plenty of NGLs and 'wet' gas with a low cost of extraction. Plus, you are right near the major refining and petrochemical heart of the United States in the Texas/Louisiana corridor. Midstream MLPs will be investing huge sums to provide much needed gathering & takeaway, rich gas processing, NGL fractionation/storage, and downstream distribution services. All of this means oil pricing should be close to LSS pricing, without the WTI-minus discounts seen in the Permian, Bakken, and other Mid-Continent basins. The Eagle Ford, Permian, and Bakken formations are likely by themselves to account for 100% of total U.S. domestic production growth for 2012 and 2013, and about 40% of natural gas production growth.

The 5 companies listed above let you have access to the Eagle Ford, additional shale plays, and other long-lived/low-CAPX assets. You get diversification, overseas assets, M&A possibilities, and dividend yields, too. These additional levers can give your portfolio some shale exposure without causing you much angst if oil prices fall or if a solo operator has production problems.

"Shale" we go ahead and buy ? LOL

Source: 5 Hidden Oil Shale Plays For 2013