'Shale' We Dance? (How Best To Profit Now From Energy Investments)

Includes: XOM
by: Peter F. Way, CFA

In many cultures dancing is an expression of joy, often publicly displayed and enjoyed. The intended pun in the headline is further intended to reinforce the notion that an underlying enormous strength of the United States of America is that its free-market democracy provides continual incentives for individuals to think and create and improve, knowing that substantial rewards often usually follow such accomplishment.

Currently the geology of shale formations is playing a significant role in our national well-being.

It is the nature of the extractive industries in dealing with natural resources, to maximize the values of the deposits available by balancing its richer pockets of product with leaner parts, within the average costs of recovery, so that best overall profits can be achieved. Ultimately, the costs of extraction define the economic scope of the resource body and its depletion turns production attentions to higher-cost sources.

Those costs of extraction are the result of learned technologies that usually improve through time, hopefully expanding the life of the resource body with minimal increase in its breakeven costs and in the ultimate price for what is being extracted. In oil and gas recovery the cost-benefit tradeoff of vertical drilling practice and technology has seen severe degradation when applied to smaller and more distant reserves, resulting in prices doubling, in crude oil for example, from $50 a barrel to over $100.

But the "mother" of necessity has spawned a leap of technology that carries huge economic advantages.

Skills learned in vertical drilling allow directional guidance of the drillbit, to the extremes of a shift from vertical to horizontal, and in any desired compass direction. Coupled with water injection under pressure and the accompaniment of granular materials to hold open fractures induced in shale beds by the water, "fracking" now allows the recovery of hydrocarbons known to exist, but previously uneconomic to recover.

The original objective was to acquire natural gas, but the bountiful surprise was that enormous quantities of crude and other hydrocarbon liquids (NGLS) accompanied the natgas paystream. Some experiences were of liquids carrying more than 90% of the total value. With crude selling at a heat content some 5-6 times the equivalent natgas content, oilfield development objectives rapidly changed from solely seeking natgas.

Production of natgas from older, vertically-drilled wells (dry gas production) is quickly being supplanted by the "unconventionally-produced" equivalent from new-technology "wet-gas" wells, because of the rewards coming from their liquids.

The challenge now is to find markets for all the newly-available natural gas, and find ways to get the gas to those markets.

A major potential natural gas market is in the generation of electricity, now primarily fueled by coal. That fuel's contribution to air pollution can be controlled, but at an additional expense that detracts from coal's price. Transportation, typically by rail to most utilities, is another coal price offset, dependent largely on distance from mine to power plant.

Natural gas has virtually no pollution cost penalties, and its ideal transportation method is by pipeline, which can out-compete rail transit under most circumstances - where a pipeline exists. The problem for natgas is that pipelines have a high initial capital cost that must be financed up-front. That financing needs the assurance of long-term demand contracts for the to-be transmitted fuel. Once in place the pipeline is geographically inflexible and fairly fixed in its operating cost, so transmission loads at high levels of capacity are essential. Again, assurances of demand will support the pipeline's financing.

This competition between coal and natgas boils down to the price per million BTUs delivered at the power plant. Cost of extraction of the fuel from nature's resting place will determine the winner in most cases, after transit and ecological factors are considered. But geographic locations play a part.

Another unexpected development in the exploitation of the shale oil & gas is the quality of the liberated fuels. One major player is indicating breakeven crude costs at $37 a barrel, partly because the product is very low-sulfur (sweet) and light in weight. Present WTI crude trading in the neighborhood of $90 suggests that there can be a good deal of elbow-room in the pricing of the joint-cost products of gas and oil. Prices for crude from these unconventional productions are in some cases bringing price premiums over the quoted WTI standard-spec product.

Ultimately lower crude prices as a result of greater supply and known reserves are a logical outcome of the present scene. That puts much more restraint on stocks of companies with presently-known developable conventional crude and dry-gas reserves than it does on previously less-well-found companies that are now building portfolios of claims to unconventional-development reserves.

That seems reflected in the future price expectations implied by hedging actions by market-makers in the stocks of major integrated conventional-play producers, in contrast to the rapidly-evolving independents, working hard to expand their control over the better-positioned unconventional-production field acreage.

The whole issue of future world and US energy prices is key to longer-term energy investments. While the lead energy investment analyst at Citibank some years ago, significant shifts in prospective supply and demand helped build a well-developed perspective on how energy markets have responded in the past.

The world markets are sophisticated, extremely well-developed and sensitive to both local short-term influences and evolving general trends. Market participants include major suppliers of raw materials (i.e. crude) and refined products, as well as their consumer counterparts and active and aggressive speculators. Contracts may be of a spot (immediate) nature or extend over periods of as many as 6-8 years.

Pricings involve port-to port transportation components that from time to time reflect supply and demand for shipping capacity, and even shipbuilding capabilities, as well as wartime risks and piracy potentials. Both futures contracts and options on the futures are actively traded on a 24 x 7 basis somewhere in the world.

Our contention that basic energy costs are likely to decline over coming years is reinforced by crude futures contracts for year-end 2021 at $83 a barrel, $10 less than front-month 2013 contracts at about $93. Beyond that is the following reasoning:

The developed advances in extraction technology have demonstrated two key things here in the US: 1) it is quite possible, using horizontal drilling and hydraulic fracturing to extract significant quantities of both natgas and associated liquids, including crude oil, at costs on the order of half that required to recover the same product resources by conventional vertical extraction methods, and 2) the new technologies have made enormously more resources available to recover, in quicker production times than were previously believed possible, from geological structures that are vast and geographically diversified.

Now the major question faced by investors is: "How will energy markets handle the inevitable price transitions resulting from these changed circumstances?" The answer will significantly affect investing strategies related to energy, and perhaps beyond.

Oil pricing practices have a history dating back to late 19th century and early 20th century, even before the technology-changing event of the 1920s Spindletop-well discovery. The aggressive Rockefeller-Standard Oil "trust" competitions ultimately were declared illegal by the supreme court, making history that lives to today.

Clearly, existing Major International Integrated producers that control reserves of crude developed by conventional technologies, and valued previously on that basis, are now at significant risk. Exxon-Mobil (NYSE:XOM), the Standard Oil successor, plans like the Catholic Church, with century-long horizons. XOM saw the existential threat of technology change early, and proceeded to acquire both the technology and the major US natgas production position by buying XTO Resources in its entirety.

So XOM now has defensive strengths and will play out whatever plan best suits its interests, within the law, which it will in best efforts, attempt to influence. If you were XOM, wouldn't you? If you own XOM stock, wouldn't you want them to?

But with the multitude of US independent Exploration & Production (E&P) companies (over 4 dozen of them with publicly owned, often at multi-billion dollar market caps) aggressively pursuing and improving the new "unconventional" production technologies, monopolistic approaches to control prices are unlikely to work.

Exxon-Mobil's first line of attack is to export US-produced natural gas, liquefied, by tanker ships already built for that purpose, serving other natural-gas exporting countries. The US port terminals, originally designed to import natgas from such sources, are being turned around to handle exports. Other export efforts take the form of new pipeline construction in southern Texas from the unconventional-production Eagle Ford fields to the Mexican border.

The export appeal is that Europe is currently paying $13 a million BTUs for natgas (some pipelined from Russia) while the current US price is $3.25. Mexican prices are at least double those here in gringo "el Norte."

But such major disparities may not last long. Other International Majors are establishing relationships with governments that also stand to benefit from significant energy cost reductions resulting from the new technology. The geological structures here in the US that spawn the massive production capabilities are almost certain to exist in many other countries. Australia is already working with the Chinese Oil Industry to position itself to serve Asian markets.

The cost differences of old vs. new are just too large to get finessed by media hype and ignorance. Foreign governments may be smarter than a US-consumer public.

So now what can established major old-school-technology producers do? There is already more natgas production in the US than is being absorbed by the electric-generation market. Some of that is due to delays in providing transportation to the generating stations, but that is a temporary condition, and shut-in production capacity already stands ready to fill the demand. Larger demand markets are needed.

The prize market here in the US is land transportation fuel - for autos, trucks, busses and other motive equipment. The cost economics are compelling. A gallon of gasoline contains 125,000 BTUs of heat energy, so 8 gallons equals the 1 million BTUs that natgas is priced at. Even at double a coal-competitive price of $4 per mmBTUs, that $8 looks a lot better than present day gasoline equivalents of $25 to $35.

But those $25 to $35 prices are the heart of profit margins for most present integrated major oil producers. So don't expect them to do anything to hasten the conversion from gasoline to natgas. And there are many things that will slow down the conversion:

  1. Few readily available new cars built to burn natgas. Only Honda CVX now is in production and has not "gained much traction" with consumers, perhaps because
  2. Refueling stations are not as ubiquitous geographically as gas stations
  3. US auto manufacturers may not be eager to design products potentially offensive to fuel suppliers
  4. Conversion kits for existing cars are not allowed to be imported and existing conversion regulations interfere with such installations
  5. Media organizations are hesitant to program messages that may offend big advertisers - car builders and oil companies
  6. Other interferences bound to be created by skilled competitive establishment professionals

But the conversion is certain to come, the user savings are just too great. Ultimately even the best government that money can buy will recognize the voting appeal of promoting the savings, and the political value of not being identified with interfering with their accomplishment.

So somewhere out there, today's values-in-the-ground, establishment conventional-production oil companies are going to take a major hit. Crude prices will decline, and those stock prices with them.

The winners in this game are the unconventional innovators with the smallest proportions of old-school production. Because of the rapidly evolving improvements to the new technologies, the pole position in that race will be constantly changing, compounded by the current market recognition of each competitor's true profit potential.

Overpricing and underpricing of those perceptions will probably offer more risks and opportunities than actual product market share achievements. Long-term value approaches probably will not offer the best rates of investment return.

The astute energy investor needs to be able to compare the market's perception of each stock's future price potentials, good and bad, upside sell price targets and drawdown exposures. We expect to provide periodic looks at those comparisons. Here are some at the present, contrasting old-school and new-technology participants, all as seen by market-makers, implied by their self-protective trade-hedging actions.

(used with permission)

The scales on each picture represent potential share price percentage changes, both up and down, within a few-month time horizon.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.