For a long time I've known that my friend Mr. Market was a fellow who could not control his emotions. At times he is the life of the party and is outrageously optimistic. We saw that in the late 90s, when internet companies with no earnings, no revenue and even no business plan had stock market valuations in the hundreds of millions of dollars.
In recent years, Mr. Market has often been prone to fits of extreme pessimism, believing the end of the world to be near. The result has been valuations on some publicly traded companies that we were seldom offered in the 90s and pre-housing collapse 2000s.
Last week I began to wonder if Mr. Market had now also lost his common sense.
An Unconventional Plan
After looking for bargains in the oil industry for a considerable amount of time, last year I settled on a game plan for the next several years. I call it my unconventional plan, which involves a large portion of my portfolio being dedicated to oil companies that are focused on producing light oil from unconventional shale and tight oil plays.
The plan looks like this:
1) Find unconventional producers that appear reasonably (or cheaply) valued based on current reserves and production.
2) Look for unconventional producers that in addition to being inexpensive in relation to current production and reserves, also have large positions in undeveloped acreage in known resource plays. I believe Mr. Market greatly undervalues (often ignores) these undeveloped land positions, which often contain more recoverable oil than the company has in its booked reserves on developed land.
3) The technology and techniques being used by these unconventional producers are in many cases just a few years old. I believe that over the next few years these companies are going to improve on current techniques and figure out how to recover a lot more oil than anyone expects.
When I buy one of these unconventional producers I look to pay a price that is less than the value of current production and reserves. I get the undeveloped land within the resource play for free. Plus I also get any increases in recovery factor (amount of oil that can be recovered) for free.
I'm extremely optimistic about this plan as I believe that the value in the undeveloped land and potential increases in recovery factors for the companies I own are likely worth considerably more than the price I'm paying (which is already covered by current production and reserves).
The current production and reserve value covers my downside risk on my investment. The undeveloped land and improvements in recovery factors might provide me with a lot of upside.
As time goes by I'm learning that improvements in recovery factors might turn these investments into home-runs.
EOG Resources - An Example of My Plan in Action
I don't own EOG Resources (NYSE:EOG) as it is a pretty large company that commands a little better multiple in terms of valuation than I prefer to pay. I do follow the company though, because it has been on the forefront of the unconventional resource revolution.
Last week EOG provided its year-end earnings release and it provided with an excellent example of how I envision my unconventional plan working. The big news was that EOG has been experimenting with down spacing in its massive Eagle Ford shale play. And what the company has discovered through trial and error is that the initial wells were too far apart, and that the property can handle smaller spaces between wells.
What this means is that the amount of oil EOG can recover from the Eagle Ford is going to increase from 4% to over 6%. That 2% increase doesn't sound like much. However when you consider that the 4% recover factor was resulting in 900 million barrels of recoverable oil, you can appreciate the significance a little more.
In this case, EOG believes that down spacing is taking the amount of recoverable oil from 900 million barrels to 1.6 billion barrels. Sometimes it is easy to get lost in the numbers, but 700 million barrels is enormous for virtually any company.
Here is EOG CEO Mark Papa explaining (transcript from Seeking Alpha):
First, we now have up to 200 days of well performance for multiple down spacing test, and we've concluded that our original 130-acre spacing was too wide to maximize NPV and recovery factors. Based on reservoir modeling and pilot results, we now calculate the spacing of 65 to 90 acres is more appropriate and will vary across the field depending on a number of factors including lease configuration, geology and reservoir conditions. Using this new spacing, we have a total of 3,200 additional wells yet to drill plus the 375 we've already drilled for a total potential recoverable reserve estimate of 1.6 billion barrels of oil equivalent net after royalty.
This is a 700 million barrel oil equivalent net after royalty or 78% increase from our previous estimate. Just this net increase of 700 million barrels of oil equivalent is larger, we believe, than any net domestic discovery by any company in recent history. And the total size of 1.6 billion recoverable barrels is the biggest U.S. discovery net to any one company since Prudhoe Bay in the late 1960s, in our opinion, including the deepwater Gulf of Mexico. We tend to kind of rollover some of these numbers and sometimes one gets lost in the numbers, but this is an extremely significant number and I want to quote it you again, the total size of 1.6 billion barrels of oil equivalent net after royalty that we've captured in Eagle Ford, we believe, is the biggest U.S. discovery including the entire deepwater Gulf of Mexico net to any one company since Prudhoe Bay in the late 1960s.
The outcome of our down spacing test is that we've taken the original 4% recovery factor and are now using 6%, based on geologic analysis, logs and studies, we now estimate the net after royalty oil in place under our acreage to be 27.9 billion barrels of oil equivalent.
That is pretty great news for shareholders-- a 700 million barrel increase in the amount of recoverable oil that EOG controls. There aren't a lot of companies operating in the American oil industry that have 700 million barrels of oil. EOG just added that.
How did my friend Mr. Market react? EOG shares had their worst day in two months. Apparently Mr. Market didn't like EOG's CEO telling them that production growth would be lumpy going forward. Not that the production growth wasn't going to happen, but rather that it would be lumpy because the timing of when new wells come on production varies from quarter to quarter.
Mr. Market apparently thinks that having production growth that is smooth quarter to quarter is more important than finding out EOG has 700 million barrels of oil. My three year old could figure out which is more important, but Mr. Market can't.
Even for EOG, which is one of the very largest independents, adding 700 million barrels is a huge deal. If you figure very roughly (and conservatively) that each barrel in the ground is worth $20, then that is an increase in shareholder value of $14 billion for EOG. That would add more than 50% to EOG's current market capitalization.
The part that excites me the most about this news from EOG is that this down spacing is increasing the recovery factor on EOG's Eagle Ford acreage from 4% to only 6%. That is the beauty of these unconventional plays. Because there is so much oil in place, even a small increase in recovery factors can mean steep changes in valuation for the company that controls the land.
And the nice part is that all it takes is one company operating in the play to figure out a way to improve recoveries. Once one company finds an improvement, everyone operating in the play can adopt the best practice. The key is that you have to have the acreage in the play. Then benefit as we learn how to get more oil out economically. The oil business in North America has become a real estate game. Either you have the acreage in the unconventional plays or you don't.