Good Bets To Profit From Fracking, NGLs

Includes: CHK, CLR, EOG, OKS, SLB, WLL
by: Dr. Stephen Leeb

Lately there’s been a lot of talk about the U.S. achieving energy independence. We can see a number of reasons for optimism. They center upon so-called “new technologies,” in particular hydraulic fracturing, better known as “fracking.”

According to some, this technology has the ability to unlock limitless hydrocarbons that heretofore have been shut inside very tight shale formations. And in the natural gas arena the practical results have been stunning, as natural gas production has reached record highs.

Actually, so far it has really been too much of a good thing, as high natural gas production has led to low natural gas prices – currently the lowest for this time of year in more than a decade. And we now see a lot of those natural gas rigs being moved over to spots that are more likely to contain natural gas liquids (NGLs) and oil.

NGLs are liquids derived from the processing of natural gas that can replace oil in certain applications. In industry terminology, they are called C2, C3, C4 and C5, which stand for Ethane, Propane, Butane and Condensate, respectively. (C1 is regular dry gas, or methane).

In any event, the increase in natural gas production from fracking has been a great ride, but with natural gas prices depressed and drilling rigs shifting over to oil, production of natural gas is likely to start to decline. And, in fact, it may not only be the changes in where and how the rigs are deployed that is causing the decline.

Capitalism may be the greatest economic system ever created, but it does have its warts. And one wart may be the tendency, just like the male peacock, to show off its feathers for an exaggerated effect. So just as female peacocks, who base their mating choice on an impressive display of feathers, don’t always get what they are bargaining for, investors may be in a similar position when it comes to companies engaged in fracking.

In the shale arena we think the evidence is pretty strong that the companies so avidly engaged in shale gas production have, in effect, been showing off their feathers – that is to say, going for the easy and most impressive stuff first. And there is bountiful evidence that not all shale is created equal. According to Art Berman and other unbiased experts, one part of a shale formation can contain huge amounts of liquids while another very close by may contain very little at all.

A little-known story that came out within the last couple of weeks is that China, a nation with a voracious appetite for energy of all sorts (from nuclear to coal to natural gas and oil, etc.) has postponed any plans for tapping its shale hydrocarbons for at least a decade. It turns out their shale deposits, which six months ago were believed to be among the most potentially productive deposits in the world, on closer examination are now considered to represent an extremely complex challenge. So far we don’t know the details of China’s decision on this, but if you told us that water was part of the calculation, we wouldn’t be surprised. For the process of hydraulic fracturing requires huge amounts of water. And if there’s anything that could defeat China long-term, it’s much more likely to involve H2O than hydrocarbons.

And speaking of water, here in the U.S. we, too, only have so much of it. And some of the most fertile shale deposits here are in areas where water is far from plentiful – for example, the Eagle Ford shale formation in south Texas, an area that is in the midst of a long, multigenerational drought. If you believe the climatologists, one of the consequences of global warming is that droughts are likely to last much, much longer than in the past.

So, yes, there are issues with fracking, and many reasons to suspect that reserves have been dramatically overstated, and that its long-term potential is much less than promised.

As far as companies dedicated to natural gas fracking, Chesapeake Energy Corp. (NYSE:CHK) stands out. From where we sit, it’s totally trapped by the high capital expenditures required for fracking, and the need to scramble hectically to sell assets just to keep afloat. We would short this stock.

The real promise in this area, and we’ve made this point before and continue to believe it’s true, involves oil fracking. It’s not just gas that’s found in those shale formations; there’s also oil. The major difference between oil fracking and gas fracking is that oil remains an international, not domestic, commodity. As a result, oil prices are many times higher than those for natural gas. And of course, high capital expenditures are much more easily rationalized for higher-priced than lower-priced commodities or products. This is the biggest difference between oil and gas, and it’s a huge one. And it explains why one of our recommendations, Continental Resources (NYSE:CLR), has been soaring and why Whiting Petroleum Corp. (NYSE:WLL) and EOG Resources (NYSE:EOG) have also been climbing.

And indeed we suspect that they will continue to climb. But some of the same problems faced by natural gas frackers will also be faced by oil frackers: wells, whether they be for natural gas or oil, typically have exceptionally high decline rates. As a result, what you get in your first year or so is the most you’re ever going to get from a particular well. The only way to continue to increase production, therefore, is to continue to add ever increasing numbers of rigs. Given that every well requires a lot of water, a massive number of wells will require massive amounts of water.

Thus there are two problems with declaring, as several brokerage firms have recently done, that the United States is already on the verge of energy independence. The first is that even under the most bullish possible assumptions you can make about fracking, energy independence would lead to a country dying of thirst. The water requirements are truly that huge.

The second reflects a simple analogy based on the last time we found something more or less equivalent in terms of reserves, to what is currently considered to be recoverable from these shale formations. Here we’re talking about oil, and the analogy is to Prudhoe Bay, a large oil field on Alaska’s north slope and the largest one in North America, covering 213,543 acres.

Prudhoe Bay is now estimated to have contained about 25 billion barrels of oil – really a super giant. That estimate is more or less in line with estimates of oil in the various fertile fracking formations in the United States. Eagle Ford, which is probably considered the most productive for oil, is estimated to have somewhere in the neighborhood of 10-15 billion barrels of recoverable oil. But oil that is recovered through the use of fracking will be far more expensive, far more difficult to produce and transport, and in the end will at best leave us, as did Prudhoe Bay, with no more than a short-term blip in energy production. And in no way will it change the longer-term dynamics.

But it’s undeniable that more oil and more gas are coming on stream. And in addition to those engaged in oil fracking, other clear beneficiaries here will be those companies which transport and deliver these valuable energy resources. Here we would mention an Income Portfolio recommendation, a master limited partnership ONEOK Partners LP (NYSE:OKS); we also have other recommendations in The Complete Investor that might benefit even more.

And yes, there will be some oil service companies that do well, too. We won’t stray too far out on a limb here in recommending, as we have in the past, Schlumberger Ltd. (NYSE:SLB).

Disclosure: Leeb Group, its officers, directors, shareholders, employees and affiliated entities and/or clients of such affiliated entities may currently maintain direct or indirect ownership positions in financial instruments (i.e., stocks, bonds, options, warrants, etc.) of companies or entities whose underlying exposure is in the companies mentioned in this article.