Unconventional Oil Resource Plays: The Gift That Keeps On Giving

| About: EOG Resources, (EOG)

How many good investment ideas does a person need to have in a lifetime to become wealthy? The answer is easy: one.

If you are willing to concentrate a sensible amount of your investment dollars in one exceptional idea, the results from that one investment can change your lifestyle. Of course, the extremely hard part is finding that one good idea.

I think I've got one.

This idea isn't a specific company; it is a specific type of company. I think pure play unconventional oil producers represent an incredible long-term investment opportunity today.

Here is why:

1. Reasonably high oil prices (as in $70-plus) are here to stay. The world isn't running out of oil, but it is getting to the point where we can't get it out of the ground fast enough to keep up with the global daily demand for the stuff. Daily demand for oil continues to grow relentlessly because of China, India, and the rest of the emerging world, while daily oil production appears to be flattening.

Combine that with the fact that the marginal cost of supply continues to rise (deepwater, oil sands) and I think our future is one of high oil prices.

2. I think Mr. Market is greatly underestimating the growth that these unconventional oil players have in front of them. Many of these pure-play unconventional names have drilling inventories in unconventional plays that virtually assures they can grow production for the next decade or more, yet Mr. Market values many of them at four or five times EBITA.

3. The value of the acreage in these resource plays continues to increase year after year as the technology and techniques used to develop the plays improves. Remember, these unconventional plays have only become economic in the last decade because of horizontal drilling combined with hydraulic fracturing. Improvements are being made on a regular basis that increase the amount of oil that can be recovered, decrease costs, or increase production rates.

Let me give you an example. I just finished reviewing the first-quarter conference call transcript for EOG Resources (NYSE:EOG) that Seeking Alpha generously provides. EOG Resources is at the forefront of the unconventional resource revolution in the U.S., and importantly is doing so in unconventional oil plays.

I'd like to share some information from this conference call to show how the unconventional oil plays that EOG Resources has are increasing in value every quarter.

Eagle Ford Shale

Last quarter, EOG Resources and its CEO Mark Papa unveiled the power of downspacing in an unconventional resource play. The Eagle Ford Shale was already a huge home run for the company. Last quarter, it announced that it believed more oil was actually going to be recoverable than originally thought because the Eagle Ford could handle an increase in drilling density.

By downspacing from 90 acres between wells to 65 acres between wells, EOG Resources discovered that instead of having 900 million barrels of recoverable oil in the Eagle Ford, it had 1.6 billion barrels. Consider how huge that is: an increase of 700 million barrels without spending a penny acquiring new acreage. By assigning a conservative $20-per-barrel value to those 700 million barrels, one could argue that the value of the Eagle Ford Shale to EOG Resources increased by $14 billion.

That is material to any company.

During the most recent conference call, Papa made this comment about additional downspacing:

Now that we have an additional 90 days of production history, we're even more comfortable with these downspacing conclusions. We're now testing space or tightening -- tighter than the current 65 to 90 acres, i.e. 40 acres, to determine if further densifying will be viable to increase the recovery factor and we'll likely have some results by year-end.

As I mentioned earlier, the technology and techniques used on these unconventional resource plays are still young and improving. EOG Resources has added a massive increase in value for shareholders by experimenting with downspacing. But it is also having success in the actual techniques involved in drilling the wells themselves:

…we continue to see an improvement in well performance from recent wells compared to wells completed just a year ago. This is likely due to better fracs and better placement of our laterals. This is occurring across essentially all our acreage. We've certainly seen this in our more prolific acreage where a year ago, we were highlighting wells with 1,500 barrel oil per day IP rates. And today, in those same areas, the IPs are 2,500 to 3,000 barrels of oil per day. These 2,500 to 3,000 barrel oil per day rates are holding up and have averaged 30-day rates of 1,500 barrel oil per day. We're also making these type of improvements in areas with lesser quality rock.

Those types of increases in production rates do wonders for the IRR on the wells being drilled.

There was one final point of interest that Papa touched on during the conference call, and it was something that I had been thinking about for a while. If these technologies are still increasing, then maybe the best move that a company can make is to leave the oil in the ground for now so that it can be drilled in the future with even better drilling techniques.

Here is Papa on that subject:

With the success in downspacing, we have identified at least 3,200 additional locations to drill. Based on the 300 net wells we plan to drill this year, this gives us an 11-year inventory. The reason we're not accelerating the drilling of this unusually large well inventory is the technological improvements we're making. If we're making better wells than we were a year ago, who's to say we may not make even better wells a year from now? So why rush to drill wells that may not be technically optimum? We're closely focused on balancing the present value of this asset versus this technical well improvement. And you'll hear more about this in subsequent quarters.

EOG Resources Isn't The Only One

I really don't think Mr. Market has clued into just how valuable the land that companies like EOG Resources controls is. That is why I've got a portfolio loaded with unconventional oil players. Over the past 18 months I have not been rewarded for owning these companies, but since I'm still happily buying them I actually appreciate the current valuations.

Let me give you one example of a company that I own, called Petrobakken Energy (PBKEF.PK) and one of its unconventional plays. Petrobakken owns a large land position in the Bakken formation in Saskatchewan. That land position contains an estimated 1.7 billion barrels of oil originally in place. So far, Petrobakken has been allowed by its third-party reserve auditors to record reserves that assume that 6% of that oil will be recovered (102 million barrels).

Petrobakken and its nearest major competitor in the Bakken both believe that ultimate recovery from the Bakken will be closer to 30%, once the acreage is fully drilled and an Enhanced Oil Recovery program is employed. For Petrobakken that would mean that 510 million barrels are recoverable, not the 102 million barrels that are currently booked as reserves.

Petrobakken's current share price values the company at a level that is basically equivalent to its current reserve bookings. If reserves ultimately turn out to be five times what the company is currently valued at, doesn't that have to do good things for the share price over time? And don't even get me started on the 190 sections of land that Petrobakken has in the emerging Duvernay, Swan Hills, Nordegg and Montney oil plays in Alberta, which have not yet been drilled and thus have no booked reserves.

Companies like Petrobakken and EOG Resources represent the best opportunity for growth at a very reasonable price that I've ever come across. And in every way, in my opinion, time is the friend of the owners of these companies because over time oil prices will rise, technologies will improve and production will increase.

And it is never bad to have time on your side.

Disclosure: I am long PBKEF.PK.

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