In late June Seeking Alpha published "Five Lessons on Picking the Low-Hanging Fruit," an article on stock selection with specific reference to opportunities in the oil shale industry. The advice was to go where the money is and pick the companies that offer the most leverage to the investor. Activity in West Texas is giving investors plenty of choices.
One possibility is Laredo Petroleum Holdings, Inc. (NYSE:LPI), an independent oil and gas company headquartered in Tulsa, Oklahoma. CEO Randy Foutch founded the company in 2006 and took it public in December 2011 at an initial price of $17 a share. He had previously developed three E&P companies that he sold to public companies.
LPI's growth in the last five years has been excellent. Last year's 10-K shows that total revenues climbed to $510.3 million in 2012. Operating income last year was $201.9 million, and pretax income was $164.9 million. The growth has been exceptional, but the drop in oil and gas prices took a toll this year. Second quarter revenues increased 7% from the comparable 2011 period, but net income fell 24%. LPI had a 13% decline in oil prices, a 40% decline in gas prices and a 54% increase in lease operating expenses compared to last year's second quarter.
Production hit record volumes with a 36% jump from last year's comparable period and 12% from the first quarter of this year. Crude oil production increased 44%. EPS was $0.24 on 128.2 million fully diluted common shares. The average estimate of a select group of analysts covering the stock is $0.85 in 2012 and $1.40 in 2013. This places the P/E ratio at 16 times next year's earnings.
The numbers belie the potential. To place the issue in perspective, investors need to understand what is happening in the Permian "oil patch." The Permian Basin refers to a region near Midland in West Texas with a long history of oil production. More recently there has been an explosion in activity. New drilling techniques offer access to oil, gas and liquids in tight shale formations previously infeasible for economic production.
The perfection of horizontal drilling and high-pressure hydraulic fracturing of the shale has been the catalyst. Within the last few years drilling in fields such as the Bakken in North Dakota and Eagle Ford in south-central Texas have resulted in huge increases in domestic oil and gas supplies. Now the Permian plays are in full force.
An article in the Houston Chronicle on August 13 titled "West Texas taking an 'intelligent approach' to oil boom" shows why investors are taking notice. According to the article, the current Baker Hughes rig count in the Permian is 442 versus a 1999 low of 51. The same article reported that there are 155,000 wells in the area producing about one million barrels of oil per day, plus gas.
The impact on the infrastructure has been huge. Companies have formed "man camps" of trailers in vacant lots, and some workers are forced to drive huge distances to find available housing. The article claims that a "freshly graduated petroleum engineer can expect an annual salary of $80,000 sometimes with a $10,000 to $20,000 signing bonus." Roughnecks and truckers who will put in the hours are earning $100,000 a year. Unemployment in the area is a choice, not the result of regional economics.
A first reaction might be to say this is like a "shooting star," a phenomenon that is exciting to watch but unlikely to last. Industry experts disagree, and they are backing their assessment with big bucks. Laredo's recent success shows why. The company completed 69 Permian wells in the second quarter with a 100% success rate. That is unheard of in the normally high-risk drilling business. LPI's CEO, Randy Foutch, told the Oil and Gas Investor in an interview in April of this year that the company has 3500 vertical locations and 2500 horizontal locations as potential drilling sights.
Again, skeptics can play "Yes, but . . ." games: oil prices can fall; shale fuel is too costly; there are green substitutes, and political resistance may limit "fracking." Maybe, but this may also be an opportunity for astute investors.
Everyone recognizes the huge gap in U.S. energy consumption and our domestic supply. Jerry Schuyler, Laredo's president, addressed this point in a June 13th presentation to the IPAA-TIPRO "Leaders in Industry" luncheon at the Petroleum Club in Houston. Schuyler shows that imports provided 55% of our demand in 2005. Shale provided none. The U.S. and Canada, which he sees as a reliable source, provided 45%. By 2010 we had actually cut our consumption slightly through conservation efforts. Shale had emerged as a minor factor, and our reliance on imports had fallen to 42%. The projections are that by 2015 our demand will be approximately the same as current levels, and imports will only represent 18% of our demand. Shale from Permian, Bakken and Eagle Ford formations will be providing about 40% of the total.
There is no credible source that thinks renewable energy from solar, hydro, wind and biofuels combined can ever provide more than 2% of U.S. needs. Green cannot kill this growth, and oil production costs are comfortably below supply prices, which currently are approximately $86/bbl for West Texas Intermediate crude. LPI's Q2 report shows a cost per barrel of oil equivalent of $34.34. Does anyone think that supply from the Middle East will be cheaper . . . or more reliable? And if you are concerned about the politics, you can do your part to protect the industry's future in November.
Markets reflect global economics. We would be naïve to ignore top down analyses, but stock prices will respond to individual companies' opportunities. Permian plays seem to offer those opportunities, and that is where we are likely to find alpha.
Disclosure: I am long LPI.