The Energy Sector: Focus On Unconventional Oil And Gas For Long-Term Gains

Includes: CJES, RIG
by: Matthew Dow

In the past few years, I have heard several times about the threat of "peak" oil, and that in the coming decades, we are in danger of running out.

In this context, peak is referring to our conventional oil reserves (the easily available stuff close to the surface). I have heard similar stories about other energy sources, such as natural gas.

With the inevitable decline of conventional oil and gas reserves, one idea at first glance would be to focus on alternative renewable energies as a good long-term investment in the sector -- after all, there will have to be blistering growth to make up for these declining traditional reserves. Some examples of these alternatives: solar, wind, hydro, geothermal, and biofuels.

However, with any high growth and immature industries, there is always a lot of uncertainty, and nobody knows in 20 or 30 years' time which of these alternatives -- let alone specific companies -- will be the clear winners.

As a value investor, I am on the lookout for strong companies that are currently out of favor or unknown in the market, but at the same time exhibit good long-term business prospects and minimum downside risk. With the unpredictable growth in the exciting world of alternative energies, this goes against my principle of avoiding downside risk. Therefore, my investment thesis for this sector is centered on the idea that a much better and safer long-term play is to focus on those companies that are in the business of finding unconventional sources of oil and gas. I believe this makes overwhelming sense, as the uses and technology around these energy sources is much more mature.

With world population continuing to grow steadily, with estimates that it will reach as much as 9 or 10 billion people by 2050, demand for oil and gas will not likely decrease. With huge growing economies in Asia, one can easily argue that we will continue to scour the earth inside and out to find every last drop of oil and gas we can extract in a cost effective way. Below, I will explain in more detail why this is the case. In short, it boils down to the fact that even with very high growth in alternative energies, by 2050, they will still be lagging far behind our traditional sources (oil, gas, and coal). The world's energy demands will have to be met by a combination of all these sources.

However, there are some good investment opportunities out there to take advantage of the growth in non-conventional sources of oil and gas. Later, I will highlight two companies I own that are examples of how to do this -- one focused on hydraulic fracturing, and one on deep water drilling. First, however, I will go into some more background on the future growth of traditional and alternative energy sources.

Overview Of Conventional World Reserves

All the information you could want to know on world reserves and trends can be found at BP's statistical review site. I also recently read an excellent book: The New North: The World in 2050, by Laurence Smith, which gives great insight on the subject. This book summarizes the world reserves of traditional energy sources as of 2008 in a nice table. which I've excerpted here:

Energy Source Known World Reserves (metric tons) Years remaining at current consumption levels
Coal 847,488,000,000 124
Oil 168,600,000,000 25
Natural Gas 128,611,000,000 19

Of course, there are some new reserves discovered every year, but the giant and super giant oil fields that are the major producers today were all discovered 50 years ago, and there are no signs that we will discover anything to that scale in the near future. So what this table shows us is that, at current consumption rates, there are only a few decades remaining of our known reserves. Worse still, demand is almost certain to be higher than today's rates as the world's population increases, as mentioned above. So clearly, there have to be other sources of energy to add to the mix.

Projected Growth Of Oil Reserves

(click image to enlarge)

The chart above (sourced from this site), shows that the U.S. Energy Information Administration (NYSEMKT:EIA) projects that, from 2003 to 2035, there will be a 652% growth in unconventional oil as part of the total supply available for consumption (blue triangle at the bottom). This includes oil that is extracted via non-traditional methods -- e.g., oil that is trapped in thick sand or tight shale. This graph also includes 13% of the total supply (grey section at the top), which is attributed to other liquids such as ethanol, biodiesel, coal-to-liquids and gas-to-liquids. I won't discuss those in detail in this article, however.

So How About The Expected Growth Of Renewable Energies?

As mentioned above, there are a lot of alternative renewable energies that are slated to grow tremendously between today and 2050. According to The New North: The World in 2050, the world's electricity supply sources will be broken down in 2050 as shown in the table below:

Energy Type Energy Source Percent of Total Energy Supply in 2010 Percent of Total Energy Supply in 2050
Non - Renewable Coal 40% Between 36 - 85%
Natural Gas 20%
Uranium 15%
Oil 7%
Renewable Hydropower 16% 14%
Other Renewables (Wind, Solar, Geothermal, etc) 2% Between 1 - 50%

Of course, the first thing that jumps out is the uncertainty of the ranges available in 2050. You may be wondering, how can that be? Smith, the book's author, explains that all of the less mature renewable sources like wind and solar are now starting at a base of close to 0% of the world's energy supply, and their growth depends on so many unknown factors -- for example, political choices and technological advances that are currently unpredictable. Hydropower is expected to remain nearly stagnant, as there are only so many mega-rivers available on the planet where this is a viable option, and those have already largely been tapped out.

So where does all of this leave us? For me, the choice is clear -- the path that offers less risk, with future prospects that are still strong is to focus on the growth of unconventional oil and gas reserves. Although renewable energies will almost certainly grow substantially, it is completely unclear to me which companies, or even which energy sources, have the best prospects at this time.

Example Investments In Unconventional Oil And Gas

Currently, I own shares of Transocean (NYSE:RIG) and C&J Energy Services (NYSE:CJES). These are two very different companies, but I think value investors can look at them as examples that follow my thesis, described above.

For those who may have read some of my previous articles (an example here), you know that I normally follow my 10 point system to evaluate companies. I won't do that in detail here for these two stocks, but I've provided a summary table below that shows their strengths and weaknesses in the primary areas I find most important.

First, a short description of each company:

Transocean provides offshore contract drilling services for oil and gas wells worldwide. It offers deepwater and harsh environment drilling, oil and gas drilling management, and drilling engineering and drilling project management services. (Source: Yahoo Finance)

C&J Energy Services provides hydraulic fracturing, coiled tubing, and pressure pumping services to oil and natural gas exploration and production companies. (Source: Yahoo Finance)

If you know these companies or industries, you may know that both of them have been out of favor in general in the market over the past few years. For Transocean, this is due mostly to the Macondo oil disaster in the Gulf of Mexico. For C&J, the issue is more about the uncertainty of federal regulation and environmental concerns about hydraulic fracturing, as well as increased future competition that could potentially hurt its margins. Without describing these concerns in detail, I'll just say in summary that I think they are short-term "bumps in the road," so to speak, that give value investors a good opportunity to buy these companies at cheap prices. The long-term business prospects remain very bright, following the trends I discussed in detail above.

The table below summarize my other criteria with respect to these companies:

Criteria Transocean C&J Energy Services
Good Business Prospects Deep water drilling will continue to grow substantially as an unconventional source of oil. Hydraulic fracturing is already drastically altering the available reserves for natural gas. This will continue to grow worldwide for unconventional reserves of both oil and gas.
Competitive Moat Transocean is the oldest deep water driller, and it owns nearly half of the platforms in the world. This gives it long-standing competitive advantages. In this relatively new market, C&J is growing very fast and has impressive industry margins. This shows the company is working on some technically challenging and niche projects that give it a competitive advantage in terms of pricing power.
Conservatively Financed Debt/Equity ratio a bit high at 0.82. Debt/Equity ratio is under 0.50, with a current ratio over 2.
Shareholder Friendly

Large dividend was stopped earlier this year. Also some surprise as share dilution took place. I think this is the company's weakest point at the moment.

No dividend, although not surprising with high growth rates.
Valuation (Margin of Safety) EV/EBITDA of 8, forward P/E of 10, and PEG 0.83. EV/EBITDA of 3.74. Forward P/E 5.77, and PEG 0.28.
Predictable Earnings Due to recent Macando disaster expenses, earnings were actually negative. Trending positive now, but still some short-term headwinds. Only public for a year, but the past few years have shown steady strong growth with no surprise dips.

In conclusion, I think C&J remains a strong buy. I have owned Transocean for about a year, and at the time, it was definitely a buy under my system. I do have some issues with the company since then, particularly with its handling of the dividend and share dilution. However, the business continues to turn around and has performed well over the past few quarters. Additionally, the long-term business prospects remain intact, which is why I continue to hold it.

I think this is a great strategy for playing the energy sector in the coming decades, and that patient long-term investors will be handsomely rewarded. Of course, there are other great companies out there to invest in to take advantage of growth in unconventional oil and gas. I invite your comments on this below.

Disclosure: I am long RIG, CJES. 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.

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