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The Changing Oil Industry

|Includes:CVX, Exxon Mobil Corporation (XOM)

The oil industry is changing. Right before your eyes. There's a secular shift going on in the oil sector that's realigning the entire industry. It's a technique known as hydraulic fracturing or "fracking" and it's the fracturing of rock by a pressurized liquid in order to separate the petroleum products or hydrocarbons from the rock. The result of this process is to release vast amounts of hydrocarbons that were formerly inaccessible using traditional methods. This "fracking" technique today is most often applied to wells drilled for shale gas because this fracking techniques can easily separate the gases and the liquids from the shale rock. This technique can also often be repeated over and over in the same well as the oil becomes slowly depleted over time. As today's oil industry shifts away from those traditional drilling methods to this newer technique, hydraulic fracturing will begin to spread internationally. And this secular shift will only accelerate.

Shale Gas Formations in the Continental US

The big oil companies (XOM, CVX) that for decades have had the strategic and financial advantage to drill offshore wells in the world's great oceans while onshore wells were slowly being depleted throughout the 20th century, have today found themselves slow to redirect their efforts toward this new technique of hydraulic fracturing. They apparently don't have the necessary financial means to operate everywhere simultaneously while entering into this new area of oil and natural gas exploration. To fund their shale gas expansion, the major oil and gas companies are being forced to sell off their more mature, conventional acreage and the upstream MLPs are buying. This supply of mature, onshore US assets for sale keeps rising each year and the sales to the MLPs will continue for decades.

I believe that this secular shift has been underway for a couple of years within the energy sector, wherein the large integrated oil companies and large capitalization exploration and production (E&P) companies have sold their mature E&P assets to the smaller upstream MLPs for cash. These older, mature assets are especially suited for the organizational and tax structures of the upstream MLPs but that they fall far below the rate of return required of the larger corporate oil and gas producers. If I'm correct that the current strong demand for yield by older investors will continue as the general population ages, and that the growth of upstream MLP assets will also increase while at the same time maintaining their high yields, I think that MLPs will be a great investment for individual investors like myself for years to come.

It's currently estimated that it will take more than $2 trillion to fully develop the known potential shale formations. The Bakken Formation is still undeveloped, the Eagle Ford Formation has just gotten started, and the Marcellus Formation's abundance of natural gas will ensure that it can be drilled for decades even with low natural gas prices. These three shale plays alone will demand every cent the big oil companies can obtain for years to come. And that money will come from selling off those mature properties to the MLPs.

In addition, if the Utica, Monterrey or Permian Formations yield huge liquids discoveries, it will only increase the pressure on producers to sell off additional acreage and redirect those funds into shale expansion. Since the sale of Big Oil's mature assets is ultimately connected to this shale revolution, I believe there will be a continuous and abundant supply of available acreage for at least a decade and probably longer. And the upstream MLPs will continue to take advantage of this situation.

There are a number of MLPs that fit into the category of upstream oil and natural gas exploration and production companies. Most of them can be discovered with the use of a simple screener on any number of stock screeners located throughout the internet. The master limited partnerships that I'm most interested in are those listed and located in another section of this website entitled "Exploration and Production MLPs". My favorites are those that are the most agile and aggressive since this industry lives and dies by acquisitions. The nature of this business is such that oil and gas fields will eventually become depleted so companies that aren't aggressive in their acquisitions or aren't interested in pushing the technology for retrieving oil and gas from mature oil fields are companies that won't be around ten years from now.

BreitBurn Energy (BBEP) has been both selective and predatory. In the last few years, it has picked up multiple producing fields at great sale prices. It's mostly gone after properties in the Permian Basin while building an impressive asset base in the Niobrara. Its acquisitions from Whiting Petroleum have also added lots of oil intensive acreage in Oklahoma and New Mexico to their inventory. The stock yields 9.06% in dividends annually and it has a market capitalization of $2.63 billion.

Mid-Con Energy Partners (NASDAQ:MCEP) also has extensive mature acreage containing generous amounts of conventional oil. Up until recently MCEP has added only small but iconic acreage in Cushing and the Hugoton Basin, but going forward it is expected to grow at a more aggressive pace. This relatively small company has a market capitalization of $416 million and yields 9.24% annually.

Legacy Reserves L.P. (NASDAQ:LGCY) has an extensive footprint within the Permian Basin as a result of many years of highly economic acquisitions of small-scale mom-and-pop acreage positions. Because the partnership has reached a scale where it would be challenging to screen, negotiate and execute a sufficient number of small deals to sustain growth, Legacy has shifted its focus to acquiring larger asset packages. Legacy Reserves has a market capitalization of $1.73 billion and yields 7.71% annually.

Vanguard Natural Resources (NYSE:VNR), arguably the most conservative of all the upstream oil and gas MLPs, has taken the opposite strategy of Mid-Con Energy Partners. Instead of going for costlier oil assets, it has scooped up gas acreage on the cheap in the Niobrara, Permian and Arkoma areas where it's gotten a particularly good deal. Vanguard yields 8.06% annually and has a market capitalization of $2.49 billion.

Linn Energy (LINE), the largest of all upstream MLPs at $10.17 billion, does acquisitions in a class of its own. Two years ago it purchased assets from BP at fire sale prices over a series of transactions. Last year it bought Berry Petroleum, whose oil producing assets in the Midway-Sunset field of California are among the best in that state. Linn used to trade at a premium to most upstream MLPs, but has since become a battleground stock with the short-sellers allowing for great entry points. It now yields 9.31% annually.

These and other upstream oil and natural gas companies are a great place for a person interested in dividends (like myself) to look for investment opportunities. In the future, I believe upstream MLPs will continue to acquire highly desirable mature oil and gas assets and develop them into stable and predictable sources of income for many years to come. This is exactly the kind of investment I'm looking for and it's what makes their story so attractive to income investors. I really believe the MLP unit holders/shareholders of today will enjoy financially stable and increasing distributions for a very, very long time.

Good Luck and Good Trading.

Disclosure: The author is long BBEP, MCEP, VNR, LINE.

Stocks: XOM, CVX