7 Reasons to Concentrate on Unconventional Oil Producers

by: Devon Shire
It is amazing how quickly people adjust to change. Imagine 10 years ago someone telling you that oil would be $70 per barrel and that you would be paying four times as much to fill up your car. You would have thought $70 per barrel was an astronomical figure and bought a bicycle.
Now $70 per barrel sounds pretty reasonable and $90 to $100 really doesn’t change the amount North Americans drive.
The idea that the world is getting close to the point where we can’t get oil out of the ground fast enough to meet daily global demand has moved from the fringe to the mainstream. Even the IEA which five years ago assured us that we could comfortably grow oil production through 2030 has admitted that conventional oil production peaked in 2005.
The current oil market situation seems pretty simple to me. The only real spare capacity in the world is in Saudi Arabia. The country seems likely to have about 2 million to 4 million barrels per day of spare capacity. Global oil demand is set to grow by about 1.7 million barrels both in 2011 and 2012. So after 2012 the world has no spare capacity and any future demand growth can’t be supplied. Thus the only way to keep demand even with supply becomes an increase in oil prices.
I want to be invested to take advantage of high oil prices, and after a couple of years of trying to get myself ready I’ve come to the conclusion that the best investments that I can find are in North American unconventional oil producers. I have seven major reasons why I believe this:
1) Little political or physical risk – I want oil exposure and I like to buy those assets at a discount, but I want to be able to sleep at night. Therefore I’m most interested in being invested in companies that operate in North America where for the most part government action or violence is not a large concern. There are plenty of unconventional oil resources inside of North America that are just starting to be developed.
2) Avoid the risks involved in deepwater exploration and production – While I don’t feel adventurous enough to invest in reserves in unstable countries, I also don’t feel particularly comfortable owning oil reserves and production that involve operating in miles of water with expensive infrastructure that is in the path of major hurricanes. Unconventional oil plays allow me to avoid being exposed to another Macondo style event.
3) No exploration risk – I love the idea of owning an oil company that hits on a giant oil discovery that immediately triples the value of the company. The reality is though that the wildcat oil exploration is high risk, and I have no ability to assess the likelihood of a successful outcome. These unconventional oil plays on the other hand are resource plays that have a broad areal extent and very little exploration risk. That is why you see companies like Petrobakken (PBKEF.PK) in Canada with a 99% success rate when drilling wells. They are basically repeatable manufacturing like operations.
4) Potential for large increases in the amount of oil recovered from enhanced oil recovery techniques – Profitable production from unconventional oil resources is relatively new. The Bakken in Canada for example did not produced economically until 2005/2006 when horizontal drilling with multi-stage fracturing “cracked the code” in this play allowing for sufficient rates of production to allow for an attractive return on investment. As these technologies and the plays themselves are young, every year sees improvements in technology and techniques that make these resources more valuable. I have my eye on two Canadian unconventional oil producers - Petrobakken and Crescent Point Energy (CSCTF.PK). They both operate in the Bakken and are moving forward with enhanced oil recovery techniques that both companies suggest will double the amount of oil recoverable and increase the value of their reserves by over 75%. Crescent Point is using water flooding. Petrobakken is injecting natural gas. Eventually all unconventional producers will adopt what turns out to be the best technique.
5) Undeveloped acreage tends to be undervalued by the stock market – Despite the positive things I have said already about these unconventional resource players, I would not be interested in them unless I thought they were undervalued by the stock market. What I am finding in many cases is that the stock market values these companies based on existing production and is slow to acknowledge cases where a company holds huge parcels of undeveloped land within established boundaries of a particular resource play. Every week I see transactions involving undeveloped land that proves it has considerable value, but until the stock market sees production coming out of the ground little value is often assigned. This means there is great opportunity to find a company that has a relatively small amount of current production but a long runway or production growth through a large undeveloped land base within an unconventional play. Novus Energy (OTC:NOVUF) in Canada is a perfect example.
6) Light oil production - Unconventional oil production results in a very high value light oil. Alternative means of gaining exposure to future new oil resources that I have looked at usually involves looking to heavier grades of oil. Heavier oil requires the cost of diluting to allow it to be transported through a pipeline and also is expensive to refine. Having a more valuable light oil puts these unconventional producers in much better shape to weather the cyclical nature of the oil business.
7) Consolidation of smaller players provides a likely avenue to realize value – Canada specifically has a number of emerging unconventional oil plays. These include the Viking, the Cardium and Swan Hills. In these plays are a number of very small publicly traded companies that have amassed enviable land positions. These companies are obvious acquisition targets and based on recent transaction multiples several of them have considerable upside. Companies that interest me include Arcan Resources (OTCPK:ARNBF) , Second Wave Petroleum (OTC:SCSZF) , Bellatrix Energy (OTCPK:BLLXF) and Westfire Energy (OTCPK:WFREF). The only thing better than buying undervalued securities is buying them with a catalyst to realize that value sooner than later. I believe several of the above mentioned companies will be acquired in the coming two years.
Since the start of 2011 the price of oil has increased about 17% while the average small and mid-cap energy producer in Canada has fallen roughly 16%. I think now is a pretty good time to be buying these companies. Prices may get better and if they do I will continue buying. I think these companies are undervalued and that as oil prices rise - and technology helps unlock more oil at less cost - the value of their assets will grow.