Rethink The Whole Energy Scene, And Investments In It

by: Peter F. Way, CFA

Enormous change is now upon the entire U.S. Energy Industry - both in sources and uses. The investment opportunities of the shorter term are present here and now, as they have been for at least a year. But even more important longer-term investment implications have yet to be realized.

The change impacts being felt short term have to do with the evolution of extractive technology, and the rise in importance of smaller energy fuel producers in an industry that has been dominated by big integrated international producers.

To save the time of investors with urgent decision needs or only cursory requirements for further attention, here are the better stock choices at present with prospects for capital gains at high annual rates of return and modest drawdown exposures.

The behavioral analysis supporting these choices are familiar to our regular subscribers to the Block Traders' Oil & Gold Monitor at, from which the first five comparative buy recommendation examples are drawn. In short, we draw price forecasts from the necessary hedging actions of volume market-makers as they facilitate the transaction desires of big-money hedge funds, mutual funds, endowments and other institutions.

Our buy recommendations look to the proven records of what prices subsequently occurred following prior market-maker forecasts like those seen at present. We compare the odds of success and the size of payoffs, both gains and drawdown exposures, in making buy recommendations from over 200 different energy stocks.

Here are some recent results and comparisons of those with current similar attractive prospects, using this form of forward-looking analysis. The symbols are of EV Energy Partners (NASDAQ:EVEP-OLD), Range Resources (NYSE:RRC), Carrizo Oil & Gas (NASDAQ:CRZO), Continental Resources (NYSE:CLR) and Energy XXI (EXXI).

The current recommendations of EXXI and EVEP are near-term prospects typically achieved in 6-8 weeks (as indicated in the market-days-held column of prior like forecast performances). Those average gains are net of losses (the complement of the % winners column).

The three rightmost columns are the actual outcomes of the buy recommendations in the first five rows.

For those with investment horizons longer in time, here is what is now happening in the energy industry, and what the implications of those changes are for the future.

To understand the magnitude of the change potential, we have to go back to some very basic ideas.

Civilization's progress is entwined with the common-sense basics of Economics - the balancing of benefits with their costs. For the time being, set aside all the many other convoluted, elaborate, and elegant economic theories - benefits and costs are the drivers of it all.

Humanity makes sense of this balancing process, and the better we do it, worldwide, the greater the progress of our species. As humanity has evolved from the basics of an individual's survival to the societal complexities of the industrial and information age, energy has been an increasingly important essential.

A tool in understanding the cost and benefits balancing process is the economists' Input-Output matrix.

In it there is an attempt to make explicit the elements required at each stage to conduct the activities that flow down step by step from the most general, basic, and encompassing upper levels, to the very specific, detailed, and consumptive lower level activities - perhaps also then to recycle back up to higher levels of the process.

Each cell in the matrix is intended to contain the elements essential for subsequent, lower-level activities. Present in every cell, as a component, is energy. The appropriate descriptive term for this is pervasive.

Costs and benefits. Energy replaces human and animal effort, and makes possible, through technology, many things and activities not possible by other efforts. Technology, evolved by thought and education, acts as a feedback loop reducing the cost side of the balance. The changes it brings often - even usually - evoke additional new benefits.

Enough of Econ 101-2-3. Now to get specific with energy investments.

Energy cost reductions took an enormous stride forward at the end of the 19th century from whale oil, firewood, and coal sources when massive petroleum deposits were discovered, developed, and exploited in the U.S. Their benefits were greatly expanded because delivered costs were greatly reduced and availability was thus widely extended.

Ultimately the rest of the world caught on. Additional resources were discovered, some even more extensive than in the U.S. But technology here kept U.S. costs lower than elsewhere, so we set the prices, worldwide, except for delivery cost increments. That is, until the easy, cheap-to-get stuff started to run out.

Technology has always played a role in the extractive industries. The value of natural resources is a direct product of the benefits they provide, net of the cost of their liberation and delivery. Mining has evolved, where geology permits and volumes support, from dangerous, costly, underground activity, to enormous open-cut production performed by huge (energy-consuming) mechanical equipment and modest human effort. Delivered costs declined and markets expanded, while alternatives were displaced or diminished.

Petroleum-based energy is one of those alternatives diminished in some markets by its own advancing delivered costs. Electrical energy generation is a prominent example. Coal has been the low-cost alternative, cut from open-pit mines, distant from electrical demand centers, and transported to market by "steel wheels on an iron rail."

Coal's price has been set by the costs of the petroleum alternative. That has made profitable some mining activities and transport means that are marginal.

Back in my (mid-20th century) college days, I remember students had a "currently useful generalization" that "necessity is a mother of invention." It may still hold true. The more difficult competitive cost pressures get, the more likely technology is to evolve some answers. So it has become true on the energy scene.

The enormously favorable geology of the United States of America provides the circumstances for technology to reduce delivered energy costs, expand markets, and evolve new benefits for society - here first, but ultimately to the rest of the world.

The U.S. geology already provides massive, multi-century-use coal reserves. At higher costs, the U.S. should never run out of domestically-produced energy sources. But that may not be competitively practical, as Adolf Hitler found out in World War II.

Those coal seams lie in miles-wide strata of horizontally-formed beds of deposits, common to many places in this country - and probably to other places in the world. Our geology is key to the technological advances making possible the new era of major energy cost reduction: Horizontal drilling and hydraulic fracturing - often combined into the single notion known as "fracking."

This technology goes open-cut mining a major step better, since it does not require the expensive monetary cost and emotional-political cost of removing the surface layer of earth between us and the valuable resources. Nor does it send humans into underground (or undersea) dangers.

The simple explanation of why these advances are economically beneficial is one of directional dimensions: vertical vs. horizontal.

The 20th century petroleum game relied on drilling vertically down into dome-shaped geological entrapped reservoirs or similar geo-fault-created structures. They often were limited to a few hundred feet or less of "pay." To extend the field, additional "step-out" wells had to be drilled, vertically, parallel to the "discovery" well.

"Fracked" wells often are performed on shale structures that may have rather limited vertical depth, but "pay zones" that could have miles in length. And step-outs may start their drilling already from the "pay zone" but just reach in other horizontal directions of the same strata as the initial producing well.

Another explanation of the cost-reducing impact of this technology has to do with the prize they're after -- natural gas, rather than crude oil.

Actually, the two energy sources have a common denominator, which is the real prize: BTUs (British Thermal Units) of heat source content. But the BTUs are contained in very different physical forms.

Now, all rectangles are not squares, but all squares are rectangles. Not all fluids are liquids, but all gases are fluids. NatGas is a BTU-containing fluid, and so is crude oil. There's the competition, because otherwise these two fluids are very different in their ability to deliver low-cost BTUs.

Crude oil contains about 6,000 BTUs per barrel (bbl.), and 1 million cubic feet (mcf) of NatGas has about 1,000 BTUs. Crude is priced by the bbl and NatGas by the mcf. Crude now is priced in the $87-92 range and NatGas in the $3.00-$4.50 range. If present market prices were converted at a 6 : 1 ratio, NatGas would be $18 to $25, and Crude would be $14.50 to $15.50. Gas would go up, crude would come down.

In the past 100 years, NatGas has never sold in the U.S. at $25 a mcf, and has only rarely approached $18 for very brief periods. Its average price has run around $7. Crude has not sold at $15 a bbl. except in momentary spot markets in the last 50 years and has seen low prices typically of $30 in a range that recently more often has seen prices above $100. Major price adjustments are in store, because these two energy sources are produced at the same time from the same wells. Overall production costs per million BTUs brought to the surface are going down.

With vertical drilling, NatGas was the orphan product, not reliably encountered, and was viewed as a useful "drive" element to help force crude up and out of the well. "Gushers" were crude oil-producing wells with their associated NatGas pressures temporarily not under control.

Occasionally, large volumes of NatGas would be encountered in the development of a field (usually by several competing producers), and these "gas supply bubbles" would depress crude prices, sometimes for as much as a few years. But their presence was more difficult to detect before the fact than was crude, so they were usually considered as bonus values in production, not the principal "pay" stream.

Initially, horizontal drilling's objective was to liberate NatGas from shale beds. In the process, some limited amounts of associated crude oil were also recovered. As the technology improved, sharply increased amounts of both NatGas and crude were produced, to the point where, because of crude's higher price, its value in the pay stream sometimes becomes higher than the NatGas.

Overall, the extent of the shale beds here, individually and geographically, when coupled with current productivity rates and probable further technology improvements, make it highly likely that the U.S. will be energy self-sufficient within this decade. The occupant of 1600 Pennsylvania Avenue will have little to do with that accomplishment.

The reduction of worldwide demand for crude for the U.S. will probably have a depressing effect on international prices for crude, particularly from the Mideast Gulf region and, competitively, on North Sea "Brent" oil. Other international demands will keep market prices from collapsing initially, until the spread of U.S. technology develops additional international resources. But not all present crude producers will have the geology favorable to the technology.

Within the U.S., the world's largest energy market, significant shifts in energy sources and market demand are ahead. Already a severe chill has come over the coal producers, both as businesses and as investments. At least one major bankruptcy has occurred, and others will likely follow. The stronger producers will survive at substantially reduced revenue flows and at stock prices with limited prospects. Their coal-hauling railroad compatriots face a similar outcome.

The next major consuming market in transformation is ground transportation. The payback period for trucking companies to convert their vehicles to LPG-burning engines appears to be less than a year, and UPS (NYSE:UPS), FedEx (NYSE:FDX), and the major over-highway-hauler community is reported to be broadly in conversion or preparing to do so. They will cause fuel providers to establish geographically dispersed refueling sources. Sources that undoubtedly will be open to supplying the driving public if Detroit comes to the notion that cars using the equivalent of $2 a gallon gasoline instead of $4, might be salable.

That's not good news for integrated international "Big Oil" producers. Evaluations of their stocks usually contain some notion of the worth of their recoverable reserves. While the NatGas component of that total may get significant expansion, a big negative on the diesel, heating oil, and gasoline feedstocks is likely.

Besides the lower cost of recovery coming from fracking operations, the ultimate delivery of usable product provides cost advantages. Crude requires refining to get desirable products. Refineries consume energy in the cracking, distilling, and other processes. As a result only 7/8ths of a barrel of crude winds up salable.

On the other hand, NatGas requires minimal processing, mostly the stripping off of liquids, which typically is attended to by midstream processor/transporters, independent of the producers. Upwards of 95% of the heat content of an extracted mcf of NatGas reaches the consumer. And the pipeline transportation of fluids in the form of gas, rather than liquids (especially, viscous unrefined crude) is a far less expensive ticket.

The best investment plays in energy for the past year-plus have been in the exploration and development (E&P) production companies that have small proportions of crude resources, compared to their rapidly expanding NatGas reserves from fracking activities and acquisitions.

Further out in time there may well be profit opportunities in the midstream processor community, which is bound to see major expansions of the volumes of NatGas they handle. Their revenues come from handling the assets of others, rather than like the E&P companies' initial claim of ownership of the assets by extraction. But the growth of their revenues may put their P/Es in an improving class of stocks. We will be watching to see if that is likely to develop.

Our regular readers know that our focus is on comparing the appraised price prospects of stocks in the next few months, rather than in speculating on what a long-term future may (or may not) hold.

For investors bound to long-term practices, the principal message of this article is that those big integrated oils that typically have been protective hiding places for capital in times of market turmoil may turn out to be disappointing custodians of investment capital over the next several years.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.