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Tuesday, November 26, 2013 - 14:30
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Tuesday, November 26, 2013 - 14:30

My Favorite Shale Plays Share This 1 Key Virtue

Tuesday, November 26, 2013 - 2:30pm

In today's energy market, investors often try to distinguish between oil plays and natural gas plays, but the distinction is often moot -- most of today's wells produce a healthy amount of both.

The key to finding winning investments is to focus on the relative productivity of a firm's well.

Let's focus first on natural gas (we'll shift the discussion to oil in a moment).

The natural gas market appears to have settled into long-term equilibrium. You'll surely see short-term spikes in prices when the weather gets especially cold (as increasingly appears to be the case this winter).

But unless we have strongly overestimated that amount of untapped oil and gas remaining in our shale regions, then supply increases will be the likely result of any upward move in natural gas prices.

As a result, gas prices may move into the $4 to $4.25 per thousand cubic feet (Mcf) area, but much more upside than that is unlikely. In fact, the natural gas futures market doesn't anticipate a move up above the $4.50 mark until January 2019.

To be sure, gas prices in the $3.50 to $4.50 range explain why share prices of many gas producers remain in a funk. But even at these lower prices, some gas producers are extremely profitable. And it's all about geography.

As geologists have come to realize, some shale regions produce gushers with very little drilling effort. That helps keep expenses very low and enables firms operating in these areas to make ample profits even if gas prices fall to the lower end of the price range noted above.

The most productive shale regions in terms of natural gas production: the Haynesville and Marcellus shales. According to a recent report by the Energy Information Administration (EIA), these two regions are seeing robust output from every new well deployed. "Drilling productivity has increased 50% annually in the important Marcellus gas play and 30% annually in the Haynesville play," notes Barclay's Tom Driscoll in a recent report.

Driscoll thinks the productive output in the Marcellus Shale is leading to solid output and profit gains for Noble Energy (NYSE: NBL). (Incidentally, I am a big fan of this company, thanks to its additional exposure to exposure to massive natural gas fields off of the coast of Israel.)

Changing Dynamics In Oil Productivity
Here's an unusual set of stats: Both the Eagle Ford shale and Permian Basin shale each account for roughly 1.2 million barrels of oil produced per day (according to the EIA). Yet each new rig that is going into service in the Eagle Ford produces an average 405 barrels a day (far above the industry average of 236). For the Permian Basin, that figure is just 79 barrels. The Bakken Shale joins the Eagle Ford as being the most productive region for new oil rigs.

The rising productivity at the Eagle Ford shale has surely been a share price catalyst for industry favorite EOG Resources (NYSE: EOG), which my colleague Jody Chudley recently profiled.

Barclay's Driscoll is a fan of EOG but also recommends Marathon Oil (NYSE: MRO), thanks to its exposure to both the Eagle Ford and Bakken shales, and QEP Resources (NYSE: QEP), which has been extremely productive in the Bakken region.

Meanwhile, some shale regions, such as the Permian Basin, are proving to be a headache. Far too much money is being expended, only to find that output is disappointing. For producers, a fresh drop in gas prices would spell real trouble.

Barclay's Driscoll suggests investors avoid the Permian producers, singling out Devon Energy (NYSE: DVN), Pioneer Resources (NYSE: PXD) and Occidental Petroleum (NYSE: OXY) as companies for which he has a cautious view.

Risks to Consider: The biggest risk in the energy sector right now is oil prices, which have been moderating lately. If Iran and world negotiators eventually establish a long-term nuclear agreement, than Iran's return to the oil market is likely to push oil prices yet lower.

Action to Take --> Before you invest in any oil or gas producer, select a few companies for research and then compare their drilling costs per rig and relative output at each rig (which you can find in their 10-K's and 10-Qs). If the stocks appear to be comparatively valued in terms of price to cash flow, then you should stick with the operator that is better positioned to capitalize on the trends noted above.

P.S. We've just put the finishing touches on a special report on a fast-growing oil stock with a 10.2% annual yield. In the past year, this company has quadrupled production, to 4,000 barrels of oil a day. To learn more about why we like this company, click here.

David Sterman does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.

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