A US Energy Revolution

05/19/2014 10:00 am EST

Focus: STOCKS

Ken Farsalas, analyst with The Oberweis Report, discusses the revolution in domestic energy production, highlighting the technology behind this drilling renaissance as well as his favorite stocks poised to benefit from these trends.

Steven Halpern: Joining us today is Ken Farsalas, analyst with The Oberweis Report. Thanks for taking the time today, Ken.

Ken Farsalas: Well, thank you, Steve, I really appreciate you having me on the program.

Steven Halpern: You begin your latest research report by saying forget the tech boom and Silicon Valley or the pot boom in Colorado. The biggest boom in the country is found in tiny Williston, North Dakota. What's going on there?

Ken Farsalas: Yeah, that's right. The biggest boom in the country is in Williston and it's a 21st century gold rush there. The gold that they found is black. It turns out that there's a ton of oil in North Dakota and Williston, North Dakota, population 18,500 people has been booming over the last five to six years.

Their population grew 10% last year. They're building 2,000 to 3,000 new housing units every year to keep up with demand and rents in town have gone from $350 for a two bedroom apartment five or six years ago to upwards of $2,000 today, and the State of North Dakota is having a boom and a renaissance as well.

They've got a $1.6 billion budget surplus in North Dakota this year and in an environment where most states-of course-in the union are struggling with budget issues. Things in North Dakota are going very well and it's related to, essentially, an oil rush that's been going on there since 2006-2007.

Steven Halpern: As you allude to; the success there is related to the drill inspector, and there are two new technologies that have had a significant impact there. Could you explain these technologies and the role they've played in exploiting the Bakken shale in North Dakota?

Ken Farsalas: Sure, absolutely. There's really been an emergence in commercialization—as you mentioned—of two significant advancements in energy exploration technology.

The first is horizontal drilling and the second is something called fracking, which a lot of people have heard about because it's been in the news quite a bit lately.

Horizontal drilling is a process where a well is drilled vertically to a certain depth and then that well is turned at, essentially, 90 degrees horizontally and then run horizontally for upwards of 6,000, 7,000, 8,000 feet and it provides energy companies with better access to oil reservoirs, or gas reservoirs for that matter, that are shallow but very large in surface areas.

If you think about what a reservoir might look like under the surface of the earth, a lot of times these reservoirs look like a pancake, so they're spread out over a tremendous distance but they're very thin.

Those types of reservoirs cannot really be accessed by vertical drilling—but they can be accessed—extremely efficiently from an economic standpoint—by horizontal drilling.

Then the second technology innovation really goes hand in hand with horizontal drilling because once you drill that well horizontally you need to coax the oil and the gas out of the rock and hydraulic fracturing is used to do that.

Hydraulic fracturing is a process where a pressurized liquid, and that liquid is typically a mix of water, sand, and chemicals; is injected into the well at very high pressures to create small fractures in the rock that allow the oil and gas to escape and migrate to the surface.

Horizontal drilling and hydraulic fracturing go hand-in-hand and they are two technologies that have, really, completely revolutionized and changed the way that we explore for oil and gas in the United States today.

|pagebreak|

Steven Halpern: Now, you know that this boom isn't just limited to North Dakota. What do you see occurring within the overall domestic drilling area?

Ken Farsalas: Yeah, so, the real stand is the poster child for this change and we've seen North Dakota now has become the second largest oil producer in the US, only behind Texas. Production in North Dakota is up 400% since 2008 but other parts of the country have experienced this renaissance as well.

Texas, obviously, is going to be a major oil producer in the Permian Basin and Texas has become very hot with horizontal drilling but we're also drilling for oil and gas now in places that you normally wouldn't associate with energy exploration.

Marcellus shale in Pennsylvania is a very hot natural gas exploration area now. The Utica shale in Ohio is also very hot. We have the Wattenberg in Colorado, the Haynesville in Louisiana.

So, since 2008, not only do we have that tremendous increase in production in North Dakota but production in Texas is up 130% over that timeframe. Oklahoma production is up 65%. Production in Colorado has doubled.

Overall, in the US, oil production in the United States hit 7.4 million barrels per day in 2008, that's up almost 50% since 2008 and the International Energy Agency says that the US could become the world's largest oil producer by 2015 or 2016 supplanting Saudi Arabia as number one in the world.

So it's really had a tremendous impact on the energy industry in the US over the last five years.

Steven Halpern: Now, as often is the case, the upside is also tempered by some risk. Many consider fracking to be unsafe. Could you expand on that?

Ken Farsalas: Yeah, there are some who consider fracking to be unsafe with, really, a primary concern that fracking fluid can contaminate underground drinking water supplies and I think the jury is still out on the impact that fracking has on the geology underneath the earth's surface.

But in some instances, particularly in Colorado ,we have a situation in Colorado where a number of cities have actually banned fracking and there is a proposal in Colorado for a state wide band that might make the ballot this coming November. It's something to watch very carefully.

I think as more and more jurisdictions and states are allowing fracking to occur, I think the industry and the local governments are learning more and more about its potential effects and—like anything else in business—whether it's energy exploration, or manufacturing, or whatever, it might be—there probably are some safeguards that need to be taken to protect the environment.

I think that it's a balancing act that is going to play out over the next few years, but certainly something to keep an eye on.

Steven Halpern: The other main risk that you point out is the price of oil itself. Could you explain that?

Ken Farsalas: Sure, so it costs a tremendous amount of money to drill a horizontal well; for example, in the Bakken shale in North Dakota, as we were talking about before, it can cost anywhere from $7 million to $10 million to drill and complete a horizontal well in that area.

You really need, in order for the returns on that investment to be satisfactory, you really need the price of oil to stay in excess of $70 to $80 a barrel.

Oil today is trading around $101; that's certainly not an issue right now, but again, you need that price to stay in excess of $70 to $80 for that investment to provide a sufficient return.

|pagebreak|

And, of course, there's kind of a paradox here because as production increases domestically that could potentially pressure oil prices in the future as supply increases.

This is very similar to what happened in the US natural gas market here over the last five years. The other major risk, really, to horizontal drilling and fracturing, in general, is, can that price of oil stay high enough to generate sufficient returns for the very large investment that these companies have to make in order to get the oil out of the ground?

Steven Halpern: Now, finally, let's look at some specific investment opportunities; and there are several companies that you rank as favorites at The Oberweis Report. Would you share some of these ideas with us?

Ken Farsalas: Sure, at Oberweis, we invest in companies that have something interesting and unique that's happening with their business that will allow the company to generate revenue and earnings growth in excess of consensus expectations.

In the energy space, that means investing in companies that have exposure to this fracking and horizontal drilling revolution. At the exploration companies themselves we really like a company named Callon Petroleum (CPE).

This is a microcap company, actually; it's relatively under—follows by the street, but the company has undergone a very interesting transformation over the last year and a half and they are now 100% levered to that Permian Basin in Texas that I mentioned earlier.

We think Callon will grow their oil production in excess of 120% this year versus last year and we think the stock, which is roughly around $10 per share currently, has upside to the mid-teens.

We also like a company called Bonanza Creek Energy (BCEI). Bonanza Creek is exposed to the Wattenberg, which is in Colorado.

We think Bonanza Creek will grow their production by over 50% this year and the stock, which is trading in the low $40s, has, we think, upside into the $60s. Of course, one of the key risks there is the regulatory risk in Colorado that we talked about a moment ago.

Then on the service side itself we have been long-term investors in a company called Flotek (FTK). Flotek is actually a leading supplier of those fracking chemicals that I mentioned to you earlier.

What they do is they supply those chemicals to the energy companies and they have been promoting more recently a more environmentally friendly fracking chemical that has one of its main ingredients actually comes from orange peels.

So, they've been promoting their chemical as more environmentally safe and friendly than some of the other chemicals that are available out there in the industry. Their chemicals business last quarter grew by over 40% year over year.

The stock, which is trading in the upper $20s currently, we think, has upside into the mid-$30s over the next year or so.

Steven Halpern: We really appreciate you taking the time today. Thanks for joining us.

Ken Farsalas: Thank you Steve, I really appreciate you having me.

Subscribe to The Oberweis Report here...

Related Articles on STOCKS