The oil world turned upside down--and how to invest in the rise of the U.S. to top global producer by 2017

11/20/2012 8:30 am EST

Focus: STOCKS

Jim Jubak

Founder and Editor, JubakPicks.com

Five years ago I never imagined I’d type these words.

By 2017 the United States will overtake Saudi Arabia as the world’s largest oil producer.

In addition, according to the International Energy Agency, by 2015 the United States will overtake Russia to become the world’s largest natural gas producer.

The United States is now the fastest-growing oil and natural gas producer in the world. During the last five years, according to Citigroup, the United States has added 2.59 million barrels a day to total production.

You’d think there’s an investable angle there somewhere.

I can think of two. No make that three.

First, there are the stocks of the companies that are responsible for this huge surge in U.S. production.

Second, there are the stocks of the companies that will make money from solving the current bottleneck in getting this supply to market.

Third, there are the sectors in the U.S. economy that will reap benefits from lower U.S. energy prices beyond the general advantage flowing to the U.S. economy from lower energy costs.

Let me start with the general picture and then move to individual sectors and trends.

I don’t think it’s overstatement to call what we’re seeing now “The shale revolution.” Higher oil and natural gas prices met up with the maturing of technology pioneered in the 1970s to send oil production soaring. The new production is coming from shale formations that until the development of new technologies for hydraulic fracturing—fracking—were thought unlikely to ever give up their oil content.

Not so long ago the U.S. energy story was one of an irreversible decline in production from the big oil states of Alaska, Texas, and California. Production from Alaska, for example, peaked at 2 million barrels a day in the 1970s. Production in the state ran at 567,481 barrels a day in March 2012. Production from Texas and California was falling as well.

Nothing shows the reversal in the trend more starkly that production figures from North Dakota. With 6,336 wells now pumping oil from the Bakken and Three Forks shale formations production in North Dakota climbed to 575,490 barrels a day in March 2012 from 118,103 barrels a day in March 2007. That put North Dakota ahead of Alaska—with its production of 567,481 barrels a day in March 2012—and moved North Dakota into second place among U.S. oil producing states. North Dakota now chases only Texas, which is seeing its own oil from shale boom turn projected production declines into production increase. Oil production in Texas climbed 12% from September 2011 to March 2012 to 1.72 million barrels a day.

 

The shale revolution wasn’t led by Big Oil. To take one example, the key technique known as “slickwater fracturing” was pioneered by Union Pacific Resources, now part of Anadarko Petroleum (APC) and Mitchell Energy, now part of Devon Energy (DVN.)

Big Oil has, in fact, been left playing catch up by buying acreage from smaller oil producers or buying the small producer outright. For example, ExxonMobil (XOM) bought 196,000 acres in the Bakken formation from Denbury Resources for $1.6 billion.

The problem with these deals, if you’re an investor, is that they aren’t big enough to move the needle at Big Oil. Take Royal Dutch Shell’s (RDS) purchase of acreage in the West Texas Permian Basin from Chesapeake Energy (CHK) in September 2012 for $1.94 billion. That acquisition tripled Shell’s production from unconventional sources and marked a major milestone on the company’s march to have 250,000 barrels a day in worldwide production from shale by 2017. If the company hits that goal, however, shale would still makeup just 6% of Shell’s forecast 2017 production.

No, as I have written earlier—as early as October 21, 2011 in my post http://jubakpicks.com/ -- if you want to buy producers to take advantage of the U.S. oil boom is better to buy the small companies who staked out big acreage early. Names like Pioneer Natural Resources (PXD) and Concho Resources (CXO) should be familiar since I’ve owned them on and off in my Jubak’s Picks 12-to-18 month portfolio http://jubakpicks.com/  (and Pioneer is currently a member of my long-term Jubak Picks 50 portfolio http://jubakpicks.com// ) Pioneer is up 5.28% since I added it to that portfolio on January 13, 2012, but it’s down 9.2% from its September 14 high on worries about the global and U.S. economies. Concho Resources is down 12.3% since I sold it on May 21, 2012 at $90.26 for the same reasons. Other names to look at include Oasis Petroleum (OAS), Devon Energy (DVN), Rosetta Resources, (ROSE), EOG Resources (EOG), and Approach Resources (AREX.)

Big Oil wasn’t the only group of companies caught short by the unconventional oil shale boom in the United States. The mid-continent oil infrastructure wasn’t ready for the boom either.  Whether it’s a lack of pipelines or pipelines designed to flow in the wrong direction, or even a lack of storage facilities, the infrastructure hasn’t been able to handle the increased production of oil from these unconventional plays.

That’s resulted in a huge price gap between the price that oil from these regions brings and the global market price for oil. Recent quarters have seen a huge discrepancy open up between the European Brent benchmark and the U.S. West Texas Intermediate benchmark. On November 16, for example, WTI closed at $86.92 a barrel and Brent closed at $108.95 a barrel.

But that only captures some of the price gap created by the U.S. production boom. For example, on November 8 at Midland, Texas, in the heart of some of the biggest unconventional plays in the country, WTI closed $7 a barrel cheaper than at the big central oil terminal in Cushing, Oklahoma. The price difference between WTI and the Gulf Coast’s Louisiana Light and Sweet has ranged recently from $8.50 to $30 a barrel.

Those price differences are a reflection of a glut of oil at many of these unconventional plays because of a lack of transportation capacity to get the oil to Cushing or to the big refineries on the Gulf Coast.

As you might imagine, price differences like that have created boom times for anybody that can get a bucket of oil to the end markets. It costs about one-third as much to transport oil by pipeline as it does by rail, but it takes years to build a pipeline. In the meantime Burlington Northern, now owned by Warren Buffett’s Berkshire Hathaway (BRK.A or BRK.B), and Union Pacific (UNP) have seen revenue from carting oil boom. (Just in time to make up for the decline of shipments in coal.)

Eventually, the pipelines will catch up—the longer the boom runs, the more sense it makes to build a new pipeline. From that long-term perspective, I’d look at Magellan Midstream Partners (MMP), because of its focus on pipelines in the mid-continent region and its tie-up with Anadarko Petroleum (APC), one of the biggest players in the Bakken formation, and Plains All American Pipeline (PAA) with its interesting mix of pipelines and storage capacity in the region. I’d like to get these MLPs (master limited partnerships) a little cheaper with yields of 5% or above. They right now yield 4.67% and 4.82%, respectively. (There’s a similar investment opportunity in the demand for liquefied natural gas terminals that would enable natural gas producers to ship cheap gas from producers in the United States and Australia—on trend to run neck and neck with Qatar as the world’s largest exporter of natural gas by 2030. If you’re interested in investing in this transportation trend, I’d suggest Cheniere Energy (LNG), the leader in the race to build the first liquefied natural gas export terminal in the United States.)

The increase in U.S. oil production isn’t occurring in isolation. The same fracking technologies and unconventional geologies that are at the heart of this increase in oil output have produced an even bigger boom in natural gas production. Between the two hydrocarbons, energy prices in the United States will be cheap in comparison to those in the rest of the world. Electricity, for example, is forecast to be about 50% cheaper in the United States than in Europe, according to the International Energy Agency, over the next two decades as the U.S. relies on cheap natural gas to fire new power plants.

Cheap energy is no guarantee of faster economic growth but it sure won’t hurt as cheap energy prices get factored into the thinking of companies trying to decide where to locate production. The biggest effect will be in industries where energy—and natural gas in particular—is a huge percentage of the cost of raw materials. Think Dow Chemical (DOW), du Pont (DD), and LyondellBasell Industries (LYB) in chemicals or CF Industries (CF) in nitrogen fertilizers. Companies that rely on the chemicals produced by these companies for raw materials for their own products will also benefit from lower U.S. energy costs. A paint-maker such as Sherwin-Williams (SHW) comes to mind.

And the effects of cheap U.S energy and the boom in U.S. oil and natural gas production aren’t limited to the U.S. economy. I don’t expect global oil prices to fall dramatically as more U.S. oil production works its way into the global supply chain, first as refined petroleum products and eventually as oil exports. The gradual recovery in U.S. and Chinese economic growth should keep prices in something like their current range. But that current range is bad news for some of the world’s biggest oil exporters, and most especially Russia. Russia needs an oil price near $120 a barrel to balance its national budget and to attract the capital it needs to modernize its own industry. It’s not clear that the surge in U.S. oil production is enough to put a damper on the very expensive oil produced by Canada’s oil sands industry or that promised from Brazil’s deep, deep, deep water South Atlantic finds, but I’d certainly steer my portfolio away from the most financially leveraged companies in these projects. Cheaper natural gas and oil isn’t exactly what the beleaguered global solar and wind industries need either.

And, of course, in general it pays to think about what can go wrong—and about how fast the energy picture can change (and change again.) A good part of the swing toward the possibility that the U.S. will become an oil exporter again—or at least achieve self-sufficiency in energy use and production—is due to expanding production. But some—the International Energy Agency says production is about 55% of the story and energy efficiency 45%-- is a result of increased energy efficiency in the U.S. economy prompted by higher energy prices over the last decades. If an increase in oil production leads to a roll back in those gains in energy efficiency, you can throw energy self-sufficiency as a goal out the window. (The International Energy Agency has said that its projections for U.S. energy self sufficiency assumes that the U.S. will continue to increase energy efficiency for its cars, homes, and appliances.) I’m sure that this boom in U.S. energy production from unconventional sources will convince many people to completely discount the theory known as Peak Oil. Certainly the hard form of Peak Oil is dead, but the more realistic form, which held that U.S. production from conventional sources had peaked in the 1970s and was in decline, still looks good for the U.S. and global oil industry as a whole. From this perspective you can think of each successive “exhaustion” of a conventional source of oil moving the base price of oil higher even if all the conventional supply is replaced by (more expensive to produce) unconventional sources.

And finally, of course, there’s the possibility that the real world will deliver enough disasters, storms, and data to convince everyone that global climate change is real and that the world needs to reduce its burning of all forms of hydrocarbon, even natural gas. Personally, I find the data on climate change convincing and I wish that the United States and the world would move on this problem sooner rather than later. But just because I wish it doesn't make it so. One of the essentials in investing is separating the world as you’d like it to be from the world that is likely to be. (Which doesn't mean you have to put money into trends you abhor or that you can’t invest in your hopes for a better world. It just means that you need to be aware of those choices for what to do with your money.) Surveying the world, with some sadness I don’t see action on global climate change as any near or medium term danger to any investment in oil stocks.

Full disclosure: I don’t own shares of any of the companies mentioned in this post in my personal portfolio. The mutual fund I manage, Jubak Global Equity Fund http://jubakfund.com/ , may or may not now own positions in any stock mentioned in this post. The fund owned shares of Cheniere Energy at the end of September. For a full list of the stocks in the fund as of the end of September see the fund’s portfolio at http://jubakfund.com/about-the-fund/holdings/

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