Get in on the New Oil Boom

10/08/2010 9:45 am EST

Focus: COMMODITIES

Jim Jubak

Founder and Editor, JubakPicks.com

Oil production is going gangbusters in the shale fields of North Dakota, Montana, and Saskatchewan, Canada. Here's why—and how investors can do a little wildcatting, too.

It looks like the biggest winner from the boom in natural gas production from shale formations in the United States will be the US onshore oil industry.

Thanks to techniques pioneered in the late 1970’s to extract natural gas from tight shale formations in such places as Wyoming, Texas, Arkansas, New York, and Pennsylvania, onshore US natural gas production has soared. From 2007 to 2008, a period when production from shales took off, natural gas production from these formations increased by 71%, according to the Energy Information Administration (EIA).

Thanks to that booming US supply, and an abundance of cheap natural gas on international markets and a deep economic recession, that surge in natural gas production hasn't resulted in huge profits for natural gas producers. NYMEX settlement prices on gas futures have plunged to less than $4 per million BTUs (British thermal units). That's down from a high of almost $14 in late 2005, and from more than $9 as recently as August 2008.

Producers such as Chesapeake Energy (NYSE: CHK) and Ultra Petroleum (NYSE: UPL) fell into the red in 2009.

But the same production techniques developed to release natural gas from shale formations are producing what promises to be a very profitable boom in US onshore oil production. The boom is just getting started in places such as the Bakken shale formation in the Williston Basin of North Dakota, Montana, and the Canadian province of Saskatchewan. A 2008 US Geologic Survey report put the amount of recoverable oil in the Bakken shale formation at three billion to 4.3 billion barrels. That's roughly 15% to 20% of total US proven reserves. Production from the Bakken shale has gained North Dakota a slot as the fourth-largest oil-producing state.

That's a lot of oil in terms of US production, but it's not enough to drop the global price. With oil at about $70 a barrel, producers in the Williston Basin are quite profitable, thank you.

Let me dig a little deeper into the oil shale story and then suggest some ways to invest in it.

Locked in the Rock

The oil industry discovered oil in the Bakken formation way back in 1951. But until the natural gas industry pioneered technology to tap natural gas trapped in dense shale formations, oil companies couldn't get at the oil.

The Bakken formation consists of two layers of shale with a middle layer of dolomite, another sedimentary rock. The shale has natural vertical fractures, and early drilling tried to run conventional vertical wells into these fractures. That didn't turn out to be very effective in extracting oil, because the shale swells when exposed to drilling fluids, sealing the fractures. Iron pyrite in the shales also caused irreparable well damage in some cases.

New technologies borrowed from natural gas wells in other shale formations use horizontal drilling to tap into oil. Horizontal wells can reach thousands of feet of oil reservoir rock that may be in a layer no more than 140 feet thick. Using hydraulic fracturing technology can increase the flow by creating fractures that let the oil seep toward the well.

All this certainly seems to work. For example, on October 4, Brigham Exploration (Nasdaq: BEXP) announced the completion of its Rough Rider Three Forks well with an early 24-hour peak flow rate of about 2,356 barrels of oil equivalent. The company has now completed 36 Bakken and Three Fork wells in North Dakota, with an average 24-hour peak flow rate of about 2,684 barrels of oil equivalent. Those are high rates of flow.

MORE: How to Buy in to This New Oil Boom

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Problem? It's the Water

This isn't to say that everything is going to be smooth sailing in the Williston Basin for oil producers. The big problem is water—or actually, the lack of it. Producing oil from shale requires about four barrels of fresh water to produce a barrel of oil, compared with one barrel of water required from conventional sources. That requires oil producers in the Williston Basin to employ a constant caravan of trucks to supply millions of gallons to each well site, where it is then pumped down the well bore at pressures high enough to fracture the shale. The Bismarck (N.D.) Tribune estimates that producing oil and gas from the Bakken shales will use up to 5.5 billion gallons of water a year.

North Dakota isn't exactly swimming in water. Average annual rainfall in the state ranges from 13 to 20 inches a year. That's a lot in comparison to the five inches that fall in the Mojave Desert each year. It's roughly equal to the 15 inches that fall on Los Angeles in a year. New York City gets an average of 43 inches.

How to Buy in

Interested in buying into the Bakken boom anyway? There are two ways to go.

First, you can buy shares of a relatively small, relatively pure-play oil exploration and production company in the Williston Basin.

Brigham Exploration (Nasdaq: BEXP) is an example of the kind of company I mean. As of December 31, 2009, the company had 282,584 net leasehold acres in the Williston Basin. Beginning in 2007, the company shifted the majority of its drilling operations from the Anadarko Basin in west Texas and the onshore Gulf coast to Williston. It drilled 53 wells in Williston in 2008 and 54 in 2009. Total investment in drilling, leases, and seismic exploration came to $220 million through the end of 2009.

The company has only 117 million shares outstanding and a market capitalization of just $2.3 billion. Revenue came to $70 million in 2009 and is projected to hit $778 million in 2010. Projected earnings per share are 45 cents for 2010 and 80 cents for 2011. The Wall Street consensus calls for 47% average annual earnings growth over the next five years.

Other similar pure plays in oil production from the Bakken shales include Whiting Petroleum (NYSE: WLL), with 88,000 acres in the Williston Basin and a market cap of $5.1 billion; Continental Resources (NYSE: CLR) with leases in both the Three Forks and Middle Bakken formations and a market cap of $8.2 billion; and Oasis Petroleum (NYSE: OAS) with a market cap of $1.95 billion. Oasis Petroleum has been public only since June 2010, but it boasts 292,000 net leasehold acres in the Williston Basin.

Second, you can buy pick-and-shovel companies—that is, shares of the companies that are leasing rigs and providing services to these producers.

The last year has seen an amazing resurgence of land-based drilling in the United States. As of the end of September 2010, the number of drilling rigs working on land in the United States and Canada had climbed by 641 to 1,625 from the end of September in 2009, according to Baker Hughes (NYSE: BHI). Of that total, 718 rigs are working in Texas, home of the Ford, Barnett, and Haynesville natural gas shales. That's up from just 328 rigs a year ago.

Louisiana is next with 178 rigs. And North Dakota is third with 135.

Contrast that with the trend in the offshore Gulf of Mexico, where 32 drilling rigs were working before the BP disaster and 19 are working now.

Drilling and oil-services companies with good exposure to land-based US drilling include Weatherford International (NYSE: WFT), Basic Energy Services (NYSE: BAS) and Lufkin Industries (Nasdaq: LUFK).

Many of these stocks trade near 52-week highs, but that's what happens when a boom psychology is in the saddle. A congressional investigation into high-pressure hydraulic fracturing in the natural gas shales and its effect on water supplies could put a dent in some of these stocks—if investors come to believe that congressional Democrats have the votes to enact new regulations on onshore drilling.

That might give you a chance to get in at a lower price. So might a rally in the US dollar. (See my blog post on the global currency wars, "Yes, it's a currency war, and no, no one is doing anything about it.") Is that on your list of likely events in 2010 or 2011?

At the time of publication, Jim Jubak did not own shares of any company mentioned in this column in his personal portfolio. His new mutual fund, Jubak Global Equity (JUBAX), may hold positions in the companies, and positions may change at any time.

Jim Jubak has been writing "Jubak's Journal" and tracking the performance of his market-beating Jubak's Picks portfolio since 1997 on MSN Money. He is the author of a new book, The Jubak Picks, and he writes the Jubak Picks blog. He is also the senior markets editor at MoneyShow.com.

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