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Where to invest in the U.S. oil boom

Look for companies with financial strength and operations in fertile shale regions.

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Despite new, effective drilling techniques to extract crude oil and natural gas from previously impenetrable shale rock formations in U.S. locations, most companies operating in these fertile regions have not, thus far, seen high profit margins. The primary reason: high production and development costs.

During the past two years, production growth for exploration-and-production (E&P) companies has rapidly accelerated, yet revenues for these companies on average have not kept up with rising cost structures involved with new drilling technologies (see the chart below, right). As a result, returns on fixed assets for E&P companies have declined.

Going forward, it will likely be important for investors to focus on energy production companies with the following attributes, particularly in a potential environment of stable commodity prices:

  • Strategic drilling locations. The prospect of U.S. energy independence is being driven by production growth in four specific regions—Eagle Ford (Texas), Permian (Texas), Bakken (North Dakota), and Marcellus (Appalachians).

    Within each of these four areas, there are from two to four companies (the “Haves”) that own the majority of the prime acreage and that have the financial ability, scale, and drilling technology to produce crude oil. These companies (14 total) have a competitive advantage because they are growing production faster than most of their peers and, as a result, are experiencing faster earnings growth (see the chart, right). Companies seen as “Have-Nots” either do not have leases in these four regions or do not have the scale necessary to drive down costs.
  • Superior cost control and declining production costs. The “Haves” are also demonstrating better cost control than other companies (see the chart below). For example, the companies with the prime locations within the four top-producing land basins have lower exploration budgets relative to other companies (less need to seek new locations for drilling) because they already have land-drilling leases and infrastructure (e.g., drilling pads and access roads) set up in the most fertile areas. For some of these companies, total production costs have plummeted and they have already maximized drilling pads in prime locations, which is contributing to more favorable profit growth.

    Companies seen as “Have-Nots” tend to have higher production costs because they do not have leased acreage in these four prime locations, and thus are forced to explore more vigorously to search for and identify other promising drilling regions to stay competitive.

State of the energy sector

See why you may want to be selective as oil prices could stay in a narrow range over the medium term.
Read the article.

Although most E&P companies have been handicapped by high production costs, the subset of companies with these aforementioned attributes have generated superior earnings growth during the past few years, and I believe they will continue to do so as their costs decline.

In addition, their stocks have been among the top performers in the sector even though their price-to-earnings valuations were already elevated relative to their peers. For example, one company strategically positioned to develop natural gas and crude oil in the Marcellus region has already benefited from these trends.

Elsewhere, we are starting to see production costs decline more dramatically for the “Have” companies that have already secured leases and built infrastructure in the other three regions with strong production potential (i.e., Bakken, Eagle Ford, and Permian basins). Going forward, owning the stocks of companies with operations in these strategic commodity-rich regions whose productions costs are expected to decline the fastest could prove to be a rewarding strategy.

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