Stop Worrying and Love the Shale

 | Jul 02, 2013 | 6:35 PM EDT
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The amazing shale discoveries of the last five years are really oil companies' response to a radically higher price paradigm starting earlier last decade. China and India entered the market as oil consumers in the early 2000s, quickly using up excess supply and sending prices infinitely higher it seemed.

The response was a flurry of frantic exploration activity which ultimately led to massive shale oil discoveries in North America. Other countries may have similar shale assets but have not been able or willing to exploit them for several reasons. We are now in a new reality where the United States is a major, low-cost producer.

Consider this: The Bakken's biggest player is producing oil at $30 per barrel. In the Eagle Ford, the more average players can still be profitable with oil in the $50s. These areas have the magic ingredients: production growth and a low cost base. That's why you, as an investor, should stop worrying and love the shale. If oil prices drop to say, $75, the casualties will not be these new entrants but the marginal players with a higher cost base. Think Venezuela, Brazil and Nigeria.

How you invest in the shale depends on your risk tolerance. The large-cap, diversified dividend payer in this space is ConocoPhillips (COP). It has by far the greatest shale exposure of its peers. The Bakken and Eagle Ford are a big part of their 3% to 5% annual production growth plan through 2017. Particularly interesting are their Eagle Ford wells, which significantly outperform the average there.

The more concentrated, quality, large-cap players are Continental Energy (CPPXF) and EOG Resources (EOG). Continental is the largest producer in America's largest shale play, the Bakken. They boast a 28% CAGR in production for the last five years and most of that is oil. They have a 20% IRR even with oil down at $60. There are also some exciting, new shale prospects in the SCOOP (South Central Oklahoma) where they are investing. Unfortunately, their $2.5 billion funding gap means an expanding balance sheet.

EOG is the king of the Eagle Ford and the largest overall shale producer in the United States. Since 2007, they've grown productrion by 37% compounded annually. About 78% of their Eagle Ford production is oil and they have significant exposure to the Bakken and Permian. If there is shale oil in the Permian, EOG will benefit most. Their funding gap sits at $2.1 billion.

Small and mid-cap companies can provide much higher growth but are more hit-and-miss. My current favorites are Sanchez (SN) and Gulfport Energy (GPOR). Gulfport is a bet on the nascent Utica shale of Ohio where they hold 125,000 net acres. They are more levered to the Utica than anyone else. Gulfport has the richest liquid assets there next to Chesapeake and they are growing production by an amazing 200% this year. Their $550 million funding gap is quite big for a $3.7 billion company, though. If you believe the Utica shale could ever rival the Eagle Ford, Gulfport is the best bet.

Perhaps my favorite of all is a small-cap Eagle Ford player, Sanchez Energy. Last year, they grew liquids production by an astonishing 430%. Since most of their acreage is in the "oil window," most of that is indeed crude oil. Sanchez will drill nearly twice as many wells this year. Going forward, they will spend less on purchasing land but really go overdrive on their drilling program. Despite their $140 million funding gap, Sanchez' high-quality crude oil growth is remarkable.

The shale revolution has ushered in a new paradigm for oil production, and I believe it could be the biggest opportunity of this decade. How you may want to invest depends on your objectives and risk tolerance. These five companies represent a few different ways to participate. 

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