New accounting rules in Canada are looser than before, making it harder for investors in oil and gas to understand their investments, and also more of a pain for Canadian companies to raise money in the United States.

That’s the conclusion I’ve come to after interviewing industry executives and national firm-accounting consultants in the oil patch.

“Find me a company in Canada that says we were able to raise more money at a better price with IFRS (International Financial Reporting Standards),” says Craig Nieboer, CFO at Canadian Energy Services (CEU-TSX).  “Find me an investor who can now say I understand this company’s financials better because of IFRS.”

“They don’t exist.”

This year, for public companies, Canada dropped its GAAP accounting system—Generally Accepted Accounting Principles—in favour of the IFRS—International Financial Reporting Standards.

During my interviews, I found the main difference between the two is that IFRS allows greater leeway for management and boards to use their own judgement in how to present and explain company financials.

In an era where the core financial sector of the western world is under huge scrutiny for lending and accounting practises, I found this odd.

“There are now more choices, so consistency between companies is impaired,” says Nieboer.  “For us, we have fewer lines in our statements so investors have to dig more in the notes and MD&A.”

“Has it improved better information to investors? At best no, and potentially it’s worse.”

Kevin Nielsen is a partner at Deloitte in Calgary, and works with a lot of energy companies.  I asked him to explain the switch to IFRS, and how it impacts both investors and management teams in the Canadian oil patch.

“IFRS is more “principles” based and therefore more judgement is required (by management in how to produce their financials),” he said in a phone interview. “Previously, GAAP was more rules based.  So as a result companies need to disclose in their financials more information on how their accounting policy choices are determined.

He said the new IFRS rules most benefit major international firms who operate in different countries and have different accounting practises.

For junior oil and gas companies in Calgary that have domestic assets, it obviously is not going to have the same benefit.

Stuart Symon, Chief Financial Officer at intermediate producer Angle Energy (NGL-TSX) in Calgary, says investors will have to do more digging to really understand a company with IFRS.

“You have to go to the notes in the financial statements to get the full story; read the disclosures. What’s happening behind the scenes? Is IFRS adding value to this equation? IFRS requires more disclosure that doesn’t necessarily provide incremental benefits for the reader.”

There are now more disclosures with IFRS. Management teams are trying to put the best information out there that’s the most relevant. But does the investor have time to read and understand it all?  Or does all that information drive investors back to the basics – the management team, drilling results and reserve report?

The Canadian accounting standard setters decided to move to IFRS as the majority of the world is doing so — even though Canada’s largest trading partner and largest source of foreign capital, the U.S., still uses GAAP, and there are no indications that they are moving to IFRS anytime soon.

Most changes that IFRS makes to oil and gas accounting happens below the cash flow line.  And being as most energy investors use cash flow as a primary valuation method, the IFRS changes should not have a major effect on corporate transactions, says Angle Energy’s Symon.

“We are not judged as much on earnings as we are on cash flow and recycle ratio. (Recycle ratio= field netback (profit) per barrel divided by finding cost per barrel–KS.)  So how much will this change how investors look at junior oil and gas companies? If you have an earnings emphasis, IFRS will change things, but oil and gas valuations do not tend to be as influenced by earnings.”

Here are some of the main changes that Nielsen, Symon and Nieboer say investors will notice in the junior oil and gas accounting under IFRS vs. GAAP:

1. More impairments, or writedowns—and more frequent impairments in IFRS.  Asset values are obviously tied to commodity prices in this sector, so as prices move, the industry will not only see more writedowns, but lots of reversals in impairments.  “A writedown used to be viewed as negative in the market as it was rare,” says Symon. “People are going to have to get more used to impairments and reversals giving rise to earnings volatility.” The intent is to carry assets on the financial statements at a more current or real time market valuation.
2. For service companies, one of downsides of IFRS is you don’t get true gross margin anymore, says Nieboer, as non cash items like stock based compensation and amortization are included as cost of goods sold.  “Gross margin is now artificially lower,” he says.
3. Many more costs must be expensed, not capitalized, such as transaction costs when doing a deal, and even dry holes must be expensed, whereas before they could be capitalized.  For the small junior producer, a couple misses can mean a very bad income statement.
4. All of the above points means there will be more volatility in earnings.  But few junior oil and gas companies have earnings.

No accounting system is a replacement for management integrity.  But with fewer lines in the financial statements being replaced by more detailed notes—facts being replaced with explanations—investors will now more than ever be on their own trying to determine what’s being said, and what is not.

by Cory Mitchell, CMT

The Horizon BetaPro NYMEX Natural Gas Bull+ ETF (TSX: HNU) has been one of, if not THE most profitable trades in natural gas for the last four years, yet my sense is retail investors have missed it completely.

Why? The reason is simple—you have to short it. Most retail investors don’t short, and fewer think about shorting an “Up” ETF.  I admit, it’s not a trade for novices.  But it’s available to everybody.

I’m going to outline just how lucrative this trade has been over the last four years, and how you can capitalize on this downtrend in natural gas. I’ll explain the two  “built-in” factors to this ETF that add to the profits of a short position—and lose you money if you’re long.  I’ll even tell you when, historically, the best time of the year is to initiate this trade—and it’s coming up VERY SOON.

“Shorting” means selling first and buying back later, as opposed to the more common convention of buying first and then selling.  The short seller profits by selling at a higher price and buying later at a lower price.  The difference in the price between where he sold and where he bought is the realized profit of the trade.  This is how money is made on downtrends like we are witnessing in HNU.

(If you just learned what “shorting” is by reading this, do not attempt this trade;-))

HNU started its steep downtrend in July, 2008 just a few months  after its January inception.  The ETF is down 99.86% from that high, far underperforming the underlying commodity it is supposed represent.  Now, this is very bad news if you’re long.

But if you’re short, this underperformance is a key; if you’re short it’s kind of like being The House in Vegas.

The ETF actually represents one of the most reliable trades in the sector—and it is not too late to get in.  And as I mentioned,  one of the ideal annual entry points over the last three years is coming up very soon!  If retail investors want to ride a trend this is it. The trend in natural gas is currently down, and even if the trend reverses, there are two built-in features within the fund are likely to stifle long-term upward price appreciation: “contango” and re-balancing.  I will explain both of these.

The Structure of Underperformance

HNU is a leverage ETF which attempts to “seek daily investment results equal to 200% the daily performance of the NYMEX Natural Gas futures contract for the next delivery month” according to Horizons website.

This is accomplished through purchasing natural gas futures contracts, and then at specified dates rolling the contracts which are nearing expiry into new futures contracts.  According to Horizons website “This mechanism also allows the investor to maintain an exposure to commodities over time.”

Yet those who have bought, or gone long the ETF since the start of 2011 have lost 64% of their capital, while the underlying commodity has lost 22.77%.  The ETF is leveraged, therefore the theoretical loss HNU should have experienced so far this year is negative 45.54%.  Investors have  lost about 17% more than anticipated this year alone (the fund charges a 1.15% management fee).  Since inception the picture is grimmer—but only if you’re long  It’s actually a beautiful thing if you’re short.

Adjusted for four reverse stock splits, the stock hit a high of $7,710.40 in 2008, and currently trades at $10.48 as of Friday, December 2.  It should be noted that the actual price paid at the high in 2008 was not $7,710.4 (it was $48.19).  This price reflects the equivalent value in retrospect based on the reverse stock splits that have occurred.

If an investor  picked the top and shorted 1000 shares at $48.19 ($48,190 invested) in 2008 the trade is showing a profit of $48,124.68!

Whereas if an investor bought 1000 shares at $48.19 in 2008, the first split would have left him 250 shares (1 for 4), the second split with 50 shares (1 for 5), the third split with 25shares (1 for 2) and the fourth split with 6.25 shares (1 for 4).  The original investment of $48,190 is therefore worth $65.5(6.25 times the current $10.48 share price) reflecting a 99.86% loss in capital (that is why the shorts have nearly doubled their money).  The prices on the chart are adjusted to reflect the reverse stock splits and the appropriate percentage decline of the ETF.

Figure 1. TSX: HNU –  January 16, 2008 to December 2, 2011 Logarithmic Weekly Chart with Reverse Stock Splits

Source: FreeStockCharts and split information from Yahoo Finance.

Horizons does point out that “These ETFs do not seek to meet their investment objectives over any period other than daily.”  This is clearly stated multiple times in the ETF prospectus, indicating the ETF does not track the commodity over the long-term, rather only on a daily basis.

CONTANGO

A major factor in the decline witnessed in HNU over the long-term—and something that stacks the deck in favour of being short–is due to a phenomenon known as “contango.”  Futures contracts, which HNU purchases, are an agreement to buy an asset at a fixed price at a forward or future date.  When the futures price is higher than the spot price, that is known as “contango“.  The natural gas market is usually in contango; futures prices are higher due to storage costs and uncertainty; so a premium is paid for that uncertainty.

But as that more expensive  futures contract approaches its  expiry date—the date the gas must be delivered–it will converge with the spot price—which by definition means it declines in price. Since HNU does not take physical delivery of the commodity it trades, it must continually “roll”, or sell futures contracts which are expiring and buy longer-term contracts—usually the next month.

By continually paying a higher price than the spot price each time the contract is rolled, there is an inevitable long-term systematic erosion of value within the fund, and a continual slide in the value of the ETF.

This is GREAT—if you’re short.  The House Rules are in your favour.  But it’s a profit killer if you’re “long”  though.

As for December 5, January 2012 Natural Gas is trading at $3.465.  February, 2012 Natural Gas is trading $3.492.  Not only does the fund lose money because of the downtrend (sells expiring contracts at a lower price) but it then pays a 2.7 cent (this will fluctuate) premium for the next futures contracts.  Compounded and leveraged each month, the losses become staggering, as shown by the ETFs decline.  Keep in mind the fund is leveraged-essentially doubling the premium and magnifying losses. . . Month after month, all else being equal, this occurs.

The contracts HNU is forced to sell will almost always be lower than the price which is paid for the new contracts they must purchase. This will offset any long-term gains the fund could theoretically make, even if natural gas rises over the long-term. The fund loses if natural gas drops, stays the same or even rises slightly. These regular losses and inefficiencies continually drive down the value of the ETF.  Again, if you’re short, this is adding profits to your wallet.

The second big structural factor in HNU that is in favour of the “shorts” is the issue of leverage and compounding losses.  HNU attempts to reflect 200% of the movement of natural gas on a daily basis.  Assume you invest $100 in the ETF, on the first day natural gas rises 5%.  This means your investment will be worth $110 (you make 10% because of leverage).  But assume the following day natural gas falls by 5%.  Your investment is worth $99 (you lose$11 or 10% of $110).  Many investors think they should just be back at $100, but compounding and leverage create a loss.

If you’re short, you just made $1 in two volatile days.  If you’re long, you just lost $1.

How to Make Money

Investors don’t usually think about short-selling but in this case, shorting the ETF has historically been the way to make money over the long term. Shorting selling is taking advantage of both sides of the market—up and down—movements which occur regardless of short-seller involvement.

“Market participants are permitted to sell Units of an ETF short and at any price…” according to the prospectus for the ETF.  Short selling is a legitimate way to trade the ETF and is noted in the fund’s legal documents.

Shorting ETFs is often more efficient than shorting an individual stock or commodity:

• The ETF is not prone to short-squeezes since the fund is rebalanced every day to reflect the value of its holdings-which seems systematically doomed to continue its decline.  The ETF moves intra-day as the underlying assets move, therefore all traders (long and short) are simply volume, as the price is determined by underlying assets, in this case natural gas contracts and how those contracts are managed.

NOTE: The underlying commodity may be prone to a short-squeeze where buyers push up the price and people with short positions are forced to cover their position (pushing the price even higher) or receive a margin call on their short position. Investors should be aware this can cause sudden, sharp short-term rises in the ETF.

• HNU can be shorted at any time.  This differs from a regular falling stock as the stock may not be shortable at all, or subject to the uptick rule.  An uptick rule means traders can only initiate short positions when the price is above the last trade price.  This is common on the TSX exchange, but this ETF is excused from the regulations.

In an ETF which has proven very inefficient for buyers over the long-term going short is the logical strategy.  (The industry jargon for buying is called “going long”.) Couple this with an overall downtrend in natural gas—even if natural gas begins an uptrend the rise in the ETF is likely to be muted—the trade sets up very well for investors who are willing to incorporate short selling as one of their tools.

The fund is leveraged which means on a daily basis there can be big percentage moves.  Short-selling blindly is not wise.

PART 2—On Saturday, I tell you historically WHEN is the best time to make this trade to maximize profits—and it’s coming soon.  And I’ll also explain what happens to this short trade if natural gas prices start to rise (Hint—it’s better than you think.)

Disclaimer: Cory Mitchell nor Keith Schaefer currently hold a position, short or long, in TSX:HNU.  This information is not to be construed as investment advice in any fashion. Always consult a licensed financial planner to help determine what investment strategy is best for you.

The investor trend towards yield could have a big impact on the US junior oil and gas market, a new report by brokerage firm Raymond James suggests.

Energy Analyst Kevin Smith says the stocks of Upstream Master Limited Partnerships, or MLPs, are worth almost double their regular corporate counterparts (called “C-corps” in industry jargon).  And that big valuation gap could start some Mergers and Acquisitions (M&A) activity in the junior US energy space.

“We are not saying that you should expect a rash of Upstream MLP acquisitions of C-corps tomorrow, but we are saying we think that it is coming over the next few years,” he writes.

MLPs trade like stocks on American stock exchanges.  They have a big tax advantage in that they don’t pay corporate tax; investors are treated as owners of the company, which means they get the corporate tax breaks too. (Isn’t that a switch?)  This lowers the income tax paid on the earnings.

Then the MLP pays out most of its excess cash flow to shareholders in the form of a distribution — which can end up creating a big cash yield.  (That’s why I think the U.S. will see a LARGE increase in MLPs over the coming few years as interest rates stay low.   Investors love seeing this money dropped into their account, and price the stocks based on the yield they give.)

And in this tough junior oil and gas market, yield stocks are holding up the best.  The reason is that MLP investors are looking at yield for its primary valuation method. Regular corporations, or “C-corps” as industry jargon goes, investors are looking at earnings and cash flow valuation methods — and those are likely going to decline this year and next due to the weakness in the natural gas pricing. And overall market volatility is reducing valuations on the junior oils. That’s what’s making Upstream MLPs valuations (stock prices) much more sticky vs. the “regular” C-corps.

They’re holding up so well in fact, that Smith says it’s only a matter of time before the MLPs use their much better valuation — stock price — as a currency to buy regular junior oil and gas companies.

“While no (upstream) MLP has bought a producing C-Corp yet, I think it will, I think it’s inevitable,” Smith told me in a phone interview from Houston.

Upstream MLPs have bought many producing oil and gas assets, but they have yet to swallow an entire company.

“At some point, $100 million (asset) deals won’t quench your thirst… as MLPs grow, they will need to do bigger and bigger deals,” Smith says.

There is a tax issue when MLPs buy C-Corps, but the valuation difference between the two groups now make up for most of that.

LINN Energy (LINE-NASD) is the poster child of the new upstream MLPs that are going public.  In five years it has grown from a market cap of just over $500 million to now $7 billion, and is a Top 20 oil producer in the US.

So, as an investor in junior oil and gas companies, where should I be looking at take-out candidates?

While the difference in valuation between MLPs and natural gas-weighted companies are the greatest, Smith points to the oil producers.

“I would bet (MLPs buy) oil-weighted C-Corps that are under-loved.  The most active market is the Permian Basin. We have seen quite a bit of activity in this area over the last 24 months.  And some California plays will get some looks, with low decline rates.”

In his October 31 report, Smith said that public C-corps are trading at a discount to what many private E&P property packages can be purchased for today (5-6x EBITDA for sub $500 million transactions).

This game that Smith is talking about completely changed the way junior oil and gas companies operated in Canada.  In Canada, MLPs are called “Income Trusts,” and while there might be some subtle differences, they are basically the same tax-advantaged public company that allows big chunks of their cash flow to pass through to unitholders.

——————————————————————————-

How Oil Fields the World Over Are Getting a “Second Life”

Extending the life cycle of an oil reservoir — by years — could mean the difference of tens of millions of dollars to an oil producer.

That’s exactly what one company’s new technology does… It improves oil production rates while slowing the rate of decline.

Oil producers using this powerful system are finding it a huge success, often times almost immediately.

Adoption, meanwhile, is steadily increasing inside the oil & gas sector. In fact, this company’s technology is now employed by major oil producers — or soon will be — on 4 different continents.

To get the full story – and how you could profit – click here.

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First these trusts started buying intermediate producers, those producing over 10,000 barrels a day.  When they were gone, and the number of trusts kept increasing, they went after juniors producing only 1,000 barrels a day.

The number of junior companies soared as management teams now had an easy exit plan — build up production with a decent land base and get bought out fast by a trust.  They didn’t need to plan for the long term and, generally speaking, didn’t need to be as disciplined in how they spent their capital.

With all the shale plays being discovered in the US, could this be the beginning of the same type of mania that overtook Canada?

“We’re not quite to point where we were in Canada in 2005,” says Elliot Gue, editor of MLP Profits (www.mlpprofits.com), who specializes in US MLP investing.  “We are seeing a number of MLPs getting listed.  Some are small and hoping to get bought out.”

Gue says he is already seeing a lot of MLPs buying out private oil and gas companies.  “In the Permian Basin in Texas there are over 1,500 operators. Most only own a small amount of land. Those guys are selling out to MLPs.”

So there is definitely a trend here, similar to what Canada went through starting 15 years ago?

“We’re entering that growth phase now,” says Gue.

Smith says the new upstream MLPs could be a long trend: “With current interest rate trends, it doesn’t look like that valuation gap will close anytime soon.”

- Keith

This past Friday I had a chance to dialogue with Nathan Weiss of Unit Economics, an independent institutional research firm based in Boston. Nathan explains – below – why that day may turn out to have historic significance for natural gas investors.

- Keith

To natural gas investors, 11/11/11 will, in hindsight, be remembered as a historic date.  Friday marked the first time since November of 2002 that the 12 month forward US natural gas price moved to $4.00/Mmbtu (1 Mmbtu=1 mmcf).

We think this spells the end of highly profitable hedging for a large majority of natural gas producers.  That should have a negative impact across the board for natural gas stocks in 2012. Twelve month forward natural gas prices can be seen on the following chart:

U.S. natural gas producers typically hedge more than 50% of their coming year’s production in advance, often telling investors that they are “trying to be conservative” and reduce risk.  They use the forward curve to improve earnings and cash flows, and by hedging E&Ps have added as much as 50% of their operating cash flows over the past five years–making gas E&Ps equal parts hedge funds and natural gas producers.

This means lower cash flows for natural gas producers from their hedge books.  It will make life very difficult for natural gas E&Ps as we move through 2012 and they work their way through the majority of their remaining hedge books put in place when 12 month forward gas prices were 20%+ above spot prices.  Now the forward curve is only 11% above spot prices—which are lower in themselves.  It’s like having one of your two legs get cut in half.

Here are the numbers:

Over the past five years, on average, the 12 month natural gas future contract has been priced 21.93% above the spot price.  Prior to 2005, the 12 month forward futures price was, on average, equal to the spot price, as the following chart, depicting the % contango between the 12 month natural gas futures price and the spot price going back to 1991, shows (the pink line is the five year average):

As you can see on the above chart, the current contango between the 12 month natural gas forward price and the spot price is 11.73% and falling.  That means lower cash flows from new hedging.

Investment Conclusions

Many natural gas producers have successfully used their hedge books over the last 3 years to greatly increase cash flows and help share price—by as much as 50%, thanks to a 20% contango on the forward price curve.  Now, not only is spot gas lower – at $4/mmbtu for the first time in 9 years–but the contango is lower too.

This should mean that 2012 will be the year when the cash flows of many natural gas producers take a big hit—and therefore their stock prices should too.

While this data may tempt you to run out and short a basket of E&Ps, there are a few complications that must be addressed.

The first is that with the current 27.2:1 ratio of spot oil to spot natural gas prices, even a relatively small amount of Natural Gas Liquids (“liquids” such as propane, butane or condensate/pentane) production can substantially change the economics of a “gas producer.”

For example, Chesapeake Energy (CHK) produces 83% of their BOEs from dry gas, yet generates only 52% of their revenue from dry gas at current spot prices—that’s a big liquids component.  Cabot Oil and Gas (COG) generates 95% of their BOEs from dry gas, but only 81% of their revenues at current spot pricing.  This substantially narrows the number of “gas” E&Ps.

In addition, some E&Ps (Sandridge in particular) have taken to creating Royalty Trust/MLP vehicles – carving out gassy assets and selling them to retail investors at absurd valuations, raising substantial amounts of cash.  This game will continue into 2012.

Lastly, some E&Ps are rapidly switching their production from gas to oil.  Chesapeake, for example, has decreased the percentage of their production that comes from dry gas from 90% in Q3 2010 to 83% in the most recent quarter.

The following table lists the major U.S. E&P’s, sorted by the percentage of their production (in BOEs) that currently comes from natural gas (from least to most).  The farther down companies are on this list, the more vulnerable their cash flow and stock prices are to lower gas prices.

It also shows their production mix a year ago (Q3 2010) to allow for comparison, as well as the percentage of revenues based on current production that would come from natural gas using $3.50 natural gas price realizations and $94 WTI crude realizations.

As always, feel free to call with any questions!

- Nathan Weiss

Unit Economics, founded in 2008, is a Boston-based independent research firm providing institutional investors with insightful research on small and mid-cap equity securities and market themes.  Senior Analyst and company founder, Nathan Weiss, was the author of The Weiss Report, a monthly newsletter focused on risk arbitrage and market neutral strategies from 1998 to 2000. From 2000 to 2006 Mr. Weiss was a generalist analyst and portfolio manager at Noble Partners, contributing significantly to their outstanding returns.  Mr. Weiss holds a Master of Science in Investment Management from Boston University and a BBA in Business Administration from the University of Iowa.

Unit Economics
A Division of Weiss, Harrington and Associates, LLC
44 School St., Suite 805
Boston, MA 02108
office: (617) 227-5871
mobile: (617) 763-4415

I asked Cory Mitchell to explain two scenarios that could play out in the global energy markets, and what it means for energy investors. Here’s Part 1 of his story.

- Keith

The Macro Dilemma
by Cory Mitchell, CMT

Energy investors need to be aware there are two massive macro forces in our global markets and economies battling it out.  One is obvious (and positive!), and one is not—it’s negative.  But the new global credit crunch has brought this dilemma for energy investors into sharp focus:

1.   Stagnant or declining oil production, which should mean oil prices—and oil stocks—are going higher.

But as I’ll show you…

2.   If oil production declines, it will have a negative on global debt and GDP—declining oil production will in turn lead to a long-term decline in the global economy – and a declining economy should push the price of oil down.  The lack of continued growth in oil supply has been a constraint on global growth since 2004, says Canada’s Sprott Asset Management.

One scenario points to a higher oil price, and another to a lower price—yet they are two sides of the same coin.  And while it’s counter-intuitive, lower oil production can potentially lower oil prices by constraining demand. As these contrasting forces play out now and in to the future, oil markets are likely to remain volatile.

The volatility created by this global battle will present opportunities for energy investors as the macro forces play out.

Economic Relationships with Oil

Oil production (and consumption) drives GDP and debt.  While debt is often viewed negatively, it is what allows our economy to expand.  When a consumer goes to the bank and gets a loan, money is created.

This money is then spent and deposited into someone else’s bank account, allowing the bank to grant another loan and so on.  This is healthy for the economy as long as the process is not taken to extremes and leveraged too highly, like what occurred in the 2008 “credit crisis.”

US debt had been steadily rising but has now plateaued, as shown in Figure 1. The problem is, debt—and thus the economy—do not expand if oil production does not expand.

Figure 1. US Government and Non-Government Debt:

*Source: http://www.theoildrum.com/node/8268

Figure 2 shows the high correlation of oil production and GDP.  Oil production levelling off corresponds to the flattening in debt (above) and GDP that we are currently seeing.  Oil production levelled off in 2005 and GDP is failing to get above 2008 levels after a significant decline.  The plateaus in oil production, debt and GDP may be short-term, or may indicate a long-term lack of growth or decline in global economies.

It’s interesting to note that oil production and demand has increased steadily by 10 million barrels of oil per day per decade since 1970—just as the world experienced the largest debt increase in global economic history.

Figure 2 World Oil Production and GDP (Crude Production in blue and scale on the right, GDP in red and scale on the left):

*Source: Economagic

Figure 3 shows the high correlation of oil consumption to GDP.  The relationship of oil production to these major economic factors—debt and GDP—are unavoidable.  As goes oil production so goes the global economy.  The major issue presented is that oil production has levelled off.  If oil production cannot increase the world has reached “peak oil” and by extension, peak debt and peak GDP.

This means investors need to look for places which still exhibit growth prospects and may even benefit from peak oil over the next several years to decades.

Figure 3. Oil Consumption vs GDP:

*Source: Gail Tverberg,  The Link Between Peak Oil and Peak Debt

Issues the Relationship Presents

“Peak oil” occurs when global productions hits maximum output and can no longer continue to increase, leading to a long-term decline in supply.  Oil is what allows economies to operate, and without it to fuel many projects — well, companies, consumers and banks would have no need for debt.  Debt would dramatically drop, forcing down GDP in the process.

Therefore, peak oil and peak debt will create peak GDP.

When peak oil and peak debt (and by extension peak GDP) will exactly occur is unknown, but global production has levelled off and the idea that we are rapidly approaching a global peak oil production is becoming more prominent in the media.  Canada, however, is continuing to see its oil production rise—which is providing a very interesting opportunity for energy investors around the globe.

With debt and oil production levelling off, I believe that at some point the world will hit a “growth ceiling,” until some new technological advance drives us forward once again.  This has happened throughout history, when there have been moments of radical growth following a new technology or an increase in productivity.  Then growth levels off or declines until the next big idea comes along.

That big idea may or not be here yet — shale gas, hydrogen and electricity are some the alternatives currently being explored; though the transition away from oil will take at least 30-50 years according to Vaclav Smil in the book, Energy Transitions: History, Requirements and Prospects.  That’s not hard to fathom, given the vast infrastructure aligned with our dependence on oil.  At this time, creating or extracting an alternative fuel and transporting it stills relies on oil.

In conclusion, I see the combination of (at least short term) peak oil and peak debt, which should cause lower demand and lower oil prices, continuing to do battle against the idea that lower oil production should obviously mean higher oil price.

To me, this means the oil sector will continue to be a hot bed of macro volatility and investor opportunity.  And in my next article, I’ll explain how energy investors can best profit from the volatility created by these two forces.

- Cory Mitchell, CMT

Retail consumers of oil – and retail investors of oil – are the big losers now that oil has become a financial product, says Dan Dicker, author of Oil’s Endless Bid.

But the irony is they’re doing it to themselves—by buying oil ETFs (Exchange Traded Funds) and ETNs (Exchange Traded Notes) and other financial derivative products based on oil.

I only came up for three gulps of air while reading the book, and I emailed Dan immediately afterwards asking for an interview.  He writes in a simple, earthy and honest way—that I wouldn’t have expected from an oil trader on the floor of the New York Mercantile Exchange.

One point he explained so well to me was that the investment banks that now dominate trading have created a massive new market of buyers, and only buyers – no sellers – with their financial products like ETFs.  And that has inflated the price of oil for consumers.  The oil price nowadays is not just based on fundamental supply and demand.

“In 1980 oil demand was about 60 million barrels a day.  In 1990 it was 70 million and in 2010 it was about 90 million.  What’s interesting is that demand has been fairly steady in how it’s increased; about 10 million barrels a day each decade.

“But the oil price has been entirely flat for 20 of those 30 years.  What that says to me is that something clearly changed in how we’re pricing the stuff in the last 10 years.”

And that something is the involvement of the financial industry, he says.  “It’s all about the pricing mechanism, who’s involved and the money being thrown at it.”

That money comes in the form of ETFs and index funds all geared around the price of oil, and are obviously set up by the big investment banks.

But Dicker says that is ALL “long” interest, meaning they are all BUYERS and not SELLERS.  And we all know what happens to the price of something when are more buyers than sellers.  The price goes up.

“What has happened in last 10 years, those who have been setting price based on fundamentals in the market have been swamped out by the financial sector, who have very little engagement with the physical product.  Yet their input is equally important to the price of oil as those physically involved in the sector.

“The market is democratic, but it wasn’t designed to be democratic.”

And there is the irony!  Oil becomes a democratic market—where institutional and retail investors get to help set the price by all of their buying in these indexes, ETFs and ETNs to gain exposure to the oil price (which isn’t possible, Dicker writes) but in effect drive the price up.  So they pay more at the pump.  Democracy at work!

And sadly, the other side of the coin is that the investment banks make a nice share of the coin in the oil trade.

“The stock market can theoretically have a whole group of winners as the stock market goes up—forever.  With oil that’s not true.  When someone buys oil, someone has to sell it to them.  At the end of the day or month or year when trades settle the amount of money won equals the amount of money lost.  When institutions make money trading oil, that eventually comes out of the pockets of people filling their tanks, refrigerating their meats— it’s a zero sum game.”

Well, wait a minute Dan—you just said everybody in oil is long, i.e. they’re buyers, but then you just said there has to be a buyer for every seller.

“Yes, almost everyone who is investing and even hedging oil is long, so the market has to somehow generate sellers, something the stock market for example doesn’t need to do.  So how do you generate sellers where there aren’t any to begin with?

“Well, first, you must make the price pretty high:  Imagine you own a $100,000 house in a neighbourhood of $100,000 houses and all of a sudden, a new group of home buyers wants to have your house, for whatever reason.

What will get you to sell?  Well, someone knocking on your door with a $200,000 check might get you to think about it.  So, price is driven artificially higher, that’s the first thing.”

“But sellers in an oil market also don’t have physical assets.  Even when enticed by a high price, they need a hedge for those sales, because they don’t have oil to deliver, any more than buyers want to actually accept deliveries of oil.”

“So, in generating sellers,  you also generate trade correlations. Like, the corn chart and oil chart look almost exactly the same. And the correlation between oil and oil stocks become uncannily close.”

“So you get these trade correlations, but not a fundamental correlation.  So we now have a very different correlation between the oil market and the stock market than what we had before.

“The oil market-stock market trade looks like a correlation, it’s perceived as one, but it doesn’t make sense, because high oil prices are intuitively not good for the stock market.  So they call it a measure of growth.

“Now we’re looking at a double dip recession and EU going down and oil prices more than $110—how does that fundamentally make sense.  It doesn’t because the marketplace designed for producers and consumers is overrun by people who are financially engaged.”

OK, now I am a believer that there is big premium in oil because it has become a financial product.  How big is that premium and how does… can it ever go away… can we ever end The Endless Bid on Oil?

“You’ll never know what the premium is until you remove this financial mechanism.

“The chances of ending it IMHO are pretty slim.  The path to fixing this is simple to see—but making it happen is nearly impossible in practice.

“You would need to restore the market to close to the way it was before these financial influences took control of it, and let commodity markets operate the way they were intended.  The financial industry will say that’s a destructive rollback of investment trading.  The banks and the entire financial industry have big stake in this.”

In his book, Dan tells some great and funny stories about how he won and lost lots of money (for him) on the old NYMEX floor, despite being a very small independent oil trader. In between the wry smiles, you will get his core message:

“Treating what was a commodity as if it was a stock, is inherently a bad path toward a pricing model that will be volatile, unreliable and unfairly high.

“This is a commodity that people rely on (in their daily lives), and they’re treating it like it’s investable—and the outcomes are fairly obvious to see.”

You can buy Dan’s book — again, it’s very simple English — at Amazon. Here is the link:
Oil’s Endless Bid: Taming the Unreliable Price of Oil to Secure Our Economy

- Keith

Last week we brought to your attention a world-class emerging shale play happening in Argentina’s Neuquén Basin.

The potential here for unconventional oil & gas development is enormous by any measure. A number of companies are well positioned to grow and prosper, including a few junior companies with significant land holdings.

In part 2 of our story below, my colleague and guest writer Michel Maassad of BeatingTheIndex.com shares his unique insights on those juniors… in what he calls “an opportunity of a lifetime.”

- Keith

P.S.  Neither Michel nor I own shares in any of the securities covered below.

Wouldn’t you have liked to invest in the western Canadian sedimentary (WCSB) basin 10 years ago as the new shale plays like the Bakken were being discovered?

The global Shale Revolution is not only rushing towards Argentina, it has arrived. The proven unconventional basins here are relatively underexplored and the development of unconventional oil and gas in shales is still in its infancy. Nevertheless, Argentina has a well established oil and gas industry but it pales in comparison to the Canadian oil patch where around 13,000 wells per year are drilled vs. 1,300 wells (100 exploration wells included) in Argentina.

There are only a few publicly listed Canadian companies operating in Argentina offering the exposure to an opportunity of a life time. These companies are holding large land blocks that are prospective for unconventional oil and gas development which makes them attractive targets to the majors who are running the show.

These juniors are getting courted by the likes of Exxon with farm out arrangements and it wouldn’t be surprising if “forced marriages” ensue as they get taken out one after the other on the back of significant hydrocarbon discoveries further confirming the prolific potential of the shales.

AMERICAN PETROGAS INC.
Trading Symbols: BOE-TSXv
Share Price $1.76
Production (Q2): 500 boe/d
Shares Outstanding: 180 million shares
Market Cap: ~$317 million
Net CASH: ~$75 million
Enterprise Value: $242 million
EV per flowing boe: $484,000/boe/d

Americas Petrogas has a high working interest in about 2.1 million gross acres in Argentina’s prolific Neuquén Basin. This massive acreage is distributed among 16 blocks (14 operated) on both sides of the basin (east and west). The majority of the company’s blocks are offsetting or on trend with major producing oil and gas fields. The company recently farmed out its Los Toldos blocks in the western region of the basin to Exxon Mobil which committed to fund $53.9 million in exploration to earn up to 45% in working interest. The main work will focus on the unconventional Vaca Muerta formation with the 1st well expected to spud in Q4-2011.

To date management has identified 165 conventional drilling locations only on 1 of its eastern blocks, the Medanito Sur. The company’s drilling program includes up to 25 wells in 2011 and 2012 targeting both conventional and unconventional plays. BOE will drill 15-20 wells targeting low to medium-risk conventional prospects in eastern Neuquén and 6 or more vertical test wells in the west for unconventional targets. Its production could quickly rise above the 2,000 boe/d level on the back of a successful drilling program over the next 12 months adding significant reserves in the process.

In September, Americas Petrogas announced a new oil discovery on its Rinconada Norte block located in the eastern region of the basin (south of the Medanito Sur block) where its first exploration well RN-x1004 flowed at a test rate of 1,023 boe/d (92% of 30 degree API oil). The company will be drilling 2 more exploration wells on this block where it holds a 65% working interest with its partner Gran Tierra Energy holding the rest.

Americas Petrogas offers exposure to a large diversified asset base across the Neuquén Basin with multiple proven productive conventional formations and a high leverage to the prospective Vaca Muerta shale. Its massive acreage uniquely positions this junior to benefit from the exploration efforts of many majors ramping up drilling activities all around its blocks.

Firm — Target Price

Wellington West  $4.25
Mackie Research  $4.50

MADALENA VENTURES
Trading Symbols: MVN-TSXv
Share Price $0.54
Production (Q2): 474 boe/d
Shares Outstanding: 260 million shares
Market Cap: ~$140 million
Net CASH: ~$26 million
Enterprise Value: $114 million
EV per flowing boe: $240,506/boe/d

Madalena is another pure play on Argentina’s Neuquén Basin where the company holds 280,000 gross acres in 3 blocks. Madalena’s board is chaired by Ray Smith, CEO of Bellatrix Exploration (TSE:BXE).

• Coiron Amargo in the eastern region of the basin: 35% WI in 100,000 acres. This block lies in proximity to the Loma De La Lata field which currently produces 15,000 bbl/d of oil and more than 600MMcf/d for YPF. YPF also announced a 150MMBOE discovery at Loma De La Lata following the drilling of 6 Vertical wells targeting the Vaca Muerta Shale.
• Curamhuele in the western region of the basin: 90% WI in 56,000 acres. Madalena’s block is south of the Filo Morado field (49 MMBOE cumulative production to date with 69 MMBOE EUR) as well as the El Porton field (estimated reserves of 45 MMB of oil and 282 Bcf of gas).
• Cortadera in the western region of the basin: 40% WI in 124,000 acres. Apache Corp holds 50% WI in this block. Wells in the Sierra Chata field to the east of Cortadera (when fracture stimulated) report average IP rates of up to 8.0 MMcf/d and 10 Bcf per well of reserves.

On the Coiron Amargo eastern block, Madalena drilled 5 exploratory wells into the conventional Sierra Blancas formation. Following fracture simulation, the CAS X-1 and CAN X-4 wells IPed at 200 b/d and 650 b/d respectively from the Sierras Blancas formation. The non-conventional Vaca Muerta shale was penetrated by 5 all wells; its thickness is estimated at 350-475 feet. The CAS X-1 naturally flow tested 40 b/d of light oil (32 API) from the lower of the formation. Madalena will be performing a facture simulation program on the Vaca Muerta shale for the first time in Q3 which will shape the work program plans following the results.

On September 6, Madalena finished drilling its 1st exploration well CorS X-1 with joint venture partner Apache in the Cortadera block in the western region of the Neuquén basin. This is the deepest well yet to be drilled designed to test the prospective Vaca Muerta Shale formation which was found to be 708 meters (2,323 feet) in gross thickness. The well encountered several formations overlying the Vaca Muerta which were cored as well.

Full testing and evaluation of the CorS X-1 is set to commence in October. Positive results will be a huge catalyst to the stock as the encountered thickness is an early indication of the prolific potential of the Vaca Muerta on the western side of the basin. The Curamhuele block (90% WI) just 30 km north of Cortadera will also benefit from the gathered information and results where 2 previously drilled wells will be reviewed for re-entry to test the prospective Vaca Muerta shale formation.

Firm — Target Price

Canaccord  $1.15
Frazer Mackenzie  $1.35
Byron Capital Markets  $2.15

CROWN POINT VENTURES
Trading Symbols: CWV-TSXv
Share Price $1.37
Production (Q2): 400 boe/d
Shares Outstanding: 54.6 million shares
Market Cap: ~$74.8 million
Net CASH: ~$33 million
Enterprise Value: $41.8 million
EV per flowing boe: $104,500/boe/d

Crown Point Ventures has 4 different concessions totaling 288,000 net acres in 2 proven basins: Neuquén and San Jorge.

In the San Jorge Basin the company holds between 50%-80% working interest in the 15,000 acre El Valle block. Crown Point is planning to drill 20-25 wells in 2011-2012 targeting oil in up to 4 separate formations reaching an average depth of 1100 meters. So far the company has enjoyed a 100% rate on its first 5 wells with initial production rates ranging from 200 to 600 barrels of oil per day from multiple zones. Prior to year end, the company is planning to drill 2-4 more wells on this concession.

In the north western portion of the San Jorge Basin lies the 6,320 acre Cañadon Ramirez block where the company holds 100% working interest. Crown Point plans to drill 2-5 wells on this concession in the next 12 months targeting oil. The block is connected to infrastructure and is adjacent to a producing oil field where the average well recovers about 110,000 barrels of oil.

Cerro Los Leones is a large 307,000 acre exploration concession in the Northern portion of the Neuquén Basin where the company holds 49.9% in working interest. This is an oily area surrounded by several producing fields such as Cerro Fortuna (current production 4,675 bod) and Valle de Rio Grande (current production 5,000 bod)

This block presents an excellent growth opportunity with low to medium risk for multi-zone exploration and exploitation. Wells in adjacent fields initially produce at 400-800 boe/d with around 750,000 boe in recoverable reserves. The company plans on drilling 2-4 exploration wells by the end of the year following the completion of a 2D and 3D seismic program.

Laguna De Piedra is a 247,000 acre exploration block located on the south eastern flank of the Neuquén Basin where the company holds a 50% working interest. In the first half of 2012, Crown Point will be targeting a prospect of 34 million boe, the first of five prospects identified following 3D seismic on 3,100 acres. The drilling will target the Punta Rosada and the Quituco formations.

The company is cashed up and targets increasing production from 400 bopd to 5,000-10,000 bopd over the next 3-5 years. While its blocks are considered low risk conventional plays with multi-zone potential, the large 34 million boe prospect at Laguna De Piedra provides a major upside to valuation.

Firm — Target Price

Canaccord $3.00
Frazer Mackenzie $2.65

ARPETROL
Trading Symbols: RPT-TSXv
Share Price $0.085
Production (Q2): 300 boe/d
Shares Outstanding: 572 million shares
Market Cap: ~$48.62 million
Net CASH: ~$38 million
Enterprise Value: $10.62 million
EV per flowing boe: $35,400 boe/d
ArPetrol is another junior company focused on Argentina with 2 blocks in the Neuquén Basin and a third large block in the Austral Basin which is the company’s major focus in 2011.

In the Neuquén Basin the company has 20% working interest with an opting to increase to 50% in 2 blocks: the 12,355 acre Blanco De Los Olivos Oriental and the 14,000 acre Cartiel Viejo Sur. ArPetrol plans on drilling 2-3 shallow wells (1200m) commencing in Q4 2011 targeting conventional multiple zones in Blanco De Los Olivos. While the first block sits outside of the shale oil and gas window, the Cartiel Viejo Sur block lies 60 km NE of YPF’s 150mm boe shale oil discovery at Loma La Lata Field and offers exposure to the Vaca Muerta shale. So far, the company has not announced any drilling plans on the Cartiel Viejo block.

In the Austral Basin, the company’s flagship asset is the 100% owned 8.3 million acres (33,600 sq. km) Faro Virgenes block. The Austral accounts for 35% and 20% of Argentina’s natural gas reserves and production and ArPetrol owns its only onshore processing plant (85 MMcf/d capacity). The company recently received approval for inclusion in Argentina’s Gas Plus program allowing it to increase its realized price to $2.47/Mcf up from $1.20/Mcf a year ago.

This block offers development and exploration opportunities for years to come thanks to several known pool sizes ranging between 8 and 375MBOE in multiple hydrocarbon charged formations. Faro Virgenes will be the main driver for cash flow growth and with $38 million dollars in hand, the company will be drilling a minimum of 6 natural gas wells (3 low risk development and 3 exploratory) by the end of 2012.

Firm — Target Price

Canaccord $0.30

Conclusion

Argentina is a hydrocarbon rich country with excellent geology. The few juniors that are focused on this country all share one thing in common: a high impact inventory of prospects that offers significant valuation upside exposure thanks to underdeveloped basins. As realized oil and gas prices improve, the total or partial removal of price caps is another variable that will fuel increased development and exploration. The petroleum industry is well developed with proper infrastructure and a strong internal market.

The “Why Argentina?” was easy to answer but the “Now Argentina?” is one question you will have to answer given the global turmoil we are going through and the upcoming presidential elections in October where there is always a risk to the investment climate.

- Michel Maassad
Editor, www.beatingtheindex.com

I asked my good friend Dave Blais, who trades gold and silver stocks full time, to provide an update on what he sees happening in the gold market, in follow up to the last piece he penned for OGIB readers several weeks ago.

The frustrating under-performance of the precious metals shares – in particular the gold mining shares – may be finally ending.  In fact, the stock charts are telling me the gold shares are now basing for what could be a large move up.

Certainly for the past year or more, owning stagnant gold mining shares has been a disappointment for many investors as they watched the price of gold bullion soar.

In recent months especially, the gold shares as a group have simply not played their traditional role as a leveraged play on the metals themselves. On the contrary, until very recently many gold mining shares have been acting weak, while gold itself bolted upward.

Only a small subset of the gold shares performed reasonably well by mirroring – or in some cases somewhat bettering – the action in the metal. This means successful investors have had to be very selective in which gold mining stocks they owned in 2011.

Things may be about the change – the gold shares may be shaking off their lethargy, getting ready to make a big move. A rising tide may be starting that will lift all – or at least most – boats.  I think the tide is coming in.

What’s more, the base for this potentially big rise may be forming — right now.

If so, sometime in the next few weeks, the gold shares may begin a profound rise.

This scenario fits my theory where I had been looking for a temporary top in gold to happen on either side of Labour Day.  As I explained in my last article – this has been the historical tendency when gold has had an outsized summer run like we just got.

As expected, we did get strong corrective action in gold – shortly before Labour Day gold dropped more than $200 in a few days. And then for good measure, gold rebounded, made a new temporary high and gold corrected strongly again shortly after Labour Day, diving more than $100.

However, when gold had these most recent corrections on either side of Labour Day, we saw something different happen with the gold shares that we have not seen in a very long while –when gold corrected, the gold shares were consistently stronger than the metal.

Even more surprising, when gold had its more than $100 dollar drop just after Labour Day, the shares actually rose.

And then in the last several days, the HUI, an index made up mostly of unhedged gold miners, did something remarkable – it broke out of a multi-month consolidation while gold was well below its recent highs, a very bullish sign.

Based on the very recent potential breakout action in the HUI, I scaled in modestly to some of the most promising precious metals shares I am tracking. I will scale in more if the HUI can hold above the breakout over the next few days and weeks.

We may be at a very exciting juncture that bears close watching. A few weeks does not necessarily make a trend, but make no mistake – the very recent gold stock stock action is very impressive.

If this breakout in the gold stocks holds and builds strength over the next several days and weeks, we very well may have a major breakout on our hands, portending significant gains ahead.

By Dave Blais

Today I bring you the new class of an old investment vehicle.

You may recognize them. They’ve been around for a long time, after all.

The old class was the perfect kind of income play for conservative, yield-hungry investors.

But alas, they became a tax burden for the Canadian government, and were disbanded (much to the chagrin of investors.)

Now, we’re back at it again… but in a different form.

It’s called the Energy Income Trust.

Trusts pay distributions to shareholders on a regular basis from the cash flow they get from their oil (or gas)-producing properties.

They trade on the Toronto Stock Exchange (TSX), and just about any investor can participate. (Note that withholding for U.S. residents is 15%, but you can apply to the I.R.S. for a foreign tax credit — which is essentially a refund. Do consult with a qualified tax advisor before investing.)

My feeling is that investor demand for these trusts are only going to increase. In a volatile market, dividend plays perform best, and I think these trusts could become huge winners for investors, providing steady payouts over the long haul.

(This is where I’m putting some of my money right now… to preserve capital — and get paid — while I wait for the market to bottom, and start a new uptrend.)

I explain the trust in more detail in my new video below, including the names and ticker symbols of two energy trusts that deliver excellent dividend streams.

Click here to watch the video. It’s short — roughly 3 minutes, but should give you a good starter course on these two exciting new dividend plays.

Note:  Keith Schaefer owns Eagle Energy.

It’s often tempting to cut and run following a big dump in the stock market, but it’s also a good time to take a breather and reset some priorities to take advantage of the next market cycle.

The good news is that if you’re still reading, it means you’re still in the game. Sometimes it’s easy to forget that volatility is our friend — what goes down must surely come back up again and that’s where positioning will be key to cash in on some compelling new buying opportunities that have emerged from the latest market train wreck.

Rule 1: Keep sight of the bigger picture

From an oil and gas perspective, we all know the fundamentals haven’t changed enough to justify the 25%-30% haircut we’ve seen over the past two weeks.

The world still needs oil, and Canada is going to keep producing it no matter what the futures markets do. That’s when it’s a good idea to turn off the TV and think about what’s going to happen six months to a year from now… instead of what’s on the news later tonite.

The answer? Probably not a lot, given where things sit today. Is the global economy any better than it was a week ago? Maybe not, but it certainly isn’t any worse than it was in 2008-09. It’s important to keep some perspective.

Which is all to say that there are plenty of bargains to be had, even if share prices fall into a lower trading range, presenting good opportunities to accumulate some of the names you already own and maybe broaden the portfolio with some new picks. Hopefully you kept a nice little stash of cash, because now’s the time to put it to use.

Battered service sector outlook remains bright

Not all corrections are created equal, and some sectors took it harder on the chin than others. Service stocks were already at a seasonal low even before the latest market rout — it’s just the nature of the business. The spring quarter is always characterized by down time due to weather delays and mud so thick it’ll literally swallow trucks and bulldozers (no lie) before picking up again in the drier fall months.

Yet, all the big service providers reported relatively decent Q2 numbers that beat or exceed what were admittedly low expectations, given a prolonged break-up followed by forest fires and then floods. Even so, it’s not entirely clear why expectations should be so low, given that big pressure pumpers like Calfrac (CFW-TSX) and Trican (TCW) are having a field day, so to speak, with all the new unconventional shale drilling.

But it’s a trickle-down economy that’s flowing through all sectors of the sevice industry. Precision Drilling (PD-TSX) increased its capital program for the second time in as many months to build new purpose-built shale rigs, so it’s clear that the demand for specialized equipment and services will remain strong at least through this winter.

New drilling opportunities on tap

Several new plays are on the horizon in both Canada and the US — and there’s no sign this trend is going to reverse itself anytime soon.

Ohio’s Utica shales are the latest liquids-rich rocks to be touted south of the border, with producers like Chesapeake staking out billions of dollars worth of new acreage in yet another potential Eagle Ford, or Marcellus. There’s already talk of Shell relocating petrochemical plants back to the US to take up all the liquids, which will really light a fire under what is already a hot play.

In Canada, Alberta’s Duvernay is the latest potential blockbuster, after Talisman and Encana both snapped up huge land positions and announced plans to start drilling test wells later this year.

Also, Crescent Point Energy (CPG-TSX) said this week it is plunging ahead with the Beaverhill Lake oil play — another blast from the geologic past that’s already produced two billion barrels since the 1950s, and is set to gush even more with new technology. Crescent Point increased its 2011 capital budget by 25% to $2 billion, with most of the additional monies going to the Beaverhill Lake.

If the new plays prove successful, there’s little doubt drilling levels are going to pick up in a big way, possibly returning to pre-2006 levels when some 25,000 new wells were drilled in Western Canada alone.

According to Macquarie Securities, the Duvernay may be the most prolific example yet of a widespread resource play to benefit from hydraulic fracturing. In fact, this may be an ideal time to load up on anything to do with fracking because it’s unquestionably the silver bullet that makes these plays happen.

Producers also stand to gain from Duvernay

Then there are the producers who also stand to benefit, and some offer compelling — make that irresistible — upside after the pull back.

In the same Macquarie report, the brokerage identified several names with prominent exposure to the play:

Athabasca (ATH-TSX), Daylight (DAY-TSX), Celtic (CLT-TSX), Vero (VRO-TSX), Chinook (CKE-TSX), Bellatrix (BXE-TSX) and Angle Energy (NGL-TSX) have the best exposure. On the smaller cap side, Macquarie says Delphi (DEE-TSX) has the highest leverage relative to its size, though its lands are in the unproven ‘oil window’ of the play.

As you can see the field is ripe for consolidation…

Potential acquisitors include Trilogy (TET-TSX), Sonde Resources (SOQ-TSX), Longview (LNV-TSX), Galleon (GO-TSX), Yoho (YO-TSX) and Terra (TT-TSX). As a group, these are the guys who want to take it to the next level. Last week Galleon appointed former Penn West boss Bill Andrew as its CEO, a sign things are getting competitive. Penn West pioneered the Cardium, so Andrew is a natural fit for Galleon, and intermediate producers that have struggled to regain traction over the past couple years.

Believe it or not, some big majors like Chevron are accidental tourists in this thing too, given the large historical land blocks they’ve owned since the 1950s or haven’t got around to selling off. All eyes are on Chevron’s latest Duvernay test well to see if it justifies further development. If it does, look out because this could take off fast. When did majors ever want a smaller piece of the pie?

Macquarie expects Duvernay to be a major producing play by the end of the decade but that seems to us to be conservative given all the existing infrastructure already in place. Alberta has enough capacity to move a quarter of all the oil and gas produced in North America although Macquarie notes producers will probably want to install ‘deep-cut’ processing facilities to get full value for the liquids. It may take a year or two to get moving, but it’s the right thing at the right time as far as getting it out of the ground which is what matters most right now.

__________________________________________________________________

Taking steps to bulletproof your portfolio

Investors who go long tend to focus on the speculative gains that come when everything is going right. But it’s even more important to be able to play the market when it goes down even if it means being a little more defensive.

Believe it or not, there are still oil and gas stocks that provide excellent dividend yields — Enbridge (ENB-TSX) or TransCanada Corp. (TRP-TSX) fit the bill — that are less exposed to daily oil price gyrations. Sure, they’re more expensive, but blue chips tend to outperform during a downturn. In fact, they benefit from a downturn because it reduces the costs associated with big mega-projects, especially in the oil sands.

Or, risk takers can go even longer, because the speculative upside is probably even bigger today than it was two weeks ago. (When times are good, they’re really good; when they’re bad they’re better.) For momentum takers, the rollercoaster ride is what’s it’s all about. With markets bouncing 500 points on any given day, it’s all about catching the right wave.

If you think we’ve already hit bottom, then the only choice is to double down, dollar cost average, and hang on for the ride because it can only get better from here.

As always, keep at least a little cash on hand to take advantage of some bargains or to top off some of the names you already own.

Happy hunting!