How the IEA Announcement Could Affect Junior Oil Stocks

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1940bkg
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A couple quick thoughts on today’s Big Oil News – the IEA releasing 60 million barrels from Strategic Reserves around the world to help lower global oil prices – before I get into who will benefit from this (and there’s a surprise here).

In terms of fundamentals, this really is a cry for help.

a. 60 million barrels equals about 18 hours of global production – hours, not days or weeks. It’s inconsequential.

b. The world is already well supplied with oil – there is no shortage of oil anywhere on earth that I can see.  North America in particular is overflowing with oil.

c. Oil doesn’t trade on its fundamentals, or it would be $60-$70 a barrel right now. Or pick your own number.  But it would be lower.

In terms of market psychology however, the IEA may be smarter than the pundits think.

Oil, like all markets, trades on fear.  And there is now so much liquidity in the world that often (if not usually) the tail wags the dog in commodity markets.  What I mean by that is that the financial derivatives surrounding oil – the ETFs, the futures contracts etc. – help determine the price of commodities as much as the underlying demand.  So managing their fear and greed of investors in those products is a bigger job than ever before.

With this new reality that has developed over the last decade, but especially since QE1 & QE2, I would suggest the governing elites of the world (DAD) need a new way to communicate to the capital markets (MUSCULAR INDEPENDENT TEENAGER) to really get their attention that they will pull out all the stops to obtain a semi-permanent lower oil price.

But what it could do is convince many of the new entrants in the futures market to dump their “oil long” holdings.  Speculators have been buying oil long contracts in record amounts up until a few months ago. See this chart from Canadian brokerage firm Canaccord Genuity:

Now, the chartist in me says that after a recent round of weakness, a dive in oil prices will weed out the latent longs – cause them to give up hope.  And then the liquidation of ETF holdings, of futures contracts, begins in earnest and causes a waterfall effect on oil prices.

If/when that speculative liquidation happens, trend lines get exacerbated – things go up higher than fundamentals would say they should, and go lower than what fundamentals indicate.  So I suggest that when oil traders and other market players say oil is going HERE, wherever here is, you can likely count on it going 10% past that.

That’s the tail wagging the dog, and why we have so much more volatility in the commodity markets now.

So in one sense, this chart tells me the timing of the IEA announcement was perfect, if they were targeting a large part of the market – the speculators.  They’re saying we will do everything we can to keep oil lower for longer than you think, this lower oil price scenario is not short term, so you will lose money on your trade.

(I have this mental image of the head of the IEA saying to oil long speculators – SOLDTOYOUSUCKA!)

Perhaps the IEA was looking at fundamentals saying hey, there is no need for this oil price as supplies are plentiful and the western world’s economy is weak, so if we can just change market psychology a bit, we can get what we want – $80 oil.

So who will benefit from today’s news, i.e. how can I use today’s news to make money?

One place is obvious, the other one is…counter-intuitive.

Certainly if you want lower prices, bring on more supply.  And that means more drilling, which should be music to the ears of investors in energy services stocks – the drillers and their sub-trades, like the fracking companies and the supply companies to them.

The energy producers of the world ARE increasing their spending to find new supply – a whopping 25% more in 2011 over 2010 to $133 billion, says US securities firm Raymond James.  Here in western Canada, producers will be spending 32% more this year over last, according to Canadian brokerage Wellington West Capital Markets.

But the strangest sector to benefit from lower oil prices, I think, will be junior oil stocks.   For the last two months the overriding psychology in this space has been backward.

That is – the oil price has to go down before junior oil stocks can go up.

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Junior oil stocks were having the same inverse relationship to oil that the Dow Industrials were; a high oil price will cause recession so sell riskier and junior stocks – including junior oils.

The first clue that this thinking was affecting junior oil stocks was when they did not benefit from the last $20 move in the price of oil, up to $125/barrel.

Then as the Arab Spring did NOT move into Saudi Arabia, the world’s largest oil producer, the political risk premium came out of the global oil price, and oil fell back to $100.

But that was not enough for junior oil stocks to move again.  Partly that’s because it’s summer – many investors leave for holidays, and trading volumes dry up.  A lot of these stocks have raised hundreds of millions of dollars and now have hundreds of millions of shares issued – and need lots of volume to keep their share price up.  So in one sense, the value reset button has already been pushed on many junior oil stocks.

For over a month now I’ve been reading into the junior energy markets that until oil gets under $90 and stays there for a short while, the market is not willing to buy the juniors in such a wave that a rising tide will lift all boats like it did from September 2010 to March 2011.

Another way of saying this is that junior oil stocks aren’t low because the market has no faith in the oil price; rather, it’s because the market has too much faith in it.

So once the market is convinced the oil price will stay low enough to not cause recession, it will again buy the juniors, as even at $80/bbl these companies make GREAT money.  Some valuations will get reset (though much of that is now done), but the fast growing, discovery making juniors will once again get rewarded.

The outlook for natural gas: the stocks with upside around the corner

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1940bkg
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Timing is everything in the market and being able to spot trends is critical for locking in attractive returns.

Natural gas producers have taken a beating over the past three years but there are encouraging signs that natural gas might be ready for a break to the upside.

Despite a seasonably weaker shoulder season, NYMEX prices are inching above 10-month highs and observers are finally buying into the idea that stronger prices are around the corner.

Longer term outlook expected to strengthen

The International Energy Agency (IEA) said this week that natural gas is about to enter a “golden age” with world-wide gas use to increase by 50 per cent by 2035.

That might seem far away, but the immediate present has also been encouraging of late.

Calgary based energy economist Peter Tertzakian is now predicting declines in existing production will trump new production adds from the big new shale plays, driving prices higher.

All the while, US industrial demand growth is the highest in a decade, according to the Energy Information Agency.

Add some hot weather in big consuming markets and we’ve seen a nice steady rise since May.

The contrarian view: buy low sell high

Already we’re starting to see some movement on analyst price forecasts.

FirstEnergy is a boutique brokerage firm in Calgary specializing in oil and gas.  Their analyst Martin King said Tuesday that a longer-term average gas price of $5.50 is “reasonable” heading into 2012, although his own 2011 forecast still calls for an average of $4 for the year.

The difference between the two numbers sums up the opportunity in a nutshell–almost 30 per cent on price alone. It’s not unreasonable to expect stocks to follow suit with higher multiples and valuations.

Unfortunately the pure play gas producer has become an endangered species and it’s hard to find a lot of names with growing production exposed to rising spot prices.

The gas trainwreck survivors: lean and mean

The good news is that the producers that managed to stick around over the past three years are bonafide survivors. They’ve taken a beating and still managed to be profitable through the down cycle.

In fact, many have thrived and have quietly posted nice share price appreciation. (See our story on the Surprise Junior Stock Performers)

Although some, like Birchcliff Energy (TSX-BIR), are near 52-week highs, there could be even bigger upside around the corner. In fact, there WILL be more upside with higher gas prices.

The company has been furiously developing its Montney play in Alberta and says it can still make money at a natural gas price of $3/mmcf . The company has posted positive earnings for nine consecutive quarters and has all of its production un-hedged to sell into a rising market.

It’s spending more than $260 million this year to double its processing capability which will give it room to ramp up volumes.

Peyto Exploration (TSX-PEY) has been in the wilderness forever it seems, but it is also testing year-highs. Both companies have made solid share price gains Peyto alone has quadrupled since the market low in 2009.

Crocotta Energy (TSX-CTA) is another survivor that was forced to sell assets and recap the company in September of 2009.

Since then its share price has doubled while it works liquids rich gas near Edson in central Alberta.  Liquids are in big demand in the heavy oil patch and amounted to almost a third of Crocotta’s first quarter production. Notably, Tourmaline (TXS-TOU), which just bought out Cinch Energy (TSX-CNH), is just to the west of them.

Advantage Oil and Gas (TSX-AAV) posted a small loss of three cents in Q1, which wasn’t bad considering it spun off its oil assets to focus on its core Montney development. It has 28 million cubic feet a day hedged at Canadian prices of $6.25 a gJ, which will protect the balance sheet until a full-blown recovery takes hold.

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Longer-term exports hold promise

Looking even longer term, big players like Encana, Apache and EOG are looking at exporting LNG, or Liquid Natural Gas, off the West Coast of Canada.  Natural gas prices in Asia are about double what they are in North America, and even after shipping costs producers will be making a lot more money selling gas in Asia.

But smaller players have bought in as well.  Earlier this month Progress Energy (TSX-PRQ) teamed up with a Malaysian company, Petronas, one of the world’s largest LNG companies, to develop unconventional gas and build a second LNG export terminal in B.C..

These are huge multi-billion dollar investments, and the risk is all going to be project execution and raising enough money to stay in the game. Having a huge multi-national for a partner is a huge plus in that regard. But this is definitely a five-year payback; patience is the key here.

But it suggests things are looking better in a previously dead-end sector with nowhere to go but down. Six months ago, few if any analysts gas prices would be close to $5/mmcf in North America – almost everybody was predicting lower prices.

It remains to be seen if this is a sustainable recovery for producers and their investors. Timing and finding ways to profit from a rebound will be the test.

Want to learn more about investing in junior oil and natural gas stocks? If you have a Facebook account, just “like” this article and a hidden link to Keith’s 10 page how-to on oil and gas investing will appear:

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How To Use ETFs to Predict Price Moves in Oil

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1940bkg
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ETFs, or Exchange Traded Funds, not only track the price of oil, but they can actually provide clues as to where the oil price is going.   I’ll show you how to read their charts, and show you the ETF that I think most accurately follows and even warns investors of oil price moves. (Hint – it’s not who you think.)

Currently Light Sweet Crude futures remain in an uptrend, over the last month price has tumbled from former highs at $114.83 in May to $95.25 currently on the July contract.  The two-year chart below, in 2-day increments, shows the course of oil prices with a continuous futures chart.

ETFs allow individual investors to partake in the price fluctuation of oil in a way very similar to simply purchasing a stock.  (For further information on ETFs, see Keith Schaefer’s report: ETF Investing in the Oil & Gas Market).

The chart below shows the price of light sweet crude in yellow/red, and two ETFs – USO-NYSE, which is the United States Oil Fund (purple), and an ETF which gets far less attention – XOP (light blue).  XOP is the symbol for the SPDR S&P Oil & Gas Exploration & Production ETF traded on the NYSEArca exchange – so it is an ETF that covers oil stocks/equities, whereas USO tries to track the commodity.

How to use ETFs to predict moves in the price of oil How to use ETFs to Predict Moves in the Price of Oil

Source: Thinkorswim

General Chart Comments

From the chart above much information can be extrapolated.  Namely we can see that at this time oil still remains in a primary uptrend, even though we have seen a sizable correction.  There are two trendlines shown on the chart – the first one is red and indicates an aggressive upward trend.

At some point all aggressive moves slow down.  The green trendline is also present which marks the more stable rise of oil prices over the last year.

If oil prices move below that red line, currently intersecting at $92 (this will change over time as the line is sloping), it indicates that oil is correcting to its primary uptrend level (green line).

The green line currently intersects at $80, but will rise over time as the line is sloping. An upward sloping trendline such as this helps a trader gauge when longer term trends are shifting.  Markets move in waves – in an uptrend, markets have progressively higher low prices and progressively higher high prices.

If oil can hold above the $92 level it indicates strength, based on this simple method derived from former price action.  On the other hand, if the commodity moves below that level we could see prices in the low$80s, where there is likely to be buying interest once again.

Using ETFs as a Form of Analysis

The ETFs shown in the chart are not only investment vehicles, but they are also analysis tools.  USO (purple on chart) has already broken below its trendline (yellow line) indicating that lower prices are likely for that security.  This provides some confirmation of the decline in oil, although XOP is a better gauge.

XOP provides valuable information.  Not only has it been the far more profitable play from rising oil prices, but also generally leads oil prices – providing a bit of a snapshot into potential moves in crude.

This occurs because XOP is an ETF that doesn’t track crude – it tracks oil exploration and production companies – which provide a large input the for the oil market as a whole and thus the price of oil.  If investors are buying these securities, which are held by a sector ETF such as XOP, it indicates that the market is anticipating rising oil prices.  The same situation applies if investors are selling these securities help by the XOP ETF in anticipation of falling oil prices.

Looking at the chart, XOP (light blue) has moved aggressively higher over the last year.  Rarely did it pull back significantly, even when oil declined.  I have highlighted a few sections of the chart for educational purposes.  The first, light blue highlighted box on the left s (#1) hows XOP making a lower price high, while oil made a higher price high (all contained within the rectangle).  This was a warning for oil prices and quickly oil prices corrected by about 15%.  This is commonly called divergence.

The next box to the right (#2) shows oil correcting to the prior low yet XOP pulled back very little in comparison – oil quickly moves higher following XOP’s lead.  The next highlighted blue box (#3) shows a similar situation to the last – XOP leading oil higher.

The final box is highlighted in white (#4) and is a potential warning signal similar to our first highlighted area.  For the first time in over a year XOP made a lower high, while oil made a new high.  This was a warning signal for the correction in oil, and remains a warning signal.  XOP has shown a strong tendency to lead oil prices and now it is retreating, leading oil lower.

You will notice at the far right of the chart, which shows June 15 price action, that while oil has paused near recent lows, XOP has retreated below its recent low.  This makes further declines in oil likely, as long as XOP continues to decline or fails to rally on oil price rises.

Tying it together

Investors can use the XOP ETF to help them see the likely course the commodity will take.  XOP has been a sound indicator for the strength of oil prices.  It pointed to strong oil prices through the rise, and even when crude corrected, it indicated a correction which has come and currently it is pointing to a further correction in oil.

In the beginning of this report the low $80’s was discussed as a potential target for the oil price.

If oil continues to drop below that level, we can look to the XOP indicator as a sign of a potential bottom.  When oil makes new lows (compared to recent price action), but XOP fails to make new lows, oil prices have a high probability to begin moving higher as well.

While USO comes to mind when looking for a place to take advantage of a rise in oil prices, it has proven not to be the most efficient vehicle.  XOP, when oil prices are rising, has proven to lead oil and also generally outperform.

Investors must remember XOP will also lead on the way down, retreating fast and more aggressively than oil; therefore, a prudent exit strategy is required. XOP also lacks the trading volume that USO has (still 2-10 million shares a day), yet it functions as an excellent analytical tool for oil prices.

– Cory Mitchell, CMT

Report on Junior Oil Shale Plays

By
Keith Schaefer
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The New Canadian Energy Income Trusts

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1940bkg
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Will the US oilpatch get flooded with Canadian juniors looking to build and sell production to the new Canadian energy income trusts?  Trusts are now allowed in Canada again – but with foreign assets.

After all, energy income trusts in Canada completely transformed the way business was done in the junior markets – enriching management teams and shareholders greatly.

Canadian trusts almost always had high valuations, and could buy lower-valued juniors with only 1000 boe/d production (barrels of oil equivalent) at very accretive prices.

This turned into a cookie-cutter business model where management teams and investment bankers set up company after company with the goal of only getting to a few thousand boe production from one area – and then get bought out.  It was a quick and easy exit strategy.

Because trusts need reliable cash flow, they do very little exploration.  They can’t afford misses – if they ever have to cut their monthly payout, their stock gets crushed.  So they buy production and low risk PUDs – Proven Undeveloped reserves – from the juniors.  Trusts-buying-juniors was a cash cow for years for industry insiders AND investors (wasn’t that novel?).

“I do not see a massive rush of people going down to the U.S. and building up companies to sell to the new trusts – it’s too different, too tough,” says Richard Clark, CEO of Eagle Energy Trust.  “The US oil business is different.  In the US a lot more oil assets are held privately.  In Canada, it’s something like over 90% of reserves are held in public companies.  It’s not like that in the U.S.”

Clark says land ownership isn’t the only thing more private in the U.S. – good information is as well.

“There is much less transparency as to who owns what,” in the U.S., he says.  Canada is the gold standard in the world when it comes to publicly available data.

What that means is that it’s much harder to acquire big land packages in the U.S.  In Canada you first need a computer and cash to get packages, whereas in the U.S., Clark says, you need a big team of landmen.  They visit individual landowners, and then spend countless hours in the basement at county courthouses confirming mineral rights.

Dennis Feuchuk, CEO of Parallel Energy trust, says the difference, though, can create opportunities.

“It’s just a different type of deal flow.  There are opportunities to acquire (land packages) as family ownership turns over.”

Clark says, however, that he is seeing some interest in creating new trusts in Calgary.  “The national banks are already out there getting people they know who have the capability to put teams together.”

Both CEOs pointed out that the US has Master Limited Partnerships, or MLPs, that are structured similarly to the Canadian energy income trusts.  They pay out tax-advantaged distributions to shareholders on a regular basis from the cash flow they get from their producing properties.  And there has never been a “feeder system” like the juniors created here in Canada for the US MLPs.

Robert Mullin is the Managing Partner at RAIF LLC in San Francisco, which manages a natural resource equity income fund, and has invested in MLPs.  He agrees that the feeder system for MLPs in the US has always been different than the Canadian trust model.

“The majority of big upstream MLPs haven’t been buying assets off E&P juniors,” says Mullin. “They buy boring assets of the large independents and the majors – the Apaches, Anadarkos, Devon etc. The large independents think they get better valuation for exciting exploration plays – the shale plays, the offshore plays that they think drive a premium multiple for them.”

Most of the MLPs in the US are on the infrastructure side of the energy business – pipelines for example.  But there are a few upstream (energy producers) MLPs, and I asked the two CEOs if they thought those MLPs would be strong competition for the new Canadian trusts.

“I think there will be some competition, yes,” says Feuchuk. “From our point of view, it will be tied to what are we willing to pay for the part of the assets that aren’t PDPs.  Maybe we’re willing to pay more for PUDs and probables that the MLP’s won’t put value on.”

PDPs are Proved Developed Producing reserves – basically, wells that are flowing or producing now.  PUDs are Proved Undeveloped Resources, which are drill locations that an independent reserve engineer says will produce oil when they get drilled in the future.  Between seismic and nearby drilling they have a strong comfort level that those locations will produce oil or gas.

Clark agreed that MLPs have wanted assets that have more PDPs, but recently have done deals with much lower PDP components.  Clark also noted a couple other differences to the MLP business model:  “Their leverage model is different.  We want to stay under 1.5:1 debt to cash flow, and most MLPs use a lot more leverage, and longer term leverage as well.  The MLPs also hedge most of their production, in order to facilitate their use of very long term debt.  We will never hedge more than 50%.  We’re trying to give our unitholders exposure to commodity prices without too much risk.”

The new trusts are in their infancy.  But with very high demand for yield, I expect that starting this autumn, the market will see one a month.  Despite the structural differences between the energy industry in the two countries, it will be interesting to see how Calgary junior management teams respond to this new exit strategy.

Read Energy Income Trusts Part 1 here, and Part 2 here.

– Keith

Editor’s Note:  I’ll be speaking at the World Resource Investment Conference in Vancouver, British Columbia this Monday, June 6.  I’ll be sure to include some notes from the show in an upcoming OGIB Free Alert.

Want to learn more about investing in junior oil and natural gas stocks? If you have a Facebook account, just “like” this article and a hidden link to Keith’s 10 page how-to on oil and gas investing will appear:

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Energy Income Trusts: A Comeback in the Making

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1940bkg
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Editor’s Note:  Today’s story is contributed by Dennis and Eric Hoesgen of Hoesgen Investment Partners and Canaccord Wealth Management. In this Oil and Gas Investments Bulletin-exclusive report, the Hoesgen brothers reveal what could be a comeback in income trusts (investment vehicles that aim to provide steady quarterly or monthly payouts.)  Enjoy…

-Keith

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The income trust game is back – just in a different form.

Canadian Finance Minister Jim Flaherty killed these high-yield, tax sheltered public companies on October 31, 2006 – not so affectionately called the “Hallowe’en Massacre” by the millions of investors who were enjoying 10%+ payouts annually.

Canadian companies had until January 1 2011 to convert back to a regular corporation or face new taxation that essentially reverted them back anyway.

But the market has found a loophole that may allow for many new trusts – especially in the energy sector:  don’t use Canadian assets. Two new income trusts have listed on the Toronto Stock Exchange (TSX) recently.

Last year, Eagle Energy Trust (EGL.UN) went public on the TSX, which was the first Canadian-listed oil and gas trust to launch since Flaherty’s Halloween surprise in 2006.

The company holds only foreign oil-producing assets – 1269 bopd of light oil production in Texas – a loophole that excludes it from the new Canadian tax regime.  The founders of Eagle Energy believe this new structure will serve as a template for other oil and gas companies.

They raised $150 million in their initial public offering at $10/share last November with an additional $20 million as well via a concurrent sale of securities to their vendor.

The company quickly followed up with their first distribution declaration a month later of $0.1064 per trust unit or 10.64% if you were lucky enough to have participated in the IPO.  The company is currently trading at $11.50/share as we write this, with an all time high of $12.10/share.

Parallel Energy Trust (PLT.UN) is the second new energy trust out, debuting in April 2011 on the TSX as well, after having completed a $342 million initial public offering at $10.00/share and also closing on a $51.3 million over-allotment option earlier this month.  The company plans to offer an initial yield between 8.5%-9.5%.

Parellel is producing 2900 boe/d of natural gas – again from Texas – though in their prospectus they say it is 67% Natural Gas Liquids, which get a higher price than straight dry gas.

The need for income has not gone away and we feel investors looking for a reliable source of investment income will begin to favour new oil and gas trusts.  It took about a decade before the trust market really took off last time.

This time around, with a new structure in place, and new rules to comply with, it could take much longer but the performance of Eagle and Parallel is certainly an indication the investor demand for this type of vehicle is there.

On the negative for investors, Canadian companies operating in foreign jurisdictions also offer a potential higher level of risk than that of a company whose assets are in Canada.  On the positive for the companies, Canadian companies have an advantage when they operate in the United States for example, since smaller energy companies can get access to capital more cheaply in Canada than south of the border.

BACKGROUND ON INCOME TRUSTS –

Since their debut in the 1980s, income trusts were madly popular with investors who loved their juicy quarterly or monthly payouts.  These vehicles were special in that they paid no corporate taxes but rather passed their profits on to unit holders who were then taxed.

Seniors, in particular, loved them for their ability to provide steady income at yields that were consistently better than that of traditional dividend-paying investments.

By the turn of the millenium, they had become the talk of Bay Street and any well-informed investor was not without at least a portion of their hard – earned portfolios allocated to Income Trusts.  In fact, by 2006, they became so attractive that telecom giants Telus Corp. and BCE Inc. were considering converting themselves from the traditional corporate structure into income trusts in order to reduce their tax burden.

The government stood by and watched for years while tax dollars fell by the wayside.  It was not until Gord Nixon, CEO of the Royal Bank of Canada, commented publicly about the possibility of converting the biggest bank in the country into an income trust that Ottawa finally took action.

On Oct. 31, 2006, Jim Flaherty, Canada’s Finance Minister at the time, announced his own “trick” but no “treat”, on a Halloween Tuesday unit holders will never forget.  He announced income trusts, with the exception of real estate investment trusts that adhere to strict rules, would be subject to tax on trust distributions — effectively, making them treated the same as corporations.  This announcement forced the stock-market value of these vehicles down by at least 15 per in reaction to the news. Some were way worse.

The number of energy income trusts has fallen dramatically since then. At that time, the Toronto Stock Exchange boasted 32 energy trusts with a combined market capitalization of $83.9-billion. In the last four years, that shrank to 13 with a total value of $57.2 billion.  The gap is even wider for all Canadian income trusts, which have tumbled from $209-billion in value to $140-billion.

Under the new rules, all new trusts from that date forward would be subject to the new tax regime, but Flaherty gave existing trusts (of which there were 255 on the TSX at the time, collectively worth more than $200 billion) until the then-far-off date of Jan. 1, 2011 to meet the new requirements.That deadline has come and gone and while the sector is not what it was years ago, the good news for investors seeking income is that the income trust could be making a comeback, as Eagle Energy and Parellel Energy Trust are showing.

Next story:  Oil & Gas Income Trusts, Part 2 — The ‘New Class’
Part 3:  The New Canadian Energy Income Trusts

Dennis Hoesgen and Eric Hoesgen are Senior Investment Advisors at Hoesgen Investment Partners in Vancouver, with Canaccord Wealth Management, a division of Canaccord Genuity Corp., Member – Canadian Investor Protection Fund. They can be reached at 604-643-0229 or hip@canaccord.com. The views in this column are solely those of the author. This report is provided as a general source of information and should not be considered personal investment advice or a solicitation to buy or sell securities.

Energy Services Stocks: Part 2

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1940bkg
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In my last story – Investing in Energy Services Stocks — I explained why the entire energy services industry should see rising revenue and profits over the next few years.

These are the companies in major demand as the shale revolution continues.

Now let’s look at the services sub-group that’s really benefitted from this revolution: the fracking industry.

After you drill an economic well you have to “complete” it, which means get the oil out of the ground. In shale plays, or any tight sand oil or gas play, fracking and completing have basically become the same thing.

Whereas drilling used to be the highest cost component of a well, it is now completions and testing. Today that comes to roughly 54% of the total well cost… vs. just 17% in 2000. (In Canada, the largest fracking companies generate as much cash flow as the biggest drilling companies.)

The fracking industry is judged not by the number of fracking rigs or setups, but the amount of horsepower (HP) any one company can provide. Macquarie Capital estimates that in the U.S., HP demand will jump 62% in 3 years, from 9.1 million HP now to 14.8 million HP in 2014 – and they expect the market to still be under-supplied then.

In Canada, oil and gas companies can wait up to four months for a fracking crew.

There is one other very positive trend to throw into this mix – the fact that the energy industry in North America is now becoming oily. This continent has been known as a gas basin for the last 50 years, and a boring mature one at that.

The last five years has turned that idea upside down, and that has very positive implications for the valuation of energy services companies.

As recently as 2008, more than 80% of all drilling in North America was for dry gas (methane that heats your home). It’s now 50% oil.

The gas industry was notoriously cyclical, as it depended on the weather. Cold summers and warm winters meant a glut of gas, low gas prices, and low cash flow for producers… so drilling was low.

Of course the market likes predictable cash flow – it will pay more for a less-profitable well that will last for 25-30 years than it will for a highly profitable well that is depleted in 5 years.

And now that half of all drilling is for oil, Macquarie Capital is calling for higher valuations in the energy services sector. Oil is not driven by unpredictable weather (but by unpredictable geopolitical issues ;0)).

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Click here to read my full report that explains how to get started.

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But overall global demand for oil is strong, and even if oil drops back to US$90 per barrel, almost all oil plays in North America are profitable… and will sustain steady drilling and fracking levels – keeping the cash flows of service companies high.

In conclusion, the services sector is the place to be in the energy sector for 2011 – and the next three years – for the following reasons:

1. The number of horizontal wells being drilled is increasing because they’re so profitable.

2. The depth and length of horizontal wells is increasing.

3. The industry is at capacity right now, and will be for three years.

4. One brokerage firm is expecting cash flow per share to increase 40% for the full services sector.

5. A more predictable, steadier work schedule — due to oil exploration vs. gas exploration — will mean higher valuations for energy services companies… even without increased cash flows.

As I said, fracking and drilling companies are all but maxed out. (The industry is building new rigs and more fracking equipment as fast as possible.)

And that makes natural gas the “X” factor. If natural gas prices ever pick up, it’s safe to say demand for gas rigs will go up.

In such a scenario, we could see energy services stocks really take off.

– Keith

Investing in Energy Services Stocks

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The rapid increase in horizontal drilling and the shale revolution in the energy sector is re-defining the need and demand for North American energy services companies.

This has created a work backlog that has the entire industry – drillers, fracking companies, fluid specialists, water services – stretched to the limit, which will keep revenue and profits rising for the sector for at least three years, say research analysts.

Peters & Co., a Calgary based oil and gas boutique brokerage firm, estimates 2011 cash flow per share will increase 40% over 2010 for their coverage universe in the energy services sector – 40%.

Securities firm Raymond James says oil and gas companies will increase spending 25% this year alone to US$133 billion.

Even more, they estimate spending will have to increase by about 56% above 2011 levels, to roughly US$206 billion, as more powerful rigs are needed to drill deeper —  and longer — horizontal wells. Oil & gas companies spend that money; energy services companies receive that money.

It means the energy services sector will be one of the safest and most lucrative investment opportunities during that time.  A rising tide of revenue and profits will lift all stocks, and create M&A activity that will also enrich investors.

With oil back up over $100/barrel, oil producers are drilling as fast as they can.  But the big difference between 2011 and 2007 – the last height of the drilling industry – is the number and percentage of horizontal wells being drilled.

Everyone is drilling horizontal wells – they may cost 2-3x as much as a vertical well, but producers often get 4-7x as much oil or gas out of those wells.  The economics of horizontal drilling are very strong, and that’s why horizontal wells now make up 44% or more of all wells drilled in Canada, more than triple the 14% in 2007 – only four years ago.

The other important factor to mention is that these shale plays often extend over a large area deep underground, so once a shale formation is deemed economic it can often provide tens or even hundreds of low risk repeatable drill locations – Easy money for the services sector.

Drilling a horizontal well takes a different set of technologies and skill sets that the industry is discovering and developing as they go.  As an example, companies that just do hydraulic fracturing – sending water and sand down into the well at super high pressure that breaks up the shale that holds the oil — are constantly perfecting their technology to increase the amount of oil or gas they can get out of the new shale plays. (See our recent story on the “recovery factor” and the new QuickFRAC product from Packers Plus.)

Drilling fluid companies are developing new technologies that allow the drill bit to glide along a horizontal well bore with less friction – dramatically reducing the amount of time and money it takes to drill a well.  But these specialty fluids cost more. $$$$ ;0)

One of the biggest OGIB subscriber wins has been Canadian Energy Services (CEU-TSX). Since I bought it in the portfolio at $15, it has increased its dividend three times… and the stock has more than doubled in stock price to $32.

Despite all the technology creating savings and increasing profits for the energy producers, well costs are still going higher, as is the number of metres drilled per well and the length of time it takes to drill a well.  All of these factors mean more money in the pockets of the energy service providers.

The Daily Oil Bulletin, a trade magazine in Canada, reported that the average metres drilled per rig jumped to 8,336 metres in the first quarter, up from 7,240 metres per rig in the same three months last year, as wells go deeper and the horizontal legs get longer.

The Petroleum Services Alliance of Canada says the average number of days it takes to drill a well has climbed to 11.5 in 2011 from 5.7 in 2008.  Wells are, on average, almost 600 metres deeper than they were in 2008.  Some of the deeper wells in Canada are taking 25 days or more to drill.

All these statistics means more work, and more profits for services companies.

And having rigs spend more time at one job site means more rigs, more fracking set-ups and more ancillary services are needed to fill the demand.  The industry is building new rigs and more fracking equipment as fast as they can.

Macquarie Capital estimates the US industry needs an additional 550 rigs over the coming four years to meet demand – much of it the new larger rigs that can bill out at higher profit margins.

Raymond James estimates that day rates for Canadian drillers were up 10% in Q4 2010, and will be up another 5% in Q1 2011.  I’m seeing gross profit margins go from 25% up into the low and mid 30% range — sometimes higher.

That pricing power should mean drilling stocks stay in an uptrend.

It has been one of the best-performing sectors in the OGIB portfolio.

Read Part 2 here: Energy Services Stocks — The services sub-group that’s perhaps benefitting the most from the “shale revolution”… and one very positive trend to throw into the mix.

Editor’s Note:  I’ve updated my last story — The Stocks Likely To Benefit from the Emerging Duvernay Play — with additional content that didn’t make it into the Free Alert email last week. Click here for the updated piece on the OGIB web site.

Want to learn more about investing in junior oil and natural gas stocks? If you have a Facebook account, just “like” this article and a hidden link to Keith’s 10 page how-to on oil and gas investing will appear:

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