How To Invest in Oil & Gas Stocks

By
dj
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0

ENERGY INVESTING 101

Dear OGIB Reader,

Investing in oil and gas stocks is actually quite simple.

Investors have two basic choices when starting out:

1) Do I want to get a stockbroker who specializes in oil & gas (probably based in Calgary or Texas) and do what (s)he tells me; or 2) Do my own research and stock-picking?

If your answer is 2), then you may find useful the Top 20 Answers I try to determine in my first round of research I am doing on oil and gas companies. This is hardly an exhaustive list. But I’ve tried to use simple language to help even the most novice oil and gas investor understand what questions and answers will help them decide on the potential of an energy company.

Where do you go to find these answers?

In order, I suggest:

A) Corporate Presentation on the company website

B) Call management directly (though the bigger the company the harder this is, and few energy companies have investor relations people)

C) Read the quarterly financial statements ± the numbers and the notes (the more you get into it, the more you will find that most good information is in the notes and the management discussion)

Before reading these starting points, also consider ± what type of investor are you? Do you want to invest in large stable companies with a long history and strong cash flow? Or can you tolerate higher risk, and want to look for more leverage in the junior stocks, where a discovery could either give you a multiple return or lose most of your investment?

THE TOP 20 ANSWERS YOU NEED TO KNOW:

How much of their production is oil and how much is natural gas? (gas prices are very low right now and doesn’t produce much, if any, cash flow for companies)

1) How many barrels of oil per day (bopd, or “boe” for natural gas – barrels of oil equivalent) is the company producing, and how quickly have they grown production in each of the last 3 quarters.

2) How much net cash or net debt do they have? This industry uses a lot of debt, so if a company actually has net cash, they could grow more quickly because they have an entire untapped line of credit waiting to go drilling, and grow the business. And of course no debt means no debt payments and flexibility in doing business.

3) Where are the properties? Investors give North American assets a slight premium, unless the company is either growing very fast or has a management team that has built and sold an oil & gas company. Political risk shows up in the stock price.

4) How many wells will the company be drilling in the coming nine months? This will give you an idea of how fast they may grow. Companies usually say in their presentation how many wells they will drill property by property, but don’t often give an overall number in one slide. Odd but true.

5) How much will all this drilling cost, and do they have the money or cash flow to do it? Most companies have a slide in their corporate presentation that shows their estimated cash flow for this year or next, along with their estimated capex, or capital expenditure,
which is their drilling budget. Or do they have to raise money in the market to do the drilling they want? (This is not good when the market smells a financing coming, it drives the stock lower.)

6) Are these wells higher risk exploration wells or lower risk development stage wells? Development wells are just filling in an already discovered oil field. It means these wells will almost certainly repeat the success of the discovery well; the oil or gas formation is large and drilling success is “repeatable”. The market loves certainty, and most companies go out of their way to crow about their “undeveloped land acreage” and “X year drilling inventory”; the number of wells they could drill on this development-stage land.

As an example, the new, big shale formations in North America are very “repeatable.” The Bakken oil field in Saskatchewan is “repeatable” in large scale, i.e. it could support many wells.

7) If the company is doing exploration drilling, what has been the company’s success rate in each of the last two years? HINT: if it’s not on the PowerPoint, guess what… There is new technology called 3D seismic that allows companies to see the producing oil/gas formations much better and now means a much higher success rate for exploration. Anything under 70% success in raw exploration and I get nervous.

8) What has management done in the past? Have they ever built and sold a producing energy company?

9) How many research analysts follow the story? If the answer is 3 or less, why hasn’t management been able to secure more coverage? There is a reason. It might be because your target investment is small. It might be that it is just not a compelling growth story as you think. Or it might be just be because management doesn’t raise money much, i.e. rarely (if ever) issues equity. Analysts get partly compensated on the business they can bring into their brokerage firm. If they cover a producer who will never raises money, they’ll never get paid, so who cares?

10) Without analyst coverage there is no institutional money flow in the stock. And without institutional support, your stock will need A LOT of drilling success to move up, and will likely always trade at a big discount to its peer group.

11) Decline rates are something management teams don’t really hide, but don’t really talk about either. Every well has declining production until it’s uneconomic. The new shale gas plays often have 85% decline in production in the first year. Tight oil plays (shale gas and shale oil) have 75% initial decline rates. Decline rates are increasing over time now as the industry drills deeper and tighter plays. Ask management what the initial decline rate is, both company wide, and specifically on their main, big play that they believe will be the growth engine of the company. Then ask what the decline rate flattens out to – it’s usually 20-30%. This is called the “long tail” of production.

Why is this important? Because many investors, when forecasting growth, use the only public numbers given for a well the ones in the press release. Most companies have a production decline graph in their PowerPoint, but few actually say what the production levels in the wells in the area flatten out at (and many research reports from analysts don’t either)

12) If the company is operating in a foreign country, what kind of political connections do they have? Who from that country is in management or on the board of directors?

13) What is the break even cost, companywide, and in their main play, in terms of price per barrel? Management should have a very good ballpark number at hand.

14) How much does it cost them to bring up a barrel of producing oil? Costs can range from $8000 per flowing barrel to over $30,000. Obviously, the lower the better, as this will be more profitable. Then you compare it to what companies are being bought out for. If a company can produce a barrel of oil for $10,000, and the stocks are being bought or merged at valuations of $70,000 per barrel, that’s a very accretive oil or gas play! Again, management should be able to answer that question on the phone.

15) What is the recycle ratio – both overall corporately and specifically on their main play – that will be the growth engine for the company? The recycle ratio is a key measure of profitability for an energy company. It’s a fairly simple calculation, and many companies put it in their quarterly and a few even put it in their PowerPoint. Management will know this number off the top of their head like they know their wife’s name, so don’t be afraid to ask.

The recycle ratio is the profit per barrel (called the “netback”) divided over the cost of finding that Barrel – ”F&D”– Finding and Development Costs. Both the netback and the F&D costs are in all the quarterlies, usually broken out in simple charts and language in the notes. The higher the recycle ratio, the better. Anything over 3 is great, 2 is really good and under 2 can still be OK if it’s a big field and lots of wells can be drilled. Different companies report differently so not all recycle ratios are equal, but it will give you a general idea. The higher the recycle ratio, the higher the valuation should be.

16) How much of their own infrastructure do they own? And are they the operator of their plays? Infrastructure includes things like local or regional pipelines, storage facilities, processing facilities. If they don’t own them, they have to pay charges to use them, and are subject to somebody else’s maintenance and upkeep. And the market often pays a lot less for a non-operating interest in a play, as the operator gets to call the shots most of the time.

17) Ask management what kind of discount or premium they get for their production, from quoted prices like WTI crude or Brent Crude and why that is. For example, heavy oil gets a discount up to 50% from the WTI price or Brent crude price that is always quoted in the media. Maybe their oil or gas has a high sulphur content (which would also give them a tougher time with environmental permits). A company may say they are producing 10,000 bopd, but if their price is much lower than world price, their future cash flow could be much lower than you think.

18) How much stock does management own? Which people on management are the largest shareholders in the group? And how much hard cash – not stock options – does management have in the company?

19) Look at the stock chart – Is the stock moving up or down? Ask management – what is the market missing in terms of appreciating the company and stock?

20) And lastly, ask open-ended questions, like what else is there about your company that you want to tell me? Where do you want to improve the most over the next 2-3 quarters?

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International Junior Oil Stocks

By
Keith Schaefer
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How to Find and Play the 10-Baggers Abroad – Part 1

What were the oil stocks that made me the biggest profits in 2010?

It was junior oil stocks with international plays.  Companies like Xcite Energy (XEL-TSXv) that went from 62 cents to $6 last year with a heavy oil play in the North Sea, or TAG Oil developing their New Zealand asset, moving from $2 – $6.  The one big international stock I missed was TransGlobe (TGL-TSX) which went from $3.50 – $20 on drilling success in Yemen and Egypt.

These junior international plays are often orphaned stocks with big, high-impact exploration plays – and if they hit WHOOSH! The stock can flow upwards like oil gushing out of a well.

But if they miss…ouch.   The investment can be a big win, or a big loss.  These international exploration plays are what I call a one-decision stock, or a widows-and-orphans stock (nobody gets out alive) or a binary trade – it’s a 1 or a 0.

They have several key differences from the home grown North American oil plays.  If investors know what they are, and how to “game” them, they have a much better opportunity at making a profit – whether the well is a gusher or dry.

The three obvious differences is that international plays can have:

1. more political risk that warrants a lower valuation

2. a much bigger prize (bigger well) if they hit,

3. more risk geologically compared to domestic ones, and I’ll explain why.

First, though, understand that North American plays are now dominated by shale or “tight” oil plays, like the Bakken or Cardium plays, or the US shale gas plays.  In shale oil plays in North America like the Bakken, a really good well might have an IP rate of just over 3000 bopd – but in Canada the best wells are more like 500-600 bopd.

But in countries like Colombia companies like Petrominerales are often hitting 6,000, 10,000 and 15,000 bopd wells.  The value of your investment is obviously going a lot higher with those bigger wells.

And the international arena is full of countries just opening up to new levels of investment in oil and gas and investors can expect this trend of big new discoveries to continue – onshore and offshore.

North America is a mature enough basin that all the juicy profitable low hanging fruit is gone, and can’t compete with those production numbers.

The other factor that gives (successful) international plays much more profit potential has to do with risk and valuation.

Domestic plays have become denominated by the “Resource Play” which is a large acreage of “tight” oil, or is an “unconventional” play that can hold a large number of low risk wells with highly repeatable results.

With 3D seismic and other exploration tools, investors have become accustomed to companies drilling successfully 80%, 90% or 95% of the time.

This safety factor means that companies with domestic plays can extract higher valuations from the market when they get financed – at a higher percentage of the company’s Net Asset Value, or NAV.  So not only is the upside capped on domestic plays by small IP rates, the starting point is higher due to less risk.  So the potential profit window is smaller on domestic plays.

My experience is that most domestic plays get financed between 0.7 – 1.25x NAV.  However, international plays can get financed as low as 0.2 NAV – 0.5 NAV, particularly if they are “orphaned” stocks.

What does that term mean?  It means the company has no active “sponsorship” in the market; no brokerage firm or controlling shareholder is actively promoting the company.  Most retail investors greatly under-appreciate the importance of good sponsorship in a stock.

I will often buy stocks just because the most important investment banker in Calgary or Toronto is firmly behind the company.  Besides premium assets, sponsorship creates premium valuations more than anything in the market. (This is important enough for retail investors to understand that I’ll do a whole story on the “sponsorship” game next week.)

And without it, stocks are orphaned, and can trade at big discounts.  And there are often a lot of international plays that are orphaned.  TAG Oil was orphaned from 15 cents all the way up until GMP raised them $17 million at $2.50 in 2010.  Xcite Energy was orphaned for a long time; no brokerage firm was actively telling the rest of the street – “this is our deal, we financed it, and it’s going to be a big winner”.

And there is truly a very simple way to discover, and play, these high profit potential stocks.  If you’re serious about making money in this highly profitable – but higher risk – sector, it will only mean a little bit of sleuthing.

In my next article, I will explain how I do it, and how you can play them to maximize the opportunity for capital gains.

As an added bonus, I will outline a case study of a current orphaned international play – and a current OGIB portfolio stock – that is expecting results on a high-impact well within 4 weeks, and the valuation of a recent transaction in this area tells me this stock’s valuation could triple if the well is successful.

Lastly, I would say these opportunities are likely to become more difficult to find.  That’s because after the financial crash of 2008, the oilpatch – like everybody else on earth – reduced risk and stopped spending money.  These types of high risk international plays were obviously the first to get canned from exploration budgets.  Enough risk appetite has returned to the market that these high impact international plays are now attracting a lot more mainstream attention sooner than before, and getting in REAL cheap, like I did with Xcite, will be more difficult.

But as long as the international play in your sights is not a recognized resource play, then it should still be trading at a good enough discount to NAV to provide some excellent upside potential.

If they hit.

– Keith

Follow this link for Part 2 of my International Junior Oil Stocks piece.

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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The Paris Basin Oil Shale Play

By
Keith Schaefer
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Toreador Resource’s Investment in the Paris Basin… and How Its Estimated 96 Billion Barrels of Oil was Discovered

It all started with a note.

It was a handwritten note on the margins of a long-forgotten report, in French, from a well site geologist many years ago who was on a rig drilling into the Paris Basin for conventional oil.

“That was our first clue,”says Craig McKenzie, President & CEO of Toreador Resources (TRGL-NASD). “The geologists were writing about uncontrollable oil flows from the Liassic shale and eruptions due to over-pressurization.”

“Rock was erupting into the well bore because the over-pressured oil was pushing everything out of its way. When you see this being repeated over linear distances of 50 miles or more, you get excited that this is not a one-off, but this is basin wide.”

That was the Eureka! moment for McKenzie and his team that the Liassic shale in the Paris Basin had the potential to be something very special.

It’s big.  It’s simple.  It’s over-pressured, which generally means bigger flow rates.  It’s been known since the 1950s.

The Paris Basin is the perfect example of the biggest Mega-Trend I see happening in oil and gas for the next 20-30 years: the export of shale technology around the globe, which should create dozens of discoveries for the industry, and many 5-10 baggers for investors who are able to ride this wave.

And the good news for investors is – so far – that many of these plays are being discovered by junior E&Ps (exploration and producers).

That can also mean a rocky ride for investors; juniors are by definition more risky and volatile.  Toreador’s story is no exception.

Back in 2007-08, the company had a suite of European assets, including some production in France, but the company had nearly $110 million in debt with a $40 million market cap.  Then the Crash of ’08 hit, and some tough decisions needed to be made.

One of those decisions was management.  Shareholders asked McKenzie, who was previously President for British Gas Trinidad & Tobago and later CEO of Canadian Superior, to step in as CEO of Toreador in January 2009.

“We treated everything in the company with extreme urgency,” recalls McKenzie. “2009 was a no pain no gain year – we sold prized assets of the company in Hungary and Turkey, and were very aggressive in buying down the debt and disciplined in our spending.  We focused the company to one set of assets in France, and wanted to make the base business sustainable.”

“The one investment we did make was in the Paris Basin.”  The Paris Basin is an area of roughly 100 by 150km east, south-east of Paris where Toreador already produces 900 barrels per day of oil  (from conventional reservoirs).

It was a good choice.  But it took some original thinking.

“The big majors had been drilling here in the late 1980s, with as many as 18 rigs, and they all  had a common view of the source rock.  But the thinking was that oil had migrated (up from the source rock shale) to conventional traps.  These major oil companies exited because there were just small discoveries.

“We think the reason they didn’t find any large conventional plays is that the oil is still in the source rock. There are no obvious signs of long distance (oil) migration or seepage at the surface,.  And through historical analysis we know it’s still over-pressured,” says McKenzie. (Unlike water, oil migrates up.)

So the new board of directors reasoned they needed to focus on understanding the Paris Basin better, and management started to acquire as much data as they could.

“We went searching for old cores in core boxes all across France in warehouses, searching shelves, and plugging them.” This would be the same as splitting core in mining.  Some of the core they were able to secure was just the size of a thimble of thread.

“We started getting back silica and high limestone content from our analyses of the cores.  The silica meant brittle shale, which means a favourable response to fracking.  Also, the limestone is important for shale oil in contrast to shale gas.  We’re happy to have silica, but gas molecules are small and go through rock much easier. Oil molecules are bigger and polarized – limestone is good for that.”

I asked McKenzie if his peers or the locals thought they were crazy.

“We weren’t crazy, we were different – in the beginning people didn’t pay us much attention, and then by the end of lastyear, people started asking questions. Now people are really beginning to appreciate what we’ve been doing for the last 20 months.”

So the team set to work analyzing an ever increasing amount of raw, unconnected data.

“Over 200 wells have penetrated shales in the Paris Basin,” McKenzie says.  “Of the 200 plus, we focused on the 60 in the deepest part of the basin.  It’s also the most mature rock, the most cooked of the organic matter.  In industry terms, it’s in the oil window.”

He gives me a quick layman geology lesson:

“Think of all that organic matter, settling for millenia, and it all sagged under its own weight.  So in the centre it’s the deepest.  It looks like a series of stacked plates now.  There is a window of 440-470 degrees Celsius in which oil cooks perfectly, and that’s what’s happened here.  With all the well penetrations you can start mapping out the depths, and at some point it (the Liassic shale formation) comes out of the ground, 50-100 miles away, but it (the oil) hasn’t cooked.”

The Bakken play in North America also has stacked plates – which are layered geological formations – and three are producing formations.  At this early stage in the Paris Basin, it also looks like the Paris Basin would most likely have three producing formations.

The data that McKenzie’s team rounded up came from the late 1950s to the early 1990s.  Because everyone was drilling through the Liassic shales to reach deeper targets, Toreador was just after incidental information from the drillers and the mud loggers.  And it all started to make sense after reading a series of hand written notes in French from geologists made 20-60 years ago.

“Last year we were sure we had something. We started talking to people in the Williston Basin (the Bakken play in North Dakota).  We were sure that the rock in the Paris Basin was analogous to that in the Bakken/Williston Basin.”

Fracking’s Game Changer

The debate continues over fracking, or hydraulic fracturing…

Environmental concerns, disclosures, regulations… just for starters.

Well, once you’ve read my new report, you’ll understand this debate better than 99% of the journalists who cover the topic.

And you could make a fortune in the process.

You see, one company has developed a patented fracking process that eliminates all environmental concerns over oil & gas fracking. And it does this while it increases production of the oil or gas.

I’ve been tracking this company closely for over a year. In fact I’m hard at work finishing my newest report, which I’ll be sending over to you shortly — exclusive to OGIB readers.

“We retained RBC Capital Markets (its sister firm Dominion Securities is Canada’s largest securities firm) to undertake a review of strategic alternatives. We opened a formal bid round for partnering, and engaged 40 companies.  All of them did their own technical audits of the play, and not one of them walked away because of holes in our logic.  They all agreed with our conclusions.”

“We received a number of bids, and chose not to go with a Super Major, private equity, or North American independents (producer).  We chose Hess (HES-NYSE) as it had the right scale, the right Bakken know how, and they’re reportedly spending $5 billion in Williston Basin over next 5 years, so they’re aggressive.”

“And we liked the way our teams worked together.  They replicated all our work going down to the warehouses themselves and doing their own testing.  With their experience and value in the market, they know how to do business internationally.  They set up office around the corner here from us in Paris.”

Toreador’s deal with Hess can be as much as $265 million to earn 50% of Toreador’s acreage.  So they obviously think the play has great technical merit.  While many investors are looking at this play’s success as a given after so much due diligence – Toreador’s stock trades at 6-7x its Net Asset Value (NAV), vs. a multiple of one or less for most oil and gas producers – McKenzie isn’t counting his chickens just yet.

“There is still risk.  After all this analysis, I can tell you lots of different technical things about the play – but I can’t tell you that there is one single long term completion, because there isn’t.”

Scott Hanold, Managing Director of Energy Research for RBC Capital Markets, agrees:

“While there is still substantial opportunity, we still have to prove this play works economically, which is a big hurdle.  Based on the current stock price, investors are already valuing $11 for this shale play as the conventional producing assets are worth about  $4.  If the shale is not productive and Hess walks away where does this stock go? Probably close to that $4-$5 level.

“However, with success, we could see TRGL shares double or more. Recent land deals in the Bakken – a similar play – were done at around $10,000/acre compared to a few hundred an acre just a couple years ago. That clearly shows how quickly exploration success and technology can create value. The key here is to get the first wells down and find out exactly what they have”

McKenzie says their first well will is expected to spud in January, and it will be continuous drilling until a first phase – which commits Hess to spending at least $50 million – is finished.  He expects the first two wells to be vertical, but there is no decision on wells 3-6 yet.

“We’ve effectively picked the locations, but not how to drill them yet,” he says.  “When do we go horizontal and frack?  Right now we think well number three, but if we hit what we want on first two we could do it there.”

“It depends on logging, coring, and how fast we do the analysis.  We don’t know the orientation of the natural fracking, and how much it’s naturally fracked, and that will determine how we have to set up the frack design.  Note also that the vertical wells will have the flexibility to be re-entered and continued horizontally.  We’ll have maximum optionality.”

McKenzie adds Toreador and Hess will be looking for variability spatially (how patchy or consistent is the formation), but doesn’t expect much so they could do horizontals very quickly.  He voiced his opinion that, if all goes according to plan, the market could see the first IP rates (Initial Production) in late Q1 2011.

Vermilion Energy (VET.UN-TSX) also has a land position in the Paris Basin.  According to its recent quarterly results, it continues to successfully produce oil from two old vertical wells that it re-entered and fracked in the shale – which contributes to Toreador’s sky-high valuation – but Vermilion has thus far not announced any oil flow rates.

Even if the play does work geologically, RBC’s Hanold says there could be other challenges in the Paris Basin, like the lack of energy services (drillers, frackers) and the fact that the landowners do not own the mineral rights.

“There is not as big of an incentive for landowners in France as the government owns the royalty rights,” he says, “Whereas in North America you can quickly become rich if a company drills a big successful well on your land.”

So what kind of well profile does McKenzie expect to see – what would be his best guess on IP rate and economics?

“We’re using 400 bopd (barrels of oil per day) for a 30 day IP with a 50% decline first year,” McKenzie says, adding that the Banc de Roc formation in the Paris Basin looks to be very similar to the middle Bakken at Elm Coulee in eastern Montana.

“That’s more pessimistic than what’s happening in Elm Coulee.  Continental (CLR-NYSE), Brigham (BEXP-NASD),with that type curve, are looking at EURs (Estimated Ultimate Recovery) of 500,000 barrels, on a well that costs $7 million, giving $14-$15 per barrel F&D (Finding and Development), and 12 million barrels of resource per section (one square mile = one section).”

“We think it (the amount of Original Oil in Place, or OOIP, in the Paris Basin) can go higher but we’re basing at 12 million per section.”

He anticipates that fracking will take a “typical Bakken approach”, and be done by a multi-stage frack over a 5,000 feet lateral distance.

“We don’t know exactly what kind of technique or how many fracks; we’re just starting to science that, but we are working on getting the data to figure it out.”

The Paris Basin has gone from obscurity to front page news in the global oil patch in just over a year. As a result, there has been a staking rush, and getting land now is very competitive.  Toreador has up to 1.6 million acres awarded and pending, and McKenzie says there is a lot of competition for smaller land blocks closer to the edges of the play.

(Toreador’s ground is the pale yellow colour)

“We’re still seeing small players chasing us, but a lot of the US independents have too much on their plates to worry about France.  The larger independents don’t see the acreage size to jump into the game now into a new country.  In this phase, the Paris Basin is still frontier, despite its enormous potential.

“A lot of the bigger players are sitting on the sidelines to see how this works out, but that will change with positive results.  Then we’ll see larger companies be happy with smaller land positions – but the shale gas plays of eastern Europe are there as well and they have larger parcels available.”

That change McKenzie is talking about could happen at the end of March 2011.  With estimates as high as 96 billion barrels of oil resource generated for the Paris Basin, it’s a big play the world will be watching.

And it all started with a little note.

Keith Schaefer owns Toreador Resources.

by +Keith Schaefer

Investing in Oil Services Stocks

By
Keith Schaefer
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0

Why oil services stocks are outperforming oil producer stocks

By Brian Hoffman

The share prices of oil service companies have outperformed the share prices of large-cap oil and gas companies’ common shares since the broader stock market indexes started to move higher at the start of September.  The unit price of the Oil Service Holders (OIH-NYSE, $138.52) exchange traded fund (ETF) has increased about 39% since September 1, compared to a 34% price increase for units of the Energy Select Sector SPDR Fund (XLE-NYSE, $67.22) ETF.  Interestingly, oil prices have only increased about 21% in the same time frame, which is almost identical to the move experienced by the S&P 500 Index.

There are several other ETFs that track the shares of oil and gas producers and services companies, although those other ETFs do not experience the same magnitude of trading volume as the XLE and OIH ETFs.

The XLE ETF tracks the shares of U.S. large-cap oil and gas companies with recent trading volume about 10 to 20 million units per day.  This ETF has a heavy weighting of Exxon Mobil Corp. (XOM-NYSE, $72.80), which significantly influences the direction of the ETF.  Since XOM has lagged the XLE ETF during the last several months the recent influence has been a drag on the ETF’s performance.

The OIH ETF tracks the Philadelphia Oil Services Index (OSX, 242.22), which is comprised of the shares of U.S. large-cap oil and gas service companies.  Recent trading volume is about 4 to 5 million units per day.  This ETF includes oil and gas service companies such as Schlumberger Ltd. (SLB-NYSE, $82.81), Halliburton Co. (HAL-NYSE, $40.41) and Baker Hughes, Inc. (BHI-NYSE, $56.76), which have all outperformed the OIH ETF since Sept. 1.

The comments below provide a technical analysis of these two ETFs in terms of the current price chart pattern that each ETF’s price action has formed and their relative performance against each other, but first a refresher on support and resistance levels.

A support level for the price of a security or ETF is the level at which buyers have become as powerful as sellers and stop a price decline.  Whereas resistance is the level at which sellers have become as powerful as buyers and stop a price advance.  A resistance level becomes a support level after an upward breakout of a resistance level occurs, whereas a support level becomes a resistance level after a downward breakout of a support level.

As you can see in the chart below, except for the big pull-back in the spring of 2010 after the BP Amoco PL (BP-NYSE, $43.61) gulf oil spill, the OIH ETF has outperformed the XLE ETF since Dec. 1, 2009.  The trend lines on the ratio of the OIH unit price to the XLE unit price as well as the RSI and OBV technical indicators favour continued outperformance by the OIH ETF, but breaches of those trend lines may change the bullish outperformance case for the OIH ETF.

“—-ing Will Change Everything”

Technology, by its very nature, creates change.

But there’s one technology in particular that is causing massive changes in the oil and gas exploration industries.

Now…I can’t give it all away right here.  But rest assured – “—–ing” is a technology understood by very few.

But at the same time, “—–ing” is about to create explosive short-term profit opportunities for those investors who know where to look.

That’s where I come in.

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XLE’s unit price bounced around a price range of US$50 to US$60 during the period August 2009 to October 2010, and managed to penetrate the US$61 resistance level in November 2010, which has become the support level.  The unit price has traced out a fairly steep rate of ascent, which is unlikely to be sustained, although the move above US$67 has confirmed the breakout.  The bullish trend may continue through the winter months should XLE’s unit price find support at US$61 and then make some higher highs and higher lows.

OIH’s unit price has bounced around a much wider US$90 to US$130 price range during the period August 2009 to November 2010, which is quite volatile.  The unit price managed to penetrate the US$130 resistance level in November 2010 and has also traced out a fairly steep rate of ascent, which is unlikely to be sustained.  The bullish case for oil services companies outperforming oil producers is strengthened should OIH’s unit price confirm a breakout with a move up to US$143.

oil graph 2

Notice how the resistance level of each ETF was breached in April of 2010, but the unit prices quickly dipped below those levels quite substantially after April.  Essentially, the sellers became more powerful than buyers and stopped those advances.  Recall that there was general market weakness in May.  These false break outs, or whip saws, have a greater probability of occurring if the price movements are less than 10% above the resistance level.  Normally, a break out is confirmed by a 10% price move above the resistance level, although with penny stocks you would generally want to see at least a 20% price increase to confirm a break out.

There significant short interests in both ETFs’ units (i.e. 40 million, or 35.6%, of XLE’s 112.4 million outstanding units and 6.5 million, or 36.1%, of OIH’s 17.9 million outstanding units), so a short-covering rally could take their unit prices considerably higher, although the unit prices will not diverge much from the net asset value of underlying market constituents of each ETF.

Conclusion:

The broader stock market is due for a pull-back, which could take the XLE and OIH unit prices to their support levels, which would provide low-risk entry points.  For OIH, a move to US$143 first to confirm the breakout would improve that ETF’s technical outlook.

Disclosure: I don’t currently own any units of either the OIH or XLE ETFs or common shares or debt of any of the companies mentioned in this article.

Brian Hoffman, CA, CPA, is a member of the Canadian Society of Technical Analysts (E-mail: bk.hoffman@rogers.com).

Investing in fracking companies

By
Keith Schaefer
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0

The top growth sector for investors in 2011

Hydraulic fracturing, or “fracing” companies are overtaking drilling companies as the largest subset of the energy services sector – and research from two Canadian brokerage firms suggests that investors can expect fracking companies to continue growing strong into 2011 and beyond.

All the data points to fracing stocks being the #1 place for investors to be, in the energy patch, in 2011.  I think it’s the easiest (safest) money in the oilpatch for the next 12 months at least.

(Fracing is when you send water and sand down a well at ultra-high pressure, and it blows out into the surrounding rock formation, fracturing the rock into many small pieces and creating pathways for the oil and gas in the rock to get to the well.)

Trican Well Service (TCW-TSX; TOLWF-OTCBB) is the largest fracing company in Canada, and it had revenues for the first nine months greater than $1 billion – up from $541 million in 2009.*

Precision Drilling (PD-TSX; PDS-NYSE) is Canada’s largest drilling company, and it had nine month revenue of $994 million, but squeaked past Trican for highest Q3 profits – $61.8 million vs. $53.74 million*.

Drilling companies have been the biggest single subset of the energy services sector FOREVER.   But the onset of horizontal drilling and multi-stage fracing has changed that.  And even though the “new” fracing industry is now 5-6 years old (from the time when the size of frac jobs went sky high – from a few tonnes per well to more than a couple hundred tonnes) it is still struggling to keep up with soaring industry demand.

This is good news for investors in fracing stocks. The industry is being p-u-l-l-e-d into the limelight.

There are some obvious reasons for this trend, such as the huge increase in the number of horizontal wells over the last five years as the Global Shale Revolution intensifies – an increasing number of horizontal wells is using an increasing number of fracs per well.  See this chart from securities firm Raymond James Weekly Energy Bulletin:

This chart shows that almost ALL the growth in drilling over the last year has been for horizontal wells, as the Global Shale Revolution intensifies.  I expect the Global Shale Revolution to last 20 year – which bakes success into the cake right now for a lot of fracing companies.

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But it gets better.  Fracing is taking up more and more of the budget for these wells.  First Energy, an oil and gas boutique brokerage firm out of Calgary, wrote in a December 13 report on energy services that “fracturing costs have come up the most among all services”, and that cost inflation in the oilpatch will benefit the fracing companies the most:

“Like in 2010, we believe the majority of economic rent will go toward the completions business. As a result, we see fracturing companies grabbing a higher percentage of the pie.” (Italics mine-KS)

Canada’s #2 brokerage firm, BMO Nesbitt Burns, outlined six reasons in a recent report why the fracking sector will remain strong for investors:

“1) Current Shortages: …a backlog of roughly 3,000 wells in the U.S. alone that have been drilled but not completed… more horsepower is required simply to meet current demand.

2) Continued Increases in Frac Intensity: …horizontal laterals getting longer and the number of frac stages in many plays continuing to increase

3) Longer Lead Times:…new equipment ordered over the next couple of months as part of 2011 programs will likely not be delivered as quickly as most people think…lead time is nine months to a year for new frac crews… most of the 2011 equipment capacity will not be deployed until around Q4/11

4)  Higher Attrition Rates:  With the proliferation of unconventional resource plays, fracs have increased not only in size but in pumping rates as well…some regions have gone to 24-hour operations…. that useful lives of many key components of a frac spread have been reduced by as much as 50%.

5)  More redundancies: In an effort to combat the higher repairs and maintenance costs many pumpers have added more horsepower on location than is actually needed to complete the job. Essentially, this allows the wear-and-tear to be spread over more equipment…it requires more equipment to be deployed, thereby helping to absorb more capacity.

6)  Equipment Aging:  a larger than normal chunk of the equipment in the pumping industry will be ready for replacement over the 2011–2013 time period, which should help delay the effects of the large amount of horsepower currently under construction.”

BMO Nesbitt Burns added that there was concern amongst their buy-side clients (the mutual/pension funds) that there would be too much capacity built in 2011, too much new horsepower (fracing companies are often ranked in size by their horsepower), but they did not consider that a concern in 2011.

Another final note for investors to understand is that the technology in this sector is still evolving, and it’s not just more/better technology. Some of it is out of the box innovative technology that is leapfrogging industry expectations in terms of production and cash flow fracking can produce.

I’ve made one of these innovative companies the #1 pick for 2011 in my portfolio.  It had a stellar 2010, up 80%, but I think this game-changing company will be one of my personal profit centres for years to come.

*sourced from The Daily Oil Bulletin

Publisher’s Note:  Many of my readers have emailed me to ask what my # 1 energy trade is.  That’s an easy one to answer at the moment.  It’s a little-known Canadian company with an extraordinary new technology… one that will shape the oil & gas hydraulic fracturing (fracking) market for decades to come. This company’s proprietary process is proven to increase production in wells by 40% or more — while it literally “pays for itself.”  I’ve put together a video that details this trade in full. Watch it by following this link.

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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by +Keith Schaefer

Where Will the Next Cardium Oil Opportunity Be?

By
Keith Schaefer
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0

The Experts Weigh In:  The 2001 Outlook for the Cardium Oil Formation

PART II – what did we learn in 2010 and where is the next Cardium?

Improving economics, higher oil prices and exploration that pushes the boundaries are three factors that could create even higher valuations in the Cardium play, industry executives say.

The Cardium oil play has turned into Canada’s second biggest tight oil play, after the Bakken in Saskatchewan.

Economics improved in the Cardium during 2010, as producers refined their completion techniques (i.e. they found continually better ways to frack the formation) which has generally meant a $500,000 reduction in cost per well.  Most wells are now completed for just under $3 million.

“Completion techniques are improving, leading to higher production profiles over the initial months,” says Kevin Shaw, an energy analyst at Wellington West Capital Markets in Calgary. “Costs are coming down as the industry connects ‘more wellbore to more reservoir’.   (The producers) have shifted from 600-1000 m horizontals legs to 1100-1400 m laterals with some looking to test 2000 metre plus horizontals.”

“With longer horizontal legs, the industry has moved from six to eight to 12 plus frack stages.  And both the longer legs and bigger fracs are being executed for less cost.”

Midway Energy (MEL-TSX) CEO Scott Ratushny gave me a technical talk on how they reduced costs and improved economics in the Cardium in 2010.

“We learned some big lessons in our frac(short for fracturing) spacing, and what types of fracs to use.  We started off very conservative and generic, doing 1000 metre horizontals, putting in ten stages of fracwhich is easy to manage.”

“Then we start to push on it and increased the number of fracs.  When someone puts in 20 stages of frac, there is more of a chance of error.

“And we got faster with each drill as we learned what muds and (drill) bits work best. We’re doing a well in 12-13 days now, down from 18 days, and a day of drilling is worth approximately $50,000 plus ancillaries.

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“We are still finding little efficiencies that are worth $5,000-$10,000 per improvement but nothing major.   (The formation) is overpressured so it has lots of ‘energy’ and the wells will flow on their own after the frack.  We try to encourage them to flow as long as possible before putting on pump jacks.”

“We would get an IP at 1000 barrels equivalent a day then have it drop to 150 because of pumping problems.  We used to go to a pump jack right away, but we found the oil was trying to flow past the pump.  Now we let them flow until they die and then swab  to get them flowing again, and continue to do that over and over until the well loses its energy, and then put the pump jack on.”

(Swabbing a well is like having a plastic cup, or buckets on a string, that pulls the oil up and encourages it to move up the well bore.  Then the oil will start flowing on its own for awhile).

Everybody agreed that the Cardium in 2011 will separate the haves from the have-nots – who has the highly productive property…and who doesn’t.

“It’s very variable,” says Doug Bartole, CEO of Vero Energy (VRO-TSX). “Within a mile you can have a good well, and a mediocre well.”

“There are definitely sweet spots,” agrees Shaw.  “Not all areas are created equal in-terms of the ability to “blanket drill” and get solid results.”

Shaw says several areas in the Cardium are outperforming:

“Garrington has done well for Midway (MEL-TSXv) and NAL (NAE.UN-TSX).   Going back to reserves per well being booked, these guys are seeing about 220,000 bbls per horizontal well.

“Willesden Green and South Pembina, or the entire “West Trend” as I like to call it, running from Willesden Green up through the Ferrier and Brazeau areas and ending up near Big Stone have been very good to bigger players like PennWest (PWT.UN-TSX), Daylight (DAY-TSX) and Petrobakken (PBN-TSX), as well as smaller-cap names like Bellatrix (BXE-TSX) and SkyWest (SKW-TSXv) who both have premium land positions in these areas.

“Willesden Green, for example, has seen repeatably some of the best Cardium horizontal wells with some of the thickest gross pay, and higher GORs (Gas to Oil Ratio).  This is considered a good thing given the gas helps drive more oil to surface – achieving higher oil rates – which is a big deal in tight resource plays like the Cardium.”

Producers have now pushed out the edges of the Bakken far beyond what people thought realistic when its development started in earnest several years ago.  Could the same thing happen to the Cardium, or is its geological edges well defined?

The answer, says Bartole, partially depends on the price of oil.

“We’ll continue to see it step out if the price of oil is good. “There are thin sections (in the Cardium).  We target five to six metres of pay, but there is a lot of ground with three metres of pay” which could become economic at a certain oil price, he says.

“The Bakken is laid out in a larger area,” says Ratushny.  “The Bakken is more continually laid out.  The Cardium is found in more defined pools.”  He adds “It will be interesting to watch the guys who are pushing the envelope (of where the Cardium is productive) in  2011.”

Shaw says areas like Brazeau and Lochend in the Cardium are relatively new areas that weren’t really considered productive when the Cardium started to open up a couple years ago, and these new areas could conceivably continue to be discovered.

Of course, everybody wants to know, where will the next Cardium be – the next big oil play that a basket of junior explorers can develop big reserves.

“Source rock oil might be the next Cardium,” concludes Ratushny.  “It could be Crescent Point (CPG-TSX) in the Alberta Bakken or the Nordegg (formation) in Peace River Arch, or the Duvernay.”

“But it will be somewhere that hasn’t produced economically before.  And if you think you have a good zone that’s been overlooked you can’t tell a soul.”

Follow this link for Part 1 of my Cardium Oil series.

Publisher’s Note:  Many of my readers have emailed me to ask what my # 1 energy trade is.  That’s an easy one to answer at the moment.  It’s a little-known Canadian company with an extraordinary new technology… one that will shape the oil & gas hydraulic fracturing (fracking) market for decades to come. This company’s proprietary process is proven to increase production in wells by 40% or more — while it literally “pays for itself.”  I’ve put together a video that details this trade in full. Watch it by following this link.

The Cardium’s Junior Oil Producers

By
Keith Schaefer
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0

Why “Time Is on Their Side” in 2011

PART 1 OF A 2 PART SERIES…

What mergers and acquisitions will happen in the Cardium oil play in 2011?

In the last half of 2009 and the first half of 2010 the Cardium was the hottest play in Canada.  Valuations moved up quickly through late 2009 and the buyouts started with Daylight Energy (DAY-TSX) buying Highpine.

Then valuations exploded into 2010 as Petrobakken (PBN-TSX) announced – on the very first day of trading, January 4 – the first of its three takeovers of junior Cardium players, which would happen over three months.  Daylight would also buy one more company, West Energy (which was an 80% win for OGIB subscribers in just a few months..)

The reason for all the excitement was that the Cardium has produced more oil than any other formation in Canada – it’s BIG, arcing over 1000 km along the Rocky Mountains in Alberta.

And the oilpatch just realized that a well known but previously unproductive, tight zone in the Cardium – the A Zone – was now economic, thanks to horizontal drilling and multi-stage fracing.

Here was a well known zone that had no exploration risk – it had been drilled through many times as producers went after the deeper B Zone, which was easier to produce from with regular vertical wells.   The Cardium A Zone quickly became Canada’s second big tight oil play after the Bakken in Saskatchewan.

There was a Cardium mania for the first three months of 2010 as the BIBA machine – Brokers, Investment Bankers and Analysts – and investors, remembered the billions of dollars they made off junior and intermediate producers in the Bakken as it was developed in the last decade. Cardium stocks soared.

And now, in December, the market can say that well results have borne out earlier investor enthusiasm.  But there was a lot of scepticism in the markets through the spring and summer.  (Alberta Bakken investors take note!)

The word on the Street – rightly or wrongly – was that Petrobakken overpaid a lot for those companies, and its stock was hit hard.

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Between the Petrobakken hangover and the soft market for junior oil stocks in Canada during the spring and summer, most of these junior Cardium producers didn’t see their stocks get back to the levels they hit during the January mania until late in the year.  And there has been no M&A activity since Petrobakken’s buying spree ended.

Scott Ratushny, CEO of junior Cardium producer Midway Energy (MEL-TSXv) says 2011 could see more corporate activity in the Cardium, but it depends on what the buyer is looking for.

“I think some of the trusts coming out of the “trust mode” are looking for a focus, but most companies in the Cardium aren’t pure Cardium players, or even a pure oil player,” he says.  “They might be 30% oil or 20% weighted to Cardium.  That may be too much ‘noise’. I think all the pure plays will eventually get bought up.”

Energy analyst Kevin Shaw from Wellington West Capital Markets in Calgary says that junior Cardium producers aren’t in a rush to get bought out, as “all the players are seeing the play getting better as improvements / technology evolve.”

“And for those players holding key acreage positions, time is on their side to get higher takeout prices, not lower.  Some guys have had the ability to sell but have decided not to because time is on their side.”

Shaw adds that M&A activity will pick up in 2011 because companies can’t get big land positions in the Cardium unless they make an acquisition with existing land holdings.  Buying land from crown land sales is not really an economic option with prices through the roof, nor is there enough crown land available within the play, he says.

“Skywest (SKW-TSXv) Midway, Bellatrix (BXE-TSX), etc. – these guys will all be candidates for takeouts and I fully expect the Cardium to attract top tier takeout valuations,  given that it is a repeatable oil play which the bigger players like, and require, for longer term sustainable growth,” says Shaw.

Vero Energy is one of several gas weighted juniors who discovered they had dozens of sections of Cardium lands as the play got popular.  The new Cardium oil play literally saved a lot of gas producers in Alberta from an ugly 2010.  CEO Doug Bartole said much of the Cardium has “been held for years; it’s in the heart of the old oil patch.”

He said they recently bought one section, but that no big land packages are left – which lends credibility to Shaw’s contention that any new entrants will have to buy their way in.

Read Part 2 my Cardium Oil series here.

Editor’s Note:  You may have caught my Alberta Bakken story from a few weeks ago, in which I explained why this underrated play could soon make headlines in the financial press.  I’ll be sharing more on this emerging play in future OGIB Free Alerts, but in the meantime, check out what the Edmonton Journal had to say about my Alberta Bakken coverage.

2011 Outlook for Canadian Natural Gas, Part 2

By
Keith Schaefer
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0

Canadian pipeline companies transporting western Canadian gas are slowly get squeezed out of the North American market, says a new report by Bentek, an energy analysis company based in Denver, Colorado.

“The utility of certain pipelines in Canada – of pipelines that are traditionally considered as export pipelines – that utility will drop,” says Jack Weixel, Director of Energy Analysis for Bentek.

Bentek’s report – titled The Big Squeeze – states that “planned pipeline expansions in the U.S. will unleash more supply from shale and other unconventional formations in the coming years.

“There is nearly 10 Bcf/d of capacity planned for pipeline expansions or new builds designed to support the growth of the Marcellus and other supply from unconventional plays in the Southeast/Gulf and the Rockies.”

Weixel says there are two squeezes going on for western Canadian gas.  One, outlined in my story here – https://oilandgas-investments.com/2010/natural-gas/2012-outlook-for-canadian-natural-gas/ – is that gas from western Canada is being displaced by fast growing US shale gas production in the Marcellus shale of New York State in the east and Rocky Mountain gas in the west.

The second Big Squeeze, says Weixel, could have major impact on pipelines companies, particularly TransCanada Pipelines (TRP-NYSE, TRP-TSX).

Bentek estimates Canadian gas exports into the US will drop 2 bcf/d over the next five years, out of 6.9 bcf/d exports now.  Less volume means higher tolls for natural gas producers and other shippers on TransCanada’s Mainline, as TRP has a guaranteed rate of return with its current toll, or fee, structure.

But producers cannot afford to pay higher tolls and stay competitive in the new low gas price market – so they are negotiating now with TRP to lower their tolls.  But obviously, Transcanada does not want the value of its Mainline to be reduced.

Weixel says gas transported by TransCanada from Alberta is subject to being “squeezed out” of the western U.S. market by the new Ruby and Bison pipelines that will transport cheap Rockies gas to markets in in Northern California and the Midwest.

In eastern North America,  Weixel says there is 1.7 bcf/d of new pipeline capacity from Marcellus over six or seven different projects, so US gas from the Marcellus could end up REVERSING its flow, moving Marcellus gas west in southern Ontario, displacing more western Canadian gas and further reducing the utility of TRP’s main line.

I have only seen one analyst mention that attributes TRP’s recent decline in stock price to the market’s realization that toll rates on its main gas lines must get reduced to keep WCSB gas competitive.   As a result, TRP is focusing efforts to secure shorthaul gas transportation contracts in Ontario to make up for a shortfall in longhaul gas transportation from Western Canada.

At a recent investor day presentation, TRP did say it is negotiating with the producers on its toll charges.  TRP and the producers have had a strong relationship over the years, and the producers I spoke with (nobody wanted to be quoted) were confident a good deal would be reached.  Others commented the discussions were frank and lively though.

TransCanada did not grant an interview for this story.

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In its presentation (http://www.transcanada.com/docs/Investor_Centre/MASTER_INVESTOR_DAY_2010_PDF_for_Website_Final.pdf) the company used all the right buzzwords –

• Industry negotiated solution

• Lower and stabilized toll

• Various Concepts for Toll Reduction

• Lower depreciation

• Deferral of revenue shortfall

• Rate design changes

And said it would be filing its application for toll charges with Canada’s National Energy Board (NEB) by year end.

There needs to be some very creative thinking between the Canadian producers, the pipeline companies and the government (royalties) – everybody in the food chain – to keep western Canadian gas competitive.

That is happening – TransCanada is weighing the idea of providing producers more value for the liquids portion of their gas stream (the NGLs, or natural gas liquids like propane, butane, and condensate etc.) instead of leaving that value with shippers who actually move the gas out of Alberta for export.

Bentek’s report says that by next summer, the situation will worsen for TransCanada and Canadian producers.

Rockies producers will then have an incremental 1.2 Bcf/d of westbound capacity on El Paso’s new Ruby Pipeline, bound for Oregon, which is in direct competition with Canadian supply for PG&E’s (Pacific Gas and Electric) Citygate, the premium market in the West.

Bentek’s Big Squeeze report states “The competition between Alberta and Rockies prices has already ratcheted up this year with the increased Canadian imports to the West. Ruby will intensify the battle and, given its low variable cost, ultimately displace significant volumes of Canadian gas.”

Follow this link to read Part 1 of my 2011 Canadian Natural Gas Outlook

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