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Mainstream Media and Investing Public Just Awakening to Enormous Value of Unconventional Oil Assets

November 13, 2010 | About:

I had a discussion a couple of weeks ago with a gentleman who was evaluating a company that I consider to be an excellent investment opportunity. The company has spent the last 3 years locking up large acreage positions in unconventional oil plays. This fellow when valuing the company only considered the current booked reserves of the company, despite the fact that this company has only booked reserves on about 15% of its acreage. In other words no value was assigned to almost 500,000 acres that have no booked reserves, but acreage that could be sold today for $5,000 to $10,000 per acre.

That doesn’t make any sense to me, as the success rate by the company in question in drilling out their acreage over the past 3 years has been 99%. These are large resource plays, with virtually no geological risk.

I believe that the investing public today is just starting to awaken to the fact that there is a lot production that is going to be coming from unconventional oil plays in the next 10 years and that the companies that have locked up these resource plays have a large amount of value hidden in currently undeveloped landholdings.

There is no company that gets less respect for its highly valuable undeveloped acres than Chesapeake Energy. Both in unconventional oil and gas plays. In the past 3 years Chesapeake has entered into the following joint venture transactions:

Sold a 20% interest in their Haynesville undeveloped leases for $3.16 billion.

Sold a 25% interest in their Fayetteville undeveloped leases for $1.90 billion.

Sold a 32% interest in their Marcellus undeveloped leases for $3.37 billion

Sold a 25% interest in their Barnett undeveloped leases for $2.25 billion

Sold a 33% interest in their Eagle Ford undeveloped leases for $2.16 billion

Add those up and they received proceeds of $12.84 billion. If you calculate the implied value of the portion that CHK has retained the total is $36.6 billion.

CHK has a $31 billion enterprise value. The value of just the undeveloped acreage is more than this. CHK is the largest natural gas producer in the United States, so the obviously have sizable developed reserves as well.

I’ve included two articles below that show that the value of these shale assets won’t remain hidden forever. As production starts to ramp from the oil plays specifically, investors will notice as cash inflows from oil plays are more like the equivalent of $14 per MCF vs the sub $5 natural gas prices today. The costs are much different but the revenue created is almost 3X.

New Oil Patches Sprout Across Nation

With Natural-Gas Prices Low, Drillers Set Sights on Crude Locked in Shale;


Daniel Gilbert for The Wall Street Journal

Drawn by high oil prices and new technologies that make it possible to extract oil from the dense rock that lies beneath much of the region, major energy players are raining cash on the county and its residents.

A similar wave is beginning to visit parts of North Dakota, Colorado and west Texas. The surge in onshore oil exploration is helping reverse the decades-long decline of domestic oil production, which increased slightly in 2009 for the first time in more than 20 years.

For much of this decade, energy companies pioneered new drilling technologies that allowed them to recover natural gas from a subterranean rock called shale. By drilling down and then out laterally, companies were able to exploit greater areas of the shale. And by injecting massive doses of water, sand and chemicals into the ground, they could crack open the gas-bearing rocks, allowing gas to flow to the surface.

The twin processes unlocked such vast gas deposits that it has led to a glut, depressing the price of natural gas by 21% in the last year.

Victims of their own success, energy companies began eyeing the more attractive price of oil, which, at $84.88 a barrel after Friday's price drop, is still up more than 11% in the past year. Now they are deploying the same drilling technology to shale formations containing oil.

Hot Spots in Hunt for Domestic Oil

States with significant onshore rig activity in shale formations, ranked by increase from Oct. 2009

Texas Shales: Barnett, Eagle Ford, Haynesville, PermianRig count Oct. 2010: 711 Increase: 300

North Dakota Shales: Bakken Rig count Oct. 2010: 138 Increase: 83

Colorado Shales: Niobrara Rig count Oct. 2010: 69 Increase: 39

Louisiana Shales: Haynesville Rig count Oct. 2010: 131 Increase: 24

New Mexico Shales: Permian Rig count Oct. 2010: 68 Increase: 20

The shale boom won't begin to end American dependence on imported oil, but industry experts say it is driving a significant and potentially enduring shift in the way oil is produced domestically.

"It's a game-changer for U.S. oil production," said Bill Durbin, head of global markets research at Wood Mackenzie. "The U.S. has always been perceived to be a very mature oil province with relatively little prospect for growth. Now we're seeing the declines in production being arrested by the increase in unconventional oil."

Nationally, the balance between oil and gas exploration onshore has tilted heavily toward oil. The number of oil-seeking rigs has nearly tripled since June 2009, and now makes up 42% of all rigs in use, a prevalence not seen since 1997, according to data compiled by oilfield-services company Baker Hughes Inc.

Among states, Texas has seen the greatest increase of rigs in the past year, adding 300, a 73% increase. North Dakota added 83 rigs in the last year, Oklahoma gained 71, and Colorado picked up 30. Analysts at IHS Cambridge Energy Research Associates have identified 20 significant shale prospects across North America.

Industry executives and analysts say the growth is likely to continue, at least as long as oil prices remain over $70 a barrel.

"It allows us, during a time when natural-gas prices are somewhat suppressed, to focus our efforts on areas where we can bring in a lot of crude oil," said Floyd Wilson, chief executive of Petrohawk Energy Corp., which has been drilling for oil in south Texas.

Karnes County lies at the heart of the Eagle Ford Shale, a thick layer of dense, oil-and-gas-bearing rock that sits between 5,000 and 11,500 feet beneath the surface. The formation stretches across more than nine counties, but Karnes, population 15,000, has the most rigs drilling for oil: 13 in October, according to RigData, a company that publishes land rig counts.

In town, where the predominant livelihood has been farming and ranching, the rigs' presence is unmistakable.

"Oil & Gas Boom!" reads a flyer advertising an estate-planning session, taped to the door of the county courthouse in Karnes City. The message is apparently intended for people like Paul Bordovsky, a retired druggist who netted a sum "well into the six figures" after a well on his 642-acre ranch produced nearly 34,000 barrels of oil in its first 40 days before it was temporarily capped—far more than he ever made raising purebred Charolais.

The courthouse itself teems with scores of industry hands researching land titles. Their arrival—along with rig workers—is swelling demand for lodging. Telia Diaz, the enterprising owner of the "New Wave" hair salon in town, converted an empty lot into an RV Park three months ago. The campers now provide more income than her salon clients, Ms. Diaz said, and she is planning to open a second park.

The fossil fuels contained within the shale in Karnes County were not unknown. In 1966, John Braudaway was working as a roughneck trying to kill an out-of-control well spewing oil and gas. It was, he thought, a sign of a productive well. But Mr. Braudaway, now 70 years old, remembers being told, "That's the Eagle Ford. It will only last a week or so and quit producing." New technologies have changed that.

In 2006, Mark Papa, chief executive of Houston-based EOG Resources, steered the company toward expanding its acreage in shale formations with large oil deposits. The industry dogma at the time, Mr. Papa said in an interview, was that oil would not flow out of the shale like gas, because the molecules are bigger. "We said, 'We think that's incorrect, but let's let the industry continue to believe that,' " Mr. Papa said.

The rest of the industry wasn't far behind. More than 10 companies are now drilling for oil in the Eagle Ford, including companies like EOG and Chesapeake Energy Corp. that used to focus almost exclusively on natural gas, and industry giants like ConocoPhillips and BP PLC that are better known for drilling in far-flung fields overseas or in deep water. Indian conglomerate Reliance Industries Ltd. recently bought a $1.3 billion stake in the field.

Shale formations like the Eagle Ford are attractive even to big international companies because they are faster and cheaper to drill than deep-water fields, and involve less regulation, said David Demshur, chief executive of Houston-based Core Laboratories.

The Deepwater Horizon drilling rig disaster in the Gulf of Mexico, which set off a massive oil spill on April 20, could spur even greater interest in onshore oil fields, as companies fear stricter rules and increased liability, said Bob Williams, director of news and analysis for the Land Rig Newsletter.

To be sure, natural-gas drilling in shale formations has increasingly drawn opposition from some environmental groups, who fear the process will pollute the air and contaminate drinking-water supplies—and that backlash could extend to shale-oil drilling. If state or federal regulators crack down on drilling operations, it could drive up costs for companies.

But here in south Texas, there has been little opposition, and the unexpected rise in economic activity has been welcomed.

Mr. Bordovsky, for one, couldn't be happier with ConocoPhillips, the company that drilled the well on his ranch. "They've been very, very super-good to me."

Mark Papa on the New Paradigm

Unconventional Economics

EOG's Mark Papa says shale plays have permanently and dramatically altered U.S. energy supply and security.

The true impact of unconventional drilling in unconventional rock formations is the most underreported event in the mainstream press today, according to Mark Papa, chairman and chief executive of EOG Resources Inc. The enormity of the boost to the U.S. economy is entirely overlooked, he says.

Shale development will pump tens of billions of dollars back into U.S. coffers annually. As such, the U.S. economy is experiencing a whipsaw swing to the positive.

"It's a new paradigm. Unconventional drilling has dramatically changed the U.S. natural gas and crude oil picture in the U.S. and is probably the biggest change in the last 40 years in the industry. Everybody in the world is chasing these shale plays."

Papa spoke at a Houston event hosted by the Independent Petroleum Association of America and the Texas Independent Producers and Royalty Owners Association.

Gas effects. Consider natural gas. The world "has turned upside down" with respect to the natural gas market due to horizontal drilling. Five years ago the consensus was that natural gas prices would hold between $7 and $10 per thousand cubic feet (Mcf) for the long term. The U.S. would need to import more and more liquefied natural gas (LNG) as domestic supply would fall short of demand.

Fast forward to today. In the wake of a glut of domestic gas production coming online from horizontal drilling in unconventional plays, expectations hold gas prices considerably lower at $4 to $7 per Mcf.

"There is clearly sufficient North American gas supply to last for a bunch of years, 50 years at least. And there is clearly no need for us to import liquefied natural gas for multiple years to come."

In fact, he notes, the opposite is true. Houston-based EOG is in partnership with Apache Corp. to export LNG to Asia via the Kitimat LNG terminal in British Columbia currently under construction.

The shift in capital flow resulting from unconventional production is the rest of the story, Papa emphasizes. Assuming that gas prices are at least $2 lower than if the industry never learned to extract gas from shales, then U.S. consumers of natural gas benefit by some $50 billion less burden of energy cost.

"Talk about stimulus and ways to boost the economy," says Papa. "One of most significant ways the economy has been boosted is in not having to pay an extra $50 billion a year for energy."

And that redirection of LNG? "We're going to be self-sourcing" gas, he says, which softens the balance of payments of U.S. foreign imports.

American jobs, too, have increased due to ample supply of domestic gas—and not just in the oil and gas industry. Industries such as chemical companies and steel manufacturers, he gives as examples, are choosing to keep plants here due to pricing and supply.

Horizontal shale-gas drilling has "dramatically and permanently" changed the U.S. natural gas supply picture for a long, long time. Papa says he is not of the camp that believes this production is going away in five years because of high decline rates from shale-gas wells. "I've seen enough of the specificity of what EOG has in its inventory. What's happened is clearly a game changer."

Oil's impact. The effect of unconventional drilling techniques on crude oil plays will be "consequential." U.S. oil production peaked in 1970 and has been on a steady decline since—the U.S. now imports two-thirds of the 15 million barrels it consumes daily for a $246-billion annual price tag. "That's a heck of a kick to our balance of payments."

Yet by 2015, oil extracted from shale rock will add 1 million new barrels of crude into U.S. supply daily, he predicts. While that's not significant enough to affect prices globally, "if we look at how much oil we're going to have to import, it's going to be a million barrels less per day every year. That's a $29-billion-a-year uplift in the balance of payments.

"To some degree the crude oil supply picture is going to change in the U.S. and it's going to change entirely because of horizontal drilling in unconventional rock."

Take the Bakken. Papa shows EOG's 580,000-acre position on a map, largely concentrated in Burke and Mountrail counties in North Dakota and Roosevelt County in Montana. He then highlights a much larger area about 100 square miles extending south and west to a diagonal line demarking the Bakken subcrop. Papa believes this unproven acreage is saturated with oil in the Bakken and Three Forks formations and will ultimately prove productive. "It's a very, very large area," he says.

Current oil production in North Dakota stands at 300,000 barrels per day, compared with 100,000 barrels per day before discovery of the Bakken. In five years, the output is expected to exceed 500,000 per day.

"So in one particular state in one particular play, production will have jumped by 400,000 barrels per day, just due to the Bakken shale."

As a result, North Dakota has surpassed Louisiana as the fourth largest oil-producing state. It has the lowest unemployment rate in the nation and carries a budget surplus even during these flagging economic times. "I submit that the reason is primarily due to the Bakken shale and its development. It has really changed the picture for the state of North Dakota. This is what happens when you develop an unconventional resource with horizontal drilling."

Horizontal Texas. The Bakken is just the beginning. In Texas, three unconventional oil plays are in the making: the Eagle Ford in South Texas, the Barnett Combo play in North Texas, and the multi-monikered Leonard/Avalon/Upper Bone Spring shale in the Permian Basin.

"All of these are being developed with horizontal wells. All three are going to be very, very large. Probably the smallest of these will be half a billion barrels. That’s the smallest."

EOG is currently developing a 580,000-acre position in the Eagle Ford oil window, a position that stretches 120 miles west to east. "The field itself is going to be considerably longer than that," he surmises. And when the dust settles in about 10 years, when the play has been fully delineated and is in full development mode, Papa anticipates the Eagle Ford will rank as the sixth largest oilfield ever discovered in the U.S.—counting Alaska and the deepwater Gulf of Mexico.

Imagine the economic impact. Papa does. He calculates EOG's Eagle Ford position alone, net after royalty, will amount to a hefty 900 million barrels of oil. "For a company of EOG's size, that’s a massive discovery."

And with larger effects than just for EOG shareholders. Royalty owners benefitting from EOG holdings will see $14 billion flow to them over time, he says. That money will be recycled into the economy. The state of Texas will be blessed with $3 billion in severance taxes—just from EOG's production.

And, "obviously this is going to take massive infrastructure, gas-processing plants and pipeline to move all of this product. Clearly state employment will be increased."

Add to that the Bakken, Barnett Combo, Avalon, Niobrara and "a whole lot of other plays, we'll see about a million-barrel-a-day uplift in total domestic production by 2015."

What about another prominent oil and gas CEO who claims all the U.S. shale plays have been identified? "I don't believe that all shale plays have been identified and tied up at this point. As we play this out through 2011 and 2012, the list of shale plays, both gas and oil, is likely to grow a bit longer than it is today."

Regardless of new discoveries, Papa believes the next phase over the next decade will be in recovering a higher percentage of the hydrocarbons trapped in the rock. As an example, he illustrates that in the Barnett's Johnson County in North Texas, five years ago the recovery factor was 10%. Today it routinely exceeds 40%.

Similarly, EOG is capturing about 3% to 4% of Eagle Ford oil in place today, he estimates. "We'll focus on how to get that recovery factor higher. Not so much finding new plays; it's how to get improved recoveries out of these plays."

Getting respect. In spite of the shale's gigantic boon to the American economy, Papa laments the lack of notice in the public domain. During the recent election cycle, rejuvenating the economy and jobs were the mantra, "but did you hear the slightest mention of the value of the oil and gas industry and what they're doing" for the economy? "I sure didn't."

Local economies boom when unconventional oil plays are discovered in their back yards, and it's because of the ingenuity of the oil and gas industry. He notes also that these developments involved zero federal research and development credits and subsidies, unlike ethanol, solar, wind and clean coal.

Count the articles on wind, solar and ethanol, he challenges. "But I can't find one article that is a positive story on how the U.S. oil and gas industry has lightened the burden on the American economy.

"It was accomplished by the free market, the private sector, with nongovernment capital. Maybe that's why we haven't heard anything about it."

Since pioneer George Mitchell showed gas could be economically produced from unconventional rock, the past five years have proven to be the most exciting in his 40-year career, says Papa. And the country is better for the discovery. "The industry needs a lot of credit for improving U.S. energy security and supply through the last five years."

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