The Energy Strategist The Bakken Phase 2: How to Profit from the Bakken’s Second Millionaire-Making Wave By Robert Rapier, Chief Investment Analyst, The Energy Strategist What is the Bakken? The Bakken Formation, initially described by geologist J.W. Nordquist in 1953, is a rock unit occupying about 200,000 square miles of the subsurface of the Williston Basin, covering parts of Montana, North Dakota and Saskatchewan. The first producing well in North Dakota went into production in 1951 near the town of Tioga. The picture below shows a celebration taking place at the time of dedication in 1953, a couple years after the oil was discovered. This area of the country has a history of producing oil. However, historically it has always been a far less important producer of crude oil than states such as Texas and Oklahoma. Efforts to extract the oil have generally met with difficulties. Not until 2008 did anything substantial result from this region. That’s when a U.S. Geological Survey report estimated the amount of technically “recoverable” oil in the Bakken Formation at 3.0 to 4.3 billion barrels. Various other estimates place the total reser ves, recoverable and non-recoverable with today’s technology, at upwards of 500 billion barrels. The total known reserves of Saudi Arabia right now are estimated at somewhere around 250 billion barrels of oil, so this would mean that the Bakken would contain approximately twice the known reserves of Saudi Arabia, no small matter. Four analysts who recently evaluated the future of the Bakken and Three Forks Shale play believe the Williston area – which includes Divide, McKenzie and Williams Counties – will see a lot more oil boom before a bust. The experts are calling for the boom to continue through about 2039, a decade longer than predicted a year earlier. Thus, Bakken: Phase 2 begins! Much of the oil-bearing shale in the Bakken is not unlike an Oreo sandwich cookie. There are three layers. There is an upper Bakken layer and a lower Bakken layer corresponding to the chocolate pieces of the cookie, and the middle Bakken, the main target area for drilling, represents the “filling” of the cookie. It has been known for some time that the middle Bakken layer is the best target area for the generation of oil from a well within the shale. This is the subject of considerable controversy as well, with some believing that hydrocarbons in the upper and lower layers both drain into the middle, or “filling,” layer, so if the horizontal leg goes a mile or longer, through the middle Bakken layer, significant oil is drained from the outside layers of the cookie as well. To gain from this geological marvel, we recommend the following five stocks: Emerald Oil (NYSE: EOX) Small-cap oil and gas explorers are clearly high-risk propositions that can occasionally deliver outsized rewards. The key is to catch them soon after drilling results begin to show that the downside is modest. Emerald Oil (NYSE: EOX) could well be one of those, a fledgling Bakken operator starting to deliver unexpectedly robust recovery rates in the less developed southern half of North Dakota’s McKenzie County in the core of the Williston Basin. The company, run by a former energy investment manager and banker, is in the early stages of a transformation as a non-operating investor in a number of regions to a pureplay Williston operator, with 85,000 net acres harboring an estimated 435 potential drilling locations, enough to keep Emerald’s three current rigs busy for the next decade. The company has drilled just 15 wells to date, but so far they’re delivering very impressive production rates, suggesting Emerald’s acreage remains undervalued, perhaps dramatically. Production jumped 80 percent last year from a tiny base, and is forecast to roughly double this year. Management has already said it would be raising that guidance in early May once it can better estimate the positive recent trends. If Emerald can continue to execute on achievable growth plans and delivering strong well results, the current enterprise value of 6 to 8 times this year’s likely EBITDA is going to look like a gift in a couple of years. Of course, the usual caveats apply. Emerald has a very limited operating record, and is drilling in a harsh environment with notorious infrastructure constraints (though its current wells all have pipeline access). And while the company has sufficient liquidity to fund its aggressive 2014 spending plans, it goes without saying that it’s drilling at this point with borrowed money and will need more 2 financing to bankroll the expected growth in 2015 and beyond. The market cap is a modest $439 million, and this is a volatile, high-risk investment. Nevertheless, the prospective rewards are both attractive and achievable. Continental Resources (NYSE: CLR) Continental Resources (NYSE: CLR) was a pioneer in the Bakken Formation, entering the Bakken in 2003 with a purchase of 300,000 acres. Since then it has grown tremendously, and is now the largest leaseholder and oil producer in the Bakken with more than 1 million acres leased. The company has a history of achieving “firsts,” the result of its relentless push to innovate. In 2004, Continental completed the first commercially successful well in the North Dakota Bakken that was both horizontally drilled and fractured. In 2008, Continental was the first to complete a horizontal well in the Three Forks Formation. Continental has also been a pioneer in pad drilling, which allows the drilling of multiple wells from a single pad. This approach results in an estimated 10 percent cost savings on the drilling and completion of each well. The payoff has been a huge increase in proved reserves that is the envy of the industry. In 2013, Continental announced that proved reserves had increased 38 percent over 2012, and has averaged a 44 percent compound annual growth rate (CAGR) in proved reserves over the past three years. By the end of 2013, Continental’s proved reserves topped 1 billion barrels of oil equivalent (BOE), a new record for the company. More impressive is the fact that Continental is achieving this growth while driving its production costs far below industry averages. Continental’s completed average well cost of $8 million in 2013 The Bakken Phase 2: How to Profit from the Bakken’s Second Millionaire-Making Wave was 15 percent below the industry average of $9.2 million, and the company anticipates its costs dropping to $7.5 million per completed well in 2014. Never one to rest on its laurels, Continental has more than $4 billion budgeted for capital expenditures in 2014, with three-quarters of that amount earmarked for developmental drilling. That’s one reason its stock price jumped more than 53 percent in 2013, despite paying no dividend and trading at a premium to the market. As long as Continental continues its unabated success in developing proved reserves, investors will want a piece of the action. Helmerich & Payne (NYSE: HP) Helmerich & Payne (NYSE: HP) is primarily engaged in contract drilling of oil and gas wells for exploration and production companies, which accounts for roughly half of its total revenue. H&P owns and operates rigs in over 20 countries, making it one of the biggest land and offshore platform drilling contractors in the world. H&P’s drilling business is divided into three segments: (1) U.S. land operations, (2) offshore operations, and (3) international land operations. By far, the company’s biggest component is the U.S. land operations, with 316 of its 354 rigs operating in the U.S. Another 29 rigs fall under its international land division, with 9 operating offshore. H&P boasts the highest return on invested capital ratio (excluding extraordinary items) among its peer group, returning more than 14 percent in 2013 (compared to less than 8 percent for its next closest competitor). In large part this is due to the company’s increasing reliance on “FlexRigs,” which can be moved quickly from well to well to maximize productivity, and employ variable frequency (AC) drives that provide increased precision and measurability. The FlexRig is also safer than traditional mechanical rigs, experiencing less than half the OSHA Recordable Incident Rate versus the industry average. While the U.S. has long had relatively strict rules concerning oil rig safety, only recently have other parts of the world begun enforcement of safety standards. As a result, the company has extensive back orders to deliver new FlexRigs that will increase its global fleet to more than 300 rigs. The company believes it can produce new rigs at the rate of three per month, which it expects to continue indefinitely as demand for FlexRigs escalates due to greater emphasis on horizontal drilling and multi-well pad drilling, for which it is particularly well suited. Trading at less than 18 times earnings and paying a dividend yield in excess of 2 percent, H&P remains one of the “must own” oil industry stocks for serious energy investors. Whiting Petroleum (NYSE: WLL) Whiting Petroleum (NYSE: WLL) is an independent energy exploration and production (E&P) company headquartered in Denver, Colorado. It is the second-biggest oil producer in the North Dakota’s Bakken Shale, has substantial natural gas recovery operations in Colorado’s Niobrara Formation and operates one of the largest U.S. enhanced oil recovery projects in the Permian Basin of Texas. But make no mistake, Whiting Petroleum is first and foremost an oil company. Of its 438 million barrels of oil equivalent (MMBOE) of proved reserves, 89 percent is liquids, with most of that in the form of crude oil. The remaining 11 percent is primarily natural gas. Its R/P ratio (proved reserves as a percentage of current annual production capacity) is 13 years, giving the company plenty of leeway to ramp up production as it sees fit. Whiting has done an excellent job of managing its balance sheet, chalking up a 26 percent CAGR in cash flow per share from 2009 – 2013, while lowering its net debt to EBITDA ratio 21 percent during the same period of time. In fact, 2013 witnessed a record for cash flow per share, driving Whiting’s share price above $70 for the first time since 2011. Cheap natural gas has hurt most oil drillers like Whiting, driving down the cost of oil to compete with it where it can be had in abundance. However, the company maintains an unwavering commitment to oil and is responding to low natural gas prices by greatly reducing its operating costs and improving productivity from existing wells. For example, its www.EnergyStrategist.com3 recent experiment in drilling high-density pilot wells in the Williston Basin resulted in an immediate 25 percent increase in production. If you are looking for the closest thing to a pure play in oil drilling, this company is one to consider. And with the United States expanding its export capabilities to areas of the world lacking access to cheap natural gas, the fundamental economics of the entire energy sector will be affected once those markets begin bidding on large quantities of American oil and gas. EOG Resources (NYSE: EOG) EOG Resources (NYSE: EOG) was created in 1999 when its parent company, Enron, spun off its Enron Oil & Gas operation as an MLP two years before its former parent company collapsed under a cloud of scandal. EOG, however, has been a model of corporate governorship, not only increasing more than 15 times in value since then but also being included in Fortune Magazine’s list of “100 Best Companies to Work For” from 2007 through 2012. Over the past few years, a trend has emerged among U.S.-based E&P outfits. Buffeted by ultradepressed natural gas prices and a surfeit of supply, operators have scaled back spending on this fuel while announcing plans to boost output of oil and natural gas liquids (NGLs). Enron was among the first E&Ps to begin this transition, securing territory in key U.S. unconventional oil fields roughly four years ago. This foresight should pay off: The company has amassed substantial acreage in the most prospective areas of four major shale oil plays, and in particular its prolific wells in the Eagle Ford are the envy of the industry. EOG’s estimated net proved crude oil, condensate and natural gas liquids reserves are approximately 745 million barrels. Its estimated net proved natural gas reserves are 7.8 billion cubic feet. The company has a total reserve of about 2 billion BOE. Approximately 84 percent of these reserves on a crude oil equivalent basis are located in the U.S., 9 percent in Canada, 6 percent in Trinidad and less than 1 percent in the United Kingdom and China. EOG has a reputation for being the best and most efficient primary shale oil producer in the U.S., producing shale oil for the most profits with the best profit margins. EOG is also the largest U.S. horizontal crude oil producer by a 2-to-1 ratio. The company focuses on strong liquids growth driven by crude oil, and not natural gas liquids like many other shale producers. The company is well leveraged to higher oil prices, but if oil prices were to correct and stay low for a while, the debt level EOG is carrying to grow its production could become a major burden. However, operating cash flow in the first nine months of 2013 was up 50 percent over the same period in 2012, so the company could absorb a large degree of margin pressure before needing to make substantive adjustments to its revenue model. TESBP2-0514 Investing Daily, a division of Capitol Information Group, Inc., 7600A Leesburg Pike, West Bldg., Suite 300, Falls Church, VA 22043. Subscription and customer services: P.O. Box 4123, McLean, VA 221029819, 800-832-2330. It is a violation of the United States copyright laws for any person or entity to reproduce, copy or use this document, in part or in whole, without the express permission of the publisher. All rights are expressly reserved. ©2014 Investing Daily, a division of Capitol Information Group, Inc. Printed in the United States of America. TESBP2-0514-TG. The information contained in this report has 4 Bakken 2: How to For Profit from the Bakken’s Second Millionaire-Making Wave been carefully compiled from sources believed to be reliable, butThe its accuracy is notPhase guaranteed. Disclaimer: the most up-to-date advice and pricing, go to www.EnergyStrategist.com.