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Equity Perspectives

Here's why the whole world is watching how the United States taps enormous gas and oil reserves once deemed too uneconomical to produce.

Shale drilling has reduced our dependence on foreign oil, transformed industries, created thousands of jobs, and benefited growth and value investors. Will the environmental controversy over extracting natural gas and more valuable oil from prehistoric geological formations spoil the bonanza? With a warm winter and strong production driving natural gas prices to historical lows, Robert P. Fetch, Lord Abbett Partner & Director of Domestic Equity Portfolio Management; and F. Thomas O'Halloran, Lord Abbett Partner & Director of Multi and Small Cap Growth; offer their insights. Joining the discussion are: Arthur Weise, Portfolio Manager of Small Cap Growth, and U.S. Large & Mid Cap Equity Research Analysts Vince Piazza (exploration and production companies), Jonathan Chung (chemicals), and Glenn McIsaac (regulated and nonregulated utilities).

Nothing epitomizes the exponential growth of shale drilling in the United States like the Bakken Shale, an oil and gas formation located in northeast Montana and northwestern North Dakota. Although oil was discovered there in 1951, it was only recently that technology known as hydraulic fracturing ("fracking") and horizontal well drilling penetrated shale-rock formations to release prodigious amounts of oil and gas. The more miles industry drills into the earth's crust using millions of highly pressurized gallons of water, sand, and chemicals, the better the results—all of which explains why some experts believe the Bakken could become the world's largest discovery in the last 30–40 years.1

Similar stories are playing out in a number of other states, notwithstanding water pollution and seismic activity that some critics attribute to fracking. The gargantuan Marcellus Shale, for instance, stretches through New York, Pennsylvania, Maryland, Virginia, West Virginia, and Ohio, providing a steady stream of cheap natural gas that is fueling the reindustrialization of long-forsaken sections of the Rust Belt. The Eagle Ford Shale, underlying much of south and east Texas, has triggered an oil boom in that region. (See Chart 1.)


 

Chart 1. America’s Shale Opportunity Is Enormous

Source: Energy Information Administration. Based on data from various published studies. Updated on May 9, 2011


"In the last 10 years, shale gas has gone from less than 10% of total gas production in the United States to 25%, and that should only expand as extraction technology improves," said Lord Abbett Research Analyst Vince Piazza. "The opportunity set is enormous." But it will take more infrastructure like pipelines to realize such potential, adds Lord Abbett Research Analyst Phil Kaukonen, who favors shale plays with greater amounts of oil and gas liquids.

"Every shale is different," adds Arthur Weise, Lord Abbett Portfolio Manager of Small Cap Growth. "The most important element of the shales is their thickness, and the way the rock is formed. Some are very easy to drill and yield higher amounts of oil. (See Chart 2.) Some are mostly natural gas. Others have good amounts of both, and as technology improves, recovery rates should continue to grow."


 
Chart 2. Oil Production from Shale Formations Has Increased Rapidly
(thousand barrels per day)

Source: HPDI and LLC.

 

You've Got Shale!
Some historians trace the beginning of the shale revolution to the 1980s, when a small firm of wildcat drillers tapped a vast underground geological structure near Fort Worth, Texas, called the Barnett Shale. The Barnett (for short) consisted of sedimentary rocks more than 300 million years old, and the gas between them was so tightly trapped that conventional vertical drilling recovered only a small portion. However, as engineers devised a way to change the direction of their subterranean drilling bits, recovery rates showed substantial improvement, especially when "directional drilling" technology advanced to the point that rigs could drill a mile straight down, turn 90 degrees, then bore several miles horizontally into even richer deposits of both gas and more valuable oil. More than 13,500 wells have been completed in the Barnett since 1997.2

Emboldened by such technological progress, some exploration and production (E&P) companies began leasing thousands of square miles in other states, even if they didn't have the financial resources at the time to withstand an economic downturn. One company in particular seemed to be on its last legs when the 2002–03 recession hit, but by 2004, it would prove that it could successfully apply the combination of horizontal drilling and hydraulic fracturing to its extensive properties in long-overlooked parts of Appalachia known as the Marcellus Shale.

The company had a good steady production of oil and gas, but nobody gave them credit for growth until this technology came along. Not only were they sitting on the biggest natural gas asset in the country but they also provided the best example of how you can extract hydrocarbons from the shale.

Over time, the Marcellus Shale became accepted as the lowest-cost shale play in America, and as production increased, the stock of this well-positioned company climbed dramatically between May 2004 and March 2005, at which point some value managers began to take profits by trimming or selling their entire positions. Somewhat coincidentally, however, the stock had attracted growth managers who were convinced that the company had more upside potential, and a spike in natural gas prices proved them right.

When the global economic crisis unfolded in 2008 and 2009, natural gas prices, of course, plummeted, dropping more than 50% from their peak, according to the U.S. Energy Information Administration. But that did not deter the most efficient players from producing more natural gas, particularly those closest to the beleaguered industrial sections of the country, said Piazza. That led to even lower natural gas prices, which in turn would help spur a revival of American manufacturing alter the steel industry's reliance on coking coal, and transform the chemicals industry. (See sidebar below.)

Shale Gas Makes America a Low-Cost Producer
No matter how one thinks about the environmental consequences, shale gas has been a boon to American businesses that had seen their competitive advantage steadily erode over the last several decades.

From a domestic macroeconomic point of view, lower gas prices are a wonderful thing, experts say. Many, many industries use natural gas or can use natural gas as a means for operating a plant. The premier example is the chemicals industry, which breaks down natural gas into a number of molecules used in many kinds of plastics, which factor in the manufacturing of innumerable consumer and industrial products. Elsewhere in the world, the primary chemical input is naphtha, a petroleum distillate, which is much more expensive.

As a result, America's chemicals industry is booming, said Lord Abbett Research Analyst Jonathan Chung. "Abundant supplies of cheap natural gas give the industry such a big cost advantage because whatever it makes can be produced more cheaply and sold around the world," he added.

"Chemicals are probably the easiest industry to understand because the demand curve doesn't change that much; it's always upward sloping," Chung explained. "Almost every product has chemicals in it, and if you slash the cost of manufacturing those chemicals [by using much cheaper natural gas], the U.S. chemicals industry benefits disproportionately."

How long can that last, though? Much depends on the price of Brent crude oil, the name that is typically attached to petroleum from Europe, Africa, and the Middle East. That's because outside the United States, the price of petroleum feedstocks for the chemicals industry is pegged to the price of Brent crude oil,3 which lately has been pushing $115 a barrel.

"If oil prices don't collapse, you are in the early innings of the resurgent chemicals story," said Chung. "In our opinion, Brent prices would have to drop to $60 a barrel to wipe out the benefit of shale gas."

In the meantime, oil refineries and chemical fertilizer companies that use large amounts of natural gas in their manufacturing process should continue to benefit.

Some Utilities Benefit, Others Hurt
Commenting on the impact of cheaper shale gas on the utility industry, Glenn McIsaac, Lord Abbett Research Analyst, U.S. Large and Mid Cap Equity, stressed the need to distinguish between regulated utilities versus nonregulated power generators.

"In the regulated sector, the overriding impact is that shale gas has lowered fuel costs for a lot of utility companies," said McIsaac. "And those lower fuel costs have helped offset the base rate increases needed to cover capital investments like environmental remediation [largely around coal-fired plants], new transmission projects, smart meters, and distribution system improvements. Now regulators are more open to rate increases to cover such improvements, which in turn has helped the stocks of regulated utilities to perform pretty well."

Most nonregulated power generators, however, have been hurt because lower gas prices have meant lower power prices and shrinking profit margins for their nuclear and coal-fired power plants, which in turn have put a big damper on their share prices.

Environmental Challenges
Shale-extraction techniques have stirred considerable controversy in the past two years, with negative reports focusing on the risk of illegal dumping of fracking fluid into streams after drilling a well, ultimately polluting ground water. But Weise believes such claims have been exaggerated, considering the industry is now drilling over 40,000 wells a year and has gone a long way toward avoiding lasting environmental hazards.

"Shale drilling involves heavy construction, so there is always going to be an environmental impact," Weise said. "The question is how do you approach it and what is the lasting effect? One answer can be found in the Haynesville Shale in the swamps of Louisiana. The construction project lasted for six months. At the end, the company replanted trees, leaving just a wellhead that is no bigger than my desk."

Added Piazza, "The challenge is how you reuse, recycle, and treat the water that goes into the fracking process. But the industry has been quite good at solving the puzzles that limit future development, whether it's finding friendlier chemicals to help with the drilling or finding unique ways to complete the wells."

Piazza's biggest concern centers on whether state and federal governments have the political will to see that communities most directly affected by shale drilling get their fair share of the economic benefits.

"The question is, where does the tax money and royalty money flow to? Does it flow to areas outside those areas most affected?" Piazza said. "We're talking simple things like infrastructure, particularly roads. It may sound, but the reality is constituencies in Pittsburgh are a lot louder than they are in shale drilling regions like southwest Pennsylvania."

The Outlook
While the scientific jury may still be out on the effects of shale exploration, stricter regulation at both the state and federal level seems almost certain, although presidential candidates may tread lightly with regard to regulatory measures that threaten jobs.

The United States has eclipsed Russia as the world's largest natural gas producer. Could competition from China change that? In terms of proven gas reserves, China has nearly twice the amount that the United States has, but energy experts believe it will take years for widespread development of those resources to become economical. (See Table 1.)


 
Table 1. China Is Far Behind the United States in Shale Gas Production

Source: Energy Information Administration and CAP research.
* Chinese targets based on the latest proposals from China’s National Energy Administration. They do not yet have higher-level ap proval, and senior leaders may reduce them to account for environmental and water conservation concerns. These NEA targets are included to illustrate China’s intentions rather than provide an accurate projection of future shale gas production.

 

While low gas prices have been a boon for chemicals manufacturers, E&P companies have seen their profit margins plummet, forcing at least one major producer to announce it would curtail production by cutting the number of active rigs. But investors should take a longer-term perspective. In the immediate term, there is no reason to panic, because most of the companies have already hedged substantial amounts of their production against a cataclysmic drop in gas prices using futures and options, some experts advise. Of course, those hedges don't last forever. Most will likely be good for the next 12 months, but if prices continue to stay this low after that, problems could ensue. Other companies may stop producing gas until the market picks up.

That could spell trouble for E&P companies that have 90% of their production in natural gas, one analyst added. As long as gas prices stay below $4 per thousand cubic feet, the returns are too low.

What will drive additional demand? Natural gas-fueled automobiles are not likely to have much of an impact, given limited market acceptance and the staggering costs of building the infrastructure to support widespread use. A more feasible scenario would be large truck fleets retrofitting their vehicles to run on natural gas rather than diesel, as some utilities have done over the years, albeit on a limited basis. But investors shouldn't get their hopes up just yet. Proposals to switch the federal government's enormous vehicle pool to natural gas date back at least 20 years.

A more promising source of new gas demand is in power generation. Low gas prices are already driving considerable coal-to-gas switching in power production, as the existing fleet of gas-fired plants runs more frequently and displaces some production from coal-fired plants. Looking ahead, McIsaac believes the combination of sustained cheap natural gas and stringent environmental regulation could accelerate the construction of new gas-fired power plants to replace many aging coal-fired plants, further boosting gas demand. "New EPA rules will force the retirement of many coal-fired plants by mid-decade. Once we see a rebound in economic growth, which should then drive overall power demand, we will see more interest in building new plants, and most companies are likely to look at the gas-fired generating option as the best choice," he said.

Cheap natural gas is also making widespread adoption of alternative energy, such as wind and solar, difficult. "We anticipate that gas prices could be lower for longer, and when gas gets below $4 per thousand cubic feet, it not only attacks coal but also alternative energy," Weise said. "That means it would be much cheaper for utilities to replace coal—and even heavily subsidized solar and wind—with natural gas."

—Reported by Steve Govoni


Investing in the Shale Gas Opportunity

Dozens of companies have joined the great shale stakes of the twenty-first century, leaving savvy active managers and research teams to identify the ones with the most potential over time. They could be value stocks, whose irreplaceable assets might have been overlooked or underestimated. Or they could be growth stocks with the potential to outpace the overall market.

For veteran value players such as Robert P. Fetch, Lord Abbett Partner & Director of Domestic Equity Portfolio Management, the shale gas opportunity, especially in the Marcellus Shale, was the principal driver behind the firm's investments in exploration and production (E&P) and oil service names that seemed attractively priced relative to their long-term prospects. (The firm is also a long-time investor in the largest natural gas pipeline system in North America.)

For growth managers such as F. Thomas O'Halloran, Lord Abbett Partner & Director of Multi and Small Cap Growth, the focus in the last year has been more on companies that have steadily improved returns on invested capital thanks to technology that can extract greater amounts of gas and oil, particularly oil, which can be sold much more profitably.

To understand the transformative power of abundant shale gas on manufacturing, consider the turnaround of a heavily indebted chemicals giant that went bankrupt in 2009 during the depths of the global financial crisis.

Although the chemical company still had a significant amount of debt when it emerged from bankruptcy in the summer of 2010, its long-term fundamentals remained attractive. And with the benefit of cheap natural gas, the chemical maker's profits became so robust that it paid down most of its debt (like most chemical companies), and declared a hefty special dividend in addition to its regular payout.


"Continental: Bakken's Giant Scope Underappreciated," Oil & Gas Journal, February 16, 2011.
Richard Newell, "Shale Gas and the Outlook for U.S. Natural Gas Markets and Global Gas Resources," presentation to the Organization for Economic Cooperation and Development, Paris, France, June 21, 2011.
The price of Brent crude oil is a global standard and accounts for the majority of crude oil that is sold/consumed globally. The West Texas Intermediate (WTI) standard is a U.S. phenomenon.

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