Sometimes, when we look at a market that is booming and that has risen significantly in a fairly short time it is easy to feel that we have missed the boat. A look at the performance of the Market Vectors Unconventional Oil and Gas ETF (FRAK), which specializes in companies involved in shale exploration and extraction, would definitely make you feel that way about that particular market.
After gaining over 40% in the first 11 months of last year, FRAK has stalled and is only now moving back towards November highs. If enthusiasm is rooted in fundamentals, however, rather than just hope, the flood of speculative cash that we see can be only the beginning of the move. That is not to say that there isn’t risk. That speculative money is, by its nature, fickle, so corrections in the overall market are inevitable, but over time the potential of companies specializing in the field will be realized and enormous profit can still be made.
As readers of Oil & Energy Insider, I am sure you are well aware of the fundamental case for shale oil as a sector. Improving technology has unleashed huge supplies of a valuable commodity, just as growth in the world’s developing nations has increased demand. Still, that nagging feeling remains that all of the value has gone. For an ETF such as FRAK, that may be the case, and buying anything as it edges towards previous highs is a slightly scary prospect. It could be that it will break through and race to new highs, but some resistance, at least in the short term, looks likely.
Fund Value managers playing in the US stock market have faced this dilemma for a couple of years now; where is the value in a market that rose 30% last year? The answer is to look at individual stocks rather than the market as a whole and look for companies whose stock has lagged but for whom things may be turning around.
Goodrich Petroleum (GDP) is a great example.
GDP has rallied in the last couple of days, but is still down around 38% from October 2013 highs. The sell off was warranted, as technical problems plagued wells drilled by the company in the Tuscaloosa Marine Shale (TMS) field and Goodrich has yet to perform the most basic function of a corporation, making money. On March 24th, however, GDP announced that their CMR 8-5H-1 well has been completed. CMR 8-5H-1 is currently producing at 950 BoE/Day, with around 95% oil. This is good, but it is the accompanying news that another well, the Blades 33H-1, had been completed in only 36 days, at the bottom end of expectations that may tell us more about the immediate future. This fast completion may be just lucky, but could suggest that GDP has a handle on the unique problems that TMS presents, and if that is the case then an accelerated pace of completion would quickly push the stock back to the highs and beyond.
Because of the problems, there is also significant short interest with the latest figure for March suggesting around 10 days to cover, meaning that, on average volume, it would take 10 days for the shorts to cover their position. Good news could therefore put a significant squeeze on those positions and accelerate any upward momentum. Nothing is ever guaranteed, however, and more problems are always a possibility, so a sensible stop-loss, somewhere just below $14 would limit potential losses to around 20%. A potential upside of 50% or more, though, makes for an attractive risk/reward ratio.
Even in a sector that has jumped and is looking a little tired, which, taken as a whole, could be said of US shale oil, there is usually value to be found. Thinking like a value manager and looking for distressed stock in the process of turnaround is often the best way to uncover that value, and GDP may well fit that description.