What's the difference between an oil well and a very expensive hole in the ground? Advanced hydraulic fracturing techniques, in many cases. That's why Big Picture Speculator Editor Jim Letourneau is following service companies that are helping producers get to the finish line on time and under budget. In this interview with The Energy Report, Letourneau discusses new ways to play the ever-evolving shale revolution.
The Energy Report: On July 26, George Phydias Mitchell died at the age of 94. The late Texas oilman had pioneered the use of horizontal drilling and hydraulic fracturing. Can you speak about his achievements?
Jim Letourneau: Mitchell was the founder of the entire shale oil/shale gas revolution. For decades, the Texas wildcatters had known that there was gas in the Barnett Shale, but it was very difficult to get it out. Mitchell did not invent the fracking technologies. He just wanted to get the gas out of the shale. And as the owner of an oil company, he got to challenge the technical people. He basically said, "If you guys can't figure it out, I'll find someone who can." He had the power and the money and the persistence to make it work. Mitchell Energy & Development Corp. began working on the problem in 1981, and it took until 1999 to figure it all out. The company sold for $3.5 billion ($3.5B) in 2001! It is inspiring.
TER: Were other companies trying to develop fracking?
JL: The conventional wisdom did not comprehend what George Mitchell was attempting; some folks thought he was crazy. And since some visionaries fail, we need to celebrate the ones who are successful. He grew to be very wealthy as an oilman, but he had also read the book, "The Limits to Growth," and he was very concerned about how civilization is managing the earth's resources.
TER: The extraordinary success of fracking has brought the prices of petroleum products below the cost of production, in some cases. What kinds of adjustments are the juniors that are already producing product in the North American shale field having to make in order to turn a profit, or even to just survive intact until the next boom?
JL: Because horizontal wells cost anywhere from $5–15 million ($5–15M) to drill, the juniors typically need to partner with a larger company. The big companies wait for juniors with nice land positions but not much capital to get desperate; then they move in to strike a deal.
The giant shale plays are not junior friendly, because small firms do not have the hundreds of millions of dollars needed to develop them. Thirty million dollars sounds like a ton of money, but it might only fund two wells. Statistically, it might be necessary to drill up to 10 wells to prove up a play. Typically, it's the majors that develop the new fields, and the juniors try to tag along by capturing acreage in a hot play, and that is often a good strategy. But they can't afford to spend big money to crack the code. They usually look for partners.
Even medium-sized big companies like EnCana Corp. (ECA:TSX; ECA:NYSE) are entering into partnerships with foreign companies and looking for big investors, because the amount of money required to develop these plays is so enormous. In Northeast British Columbia, literally billions of dollars of investment will be required to fully develop the resource. If a junior's land position is compelling enough, it can get a big payday from selling it. The challenge is that there are numerous shale opportunities for major oil companies to pursue and a junior needs an asset that is big enough to move the needle.
TER: For companies with producing wells, what kinds of new technologies are available to increase productivity without hurting already stressed out operating budgets?
JL: There are a lot of technological tricks with minimal costs: A producer can re-enter wells or stimulate wells or fracture older wells. It can enhance oil recovery with pulsed injection of water or chemicals.
TER: How does that work?
JL: A tool installed in the well injects fluids in pulses—pumping like a heart pumps. Think of putting a kink in a garden hose. Pressure builds up and when the kink is released there is a strong pulse of water. This technology is efficient and companies can make money doing enhanced oil recovery with pulsed injection.
TER: What names are on top of that technology?
JL: Wavefront Technology Solutions Inc. (WEE:TSX.V) provides pulsing tools to operations all over the world. It has a couple new business lines with fantastic growth rates. In well stimulation, a chemical (usually acid) is injected into a formation to clean up the area around the well bore so that more oil and gas can flow. By using pulsing, the acid is placed more uniformly and better flow rates are achieved after the stimulation. This part of Wavefront's business is growing very quickly and now accounts for roughly half of the company's revenue.
Wavefront's pulsing technology has been modified for use in performance drilling tools. Fluid pulsing behind the drill bit and drill string agitation dramatically increases the rate of penetration. Reducing drilling time by 20–40% is an easy sell, and the enhanced oil recovery business has a huge market in the field.
In another five years, these technologies will be commonplace, but it takes time since most oil companies are slow to adopt new technologies. It is going to take a few more quarters for Wavefront's revenue to ramp up, but its revenue growth is encouraging and I am quite optimistic about its prospects.
TER: How is its cash position?
JL: It has over $11M in cash. It is very close to being profitable, and it has more than enough money to see it through. The bottom line is that it has a market cap of about $25M and a rapidly growing business.
TER: How is Wavefront's stock performing?
JL: The share price is approaching all-time lows. A couple of weeks ago, I bought more Wavefront shares because it is so cheap. I could be wrong, but the company has staying power, and it is not desperate for cash, so it is a good buy right now.
TER: Where are the best shale oil plays located?
JL: The big picture is there are lots of thermogenically mature source rocks all over the world that are amenable to horizontal drilling and fracking. Typically, these plays do better where there is existing infrastructure and expertise, like Texas. It is harder to do hydraulic fracturing in relatively new areas like Pennsylvania and New York or Europe because even though these regions have a long history of petroleum development, they currently do not have the infrastructure and the regulatory environment to manage fracking. Take the Wolfberry trend in the Wolfcamp shale, for example. It's one of the hottest Texas plays with really good results coming out. And because it is in Texas, there are not a lot of regulation-related delays.
TER: Do you have any names for us in these shale plays?
JL: There is a small Canadian company with a foot in the Wolfberry door called Big Sky Petroleum Corp. (BSP:TSX.V). It has drilled one well that recovered a small amount of oil, but it remains to be seen how that plays out. Right now, Big Sky does not have a lot of staying power on its own, but it does have a big land position. However, with only about $1M in cash on hand, it needs to find a partner or get bought out. That is not an uncommon situation for a small company with a big land position. Capturing the land takes expertise and an upfront investment with no immediate return. The next step is drilling wells that flow at an economic rate. Or a company can wait for other drillers nearby to come in with good wells, which can make it easier to raise money at that point.
I also pay attention to Shoal Point Energy Ltd. (SHP:CNSX), which has big shale play acreage in Western Newfoundland, but since it did not have a lot of cash, Shoal Point partnered with another company that will earn in by drilling wells. Drilling costs a lot of money, and the first well does not always work out. Drilling can quickly turn into a giant money pit.
Generally, the challenge is the continual need to raise capital. It is a grind, but every once in a while, a company taps that gusher and sells itself to a major at a big profit. It just doesn't happen all the time. It took George Mitchell 20 years to figure out what he was doing in the Texas shales; and that is too long a wait for most investors.
TER: Do you have any other names?
JL: There is a hot new play in California called the Monterey Shale. It is world-class source rock. A little company called Zodiac Exploration Inc. (ZEX:TSX.V) has a big land package in the San Joaquin Basin. It has farmed some of it out to partners, and it is getting results. It has about $13M in cash.
TER: Are there regulatory issues in that area in California?
JL: Zodiac is drilling close to Bakersfield, which is an oil and gas-friendly neck of the woods. There are some big majors involved there, like Chevron Corp. (CVX:NYSE). And once a major gets involved in a play, it helps everybody in terms of community relations. Occidental Petroleum Corp. (OXY:NYSE) is also big in that area of California.
TER: What kind of oil price will make shale exploration profitable?
JL: At $150/barrel, we would be booming! But, seriously, even the current low prices are sustainable. There are a lot of moving targets and price is just one of them. There are the drilling and completion costs—and those costs are coming down because companies are figuring out what technologies work best. The oil and gas business is slowly learning how to frack more efficiently. Oil companies cannot do much about the price of petroleum, but they can watch their costs, and that is where the focus is now.
TER: You often talk about the "hype cycle." What is it?
JL: When something new comes along, everybody gets excited about it, everybody wants to try it and then the technological limitations kick in. The challenge is to make that technology better and better. Hype-oriented investors get in during the onslaught of the hype and then sell at the crest. Things decay as people realize, "wow, this is going to take a lot of work!"
With the advent of hydraulic fracturing, there was a big hype cycle: Everybody wanted in on the new thing. Money was thrown at all sorts of shale plays all over the world. Some of them worked out, and some of them did not do well. But the industry is maturing and optimizing the strategies that work. It is a slow grind to make horizontal drilling and hydraulic fracturing economic. But the current price of product is certainly sustainable, and oil companies can make a profit if they keep costs under control.
In the long run, oil production will operate like a manufacturing business. When the price goes up, there will be no shortage of ways to increase production. There is a huge runway, and that will keep the industry in balance for many decades ahead.
TER: It sounds like you're an optimist.
JL: I just do not see a problem in the current situation. With the new industry that George Mitchell created, we are less reliant on coal. Natural gas is a better, cleaner fuel than coal—in spite of the protests and arguments to the contrary. Most people would rather have natural gas-fired electricity than coal-fired electricity for a variety of reasons. Low energy prices are good. It's good for the economy. When we humans run out of a resource, we usually fix the problem.
One good example is the peak oil website, The Oil Drum. It recently stopped adding new content, because the peak oil argument is the same thing repeated over and over. The argument is that there is a finite amount of oil and we are going to run out of it and the consequences will be dire. But when there is a new discovery, the oil peakers have to pick it apart and say, "oh, it's not that good because these wells decline quickly" or, "the environmental impact of this is too great." They are continually negative about new developments that increase supply. And it's fair to be critical. Good business practices include environmental impact and looking at how resource development best serves all of society.
But the big picture is that we have bought ourselves a lot of time with horizontal drilling and hydraulic fracturing: we will not run out of hydrocarbon fuels, and we will be able to make a nice transition into cost-effective alternative energy during the next 10 or 20 years.
TER: Given the high costs of exploration, is there going to be a collapse of the junior sector?
JL: There has already been a natural winnowing out of a lot of juniors. It used to be that a junior with a small amount of money could develop a play to the point where a bigger company would buy it out. Now the bigger companies have all kinds of options to pursue, so they're less interested in small acquisitions and they have just as many ideas as the juniors do.
The challenge for a viable junior is to have a play in the top quartile. The odds are stacked against junior explorers. But if one of them ties up the right land, then there is an exciting payday for all involved. The key challenge is how to crack the code for the least amount of money.
TER: How can investors determine which of the small firms has the best chance of success?
JL: That is unknowable, because there are a lot of variables. The ideal situation for an investor is to hold a diverse portfolio of juniors. There definitely are attractive companies out there and they all have the same story: "We have captured acreage, and there are lots of hydrocarbons in place, and we have lots of science to support that it is valuable." And sometimes they have big companies playing right beside them, too. But advancing the story to where there is a payday for the investors is a long road.
I'm not being negative, but realistically, it's not easy right now for the juniors. They need their plays to look shiny and pretty. They need people to get interested. And there are so many shale plays out there that it's hard to stand out.
TER: Thank you, Jim.
JL: You are welcome, Peter.
Jim Letourneau is the founder and editor of the Big Picture Speculator and is a geologist living in Calgary, Alberta. He is an early-stage investor in energy, metals, biotech and technology companies. He speaks at investment conferences across North America.
By. Peter Byrne of the Energy Report