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How to Invest in Unconventional Energy


With improvements in drilling technology and higher energy prices, unconventional plays are becoming "more conventional".


As the world's thirst for energy continues to grow, unconventional resources will play an increasingly more important role as a source of natural gas and oil.

So what are unconventional energy resources?

Unconventional natural gas consists of tight gas, shale gas, and coal bed methane. Oil sands make up the largest source of unconventional oil. These unconventional resources represent an increasing proportion of oil and natural gas production each year.

What's out there?

Canada's oil sands in northern Alberta are probably the best example of unconventional oil, and are estimated to contain 1.7 Trillion barrels of oil. 174 Billion barrels, or about 10%, are deemed recoverable with today's technology, and make up approximately 15% of the world's proven reserves.

One of the best examples of an unconventional natural gas resource is the Barnett Shale where an explosion of drilling activity has occurred in North Texas. Before more advanced drilling technologies, the Barnett Shale was not commercial. The application of technologies like horizontal drilling and multi-stage fracing have helped E&P companies unlock the Barnett Shale, and made it extremely commercial.

With improvements in drilling technology and higher energy prices, unconventional plays are becoming "more conventional". But not all unconventional plays will become commercial. There are many small E&P companies touting their acreage positions as the next big unconventional play.

Now that I have highlighted a couple of examples of unconventional plays that have worked, let's look at some characteristics you should look for in some of the smaller E&P companies with unproven unconventional assets.

Existing production to provide cash flow: This is more important for the smaller cap names in the E&P space. Production = cash flow which allows an E&P company to pay the bills, and develop unconventional assets. Without production, E&P companies must tap the equity markets to finance their exploration programs.

US-based assets: I prefer to invest in companies with assets in the United States. That doesn't mean there aren't great foreign assets outside the United States. I just prefer to eliminate country risk when possible. Investing in unconventional energy assets is risky enough.

Large underdeveloped unconventional assets with little value contribution to stock price: I refer to this as the embedded optionality that may be present in an E&P, but gets little value from Wall Street. As an E&P progresses in proving up its unconventional assets, the value of its stock can increase dramatically.

Partnerships with larger E&P companies on unconventional plays: Often, a small E&P puts an acreage position together but does not have the cash flow or expertise to develop/test the asset. I like to see these smaller E&P companies partner up with larger E&P companies to provide both cash and operating experience. Partnering can also provide some validation of the potential of the unconventional assets.

Strong management team: A solid management team and board of directors will tell an investor much about and E&P before you ever take a look at their assets. I like to see a diverse background form the board of directors as well as independent chairman, and strong executive experience in the areas the E&P company operates.

Now that I've highlighted a few characteristics in smaller, lesser followed E&P names with unconventional assets, let's look at a real example of a company I follow called The Exploration Company (TXCO). The Exploration Company is a San Antonio-based E&P company with substantial unconventional assets in the Maverick and Marfa basins (South Texas). Let's see how they do using my checklist:

Existing production to provide cash flow: TXCO has a rapidly increasing production profile that is currently about 80% oil and 20% natural gas. Oil production has increased from just over 1,000 barrels of oil per day (BPOD) at the end of 2005 to 2,400 BOPD as of the most recent company operations update. This production will provide TXCO steady cash flow as it attempts to prove up some of the other assets in its portfolio.

US-based assets: All of TXCO's assets are located in the continental United States, with the majority of those assets located in Texas.

Large unconventional assets with little value contribution in stock price: TXCO has several large unconventional plays that could be significant if proven commercial. The first unconventional asset is the Pearsall Shale Gas Resource play in the Maverick Basin. The Pearsall Shale is an unconventional gas play that is over pressured but not too deep. This formation has produced some incredible gas wells with the largest flowing over 260MMcfd (Million cubic feet of gas per day). Historically, wells have average about 1/2Bcf (Billion cubic feet of gas), but that is without 3D seismic, or advanced drilling techniques such as underbalanced and horizontal drilling, fracturning/stimulation. Today, TXCO has 3D seismic on all of its Pearsall acreage, and plans to use some of the latest drilling technologies and technical expertise from its partner, Encana (ECA).

The Exploration Company also has one of the most exciting unconventional oil plays I have seen in a long time in its San Miguel Tar Sand Resource. That's right, we have oil sands in Texas…and lots of it. Mobil was the first to try and develop the Texas oil sands in the 1960's but it was Exxon and Conoco that had the best results between 1977 and 1982 on what are now TXCO leases. These pilot wells showed that the oil sands were producible with recoveries of 40-55% using steam injection, but cost and transportation were both issues back in the early 1980's. The Company now feels that there is a total of 7-10 Billion barrels of heavy oil in place basin wide. Using more modern technologies similar to those at Cold Lake (a proven heavy oil project in Canada with similar characteristics), the company believes its tar sands play is commercial at $50 oil. I will also note that 70-80% of the heavy oil refining and coker capacity is less than 150 miles away, owned by another San Antonio-based company many of you know well: Valero (VLO). At present, most of Valero's heavy crude is imported (think Venezuela), so I imagine they would be more than happy to take all the products TXCO can ship them. While it is still early, this is a perfect example of an embedded call option in TXCO that gets little to no value, but has enormous upside.

The last big unconventional asset TXCO owns is another shale gas play in the Marfa basin. Currently, there is no production in this area, but others that have been moving in to scoop up acreage include Carrizo (CRZO) and Quicksilver (KWK). Two wells are currently planned for in this year's operating budget, but no production will be possible as there is currently no infrastructure in place should the wells work. This is probably too early stage of a project to assign any value to, but is still another embedded call option investors should be aware of.

Partnerships with large E&P companies on unconventional plays: The Exploration Company has partnered up on all three of their unproven unconventional plays I detailed above. Last year, Encana (ECA) paid TXCO $80 Million cash for interests in the Pearsall Shale play which many believe confirms the potential in the Pearsall Shale. Encana will also bring its invaluable unconventional expertise to the project. Also of interest, Encana made a rather large CAPX cut earlier this year, but the Pearsall Shale Play with TXCO was not cut (many other new projects were).

On the San Miguel Oil Sands project, TXCO has partnered with Pearl Exploration (PXX.V), an E&P out of Canada with oil sands experience, in an attempt to leverage their experience in developing heavy oil projects. TXCO and Pearl have drilled the first two pilot wells and testing is underway. Plans are to drill up to an additional 37 wells by the end of the year during the first phase of this heavy oil project.

On their last unconventional play in the Marfa basin, TXCO partnered up with Continental Resources, a well respected private E&P company with a long history operating in unconventional resources. Continental Resources will act as operator, having paid an undisclosed sum for a 50% working interest.

Strong Management Team: The Exploration Company has a team of proven oilmen that have been operating in South Texas (Maverick basin) for years. Jim Sigmon, the company's CEO, is an engineer by background and has been with the company for over 20 years. Jim has done a great job of assimilating a team with decades of experience and knowledge. TXCO's board does have an independent chairman as well as other directors with different but complementary backgrounds.

Investing in unconventional energy companies can be very rewarding if you do your homework. Hopefully, the checklist I provided will help.

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Position in TXCO

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