The Upside in Unconventional Oil

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Note: This is Part 2 of my 3 part Unconventional Oil theme write-up. In Part 1 (here), I describe why $90 is the new “floor” for WTI. In Part 3 (update: published here), I’ll write-up a particularly compelling idea inside of this theme. But for now, onto Part 2: why North American unconventional oil demands my investment capital.

As explained in “The Era of Cheap Oil is Over” (here), I’m bullish oil over any time frame: short, medium and long-term. It is unquestionably my highest conviction idea. But having conviction and making money are two very different things; a massive gap lies between being right and making money. What bridges that gap is implementation. In investing, implementation is everything.

So the real question is: what’s the best way to implement a bullish oil view?

To me, the answer is via equity in North American unconventional oil producers. The reasons I believe this to be true are worth sharing:

I believe North American oil companies are the perfect conduit to access oil producing assets because they have: (1) no exploration risk, (2) no foreign government risk, and (3) minimal infrastructure / development risk. I’m not aware of any other region on the planet that shares all three of these characteristics.

As to why I have chosen to express a bullish oil view via unconventional producers, those reasons are also instructive:

For these reasons, I believe North American unconventional oil producers provide the best risk-adjusted return opportunities in the oil market. Now that you know why I’m implementing a bullish oil view via North American unconventional oil producers, I’ll get specific – here are the core questions you need to answer when evaluating unconventional oil companies:

Location

Land Acquisition Cost

Y = (Net acreage) x (estimated % of acreage that is prospective) / (640 acres per section) x (est # of wells per section) x (NPV per well)

So let’s say 70% of the land is prospective based on the technical assessment and the Company can reasonably estimate well spacing and well economics. The math is:

(10,000 net acres) x (70%) / (640 acres per section) = 10.94 prospective sections (note that 1 section = 1 sq mile)

(10.94 prospective sections) x (4 wells per section) x ($3MM NPV per well) = $131.25MM

So the undeveloped acreage is estimated to be worth $131.25MM. An acquirer might be willing to pay 30% of that figure. In this scenario, the total deal value for 1,000 boe / d of reserves and 10,000 net acres of undeveloped land would be:

$90MM + (30% x $131.25MM) = $129.375MM, or $129,375 per flowing barrel.

Reserves

Operations

High-level, that’s my checklist for evaluating North American unconventional oil opportunities. My approach has been to take a position when the proven and probable reserve value is equal to or exceeds the enterprise value of the company. There are two reasons for this: (1) the non-earning, unflowing resources are what make an unconventional oil company cheap, and (2) even if the prospective, undeveloped land disappoints there is still very good downside protection.

What I avoid (or consider as a short) is an investment where almost all the value of the company relates to an undeveloped but prospective land package. Companies like this carry significant risk as there is no downside protection if the undeveloped land turns out to be a bust.

Wherever you find opportunities where reserve value >= enterprise value, jump on them. Not only is your downside protected, but you’ll acquire three significant call options: (1) prospective, undeveloped land, (2) greater future oil production, cash flow and per barrel profitability from better extraction technology, (3) direct exposure to progressively higher oil prices in the future.

These three call options provide the upside in unconventional oil. And if you look hard enough, you can get them all for free.


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