By GREGORY ZUCKERMAN
The Wall Street Journal
First there was the tech boom. Then the housing bubble.
Now, new profits and investment opportunities are emerging from the surge in U.S. gas and oil production. Innovations in drilling techniques—such as hydraulic fracturing, or fracking, and horizontal drilling—have made it easier to extract oil and natural gas from shale and other rock formations. That has boosted production and led to billions of dollars of profits for some early pioneers and investors.
“America stands on the verge of a major change that puts it on a course to near self-sufficiency” in energy, says Tobias Levkovich, Citigroup’s chief U.S. equity strategist, who says the energy surge is a key reason to be upbeat on the market and U.S. economy.
“The implications are simply stunning on America’s current account figures, trade balances and even potentially the positioning [and cost] of U.S. military forces around the world,” he says. “The increase in production of shale gas could also add millions of new jobs.”
Investors are eager for an energy boost in a market that has only very recently shown some strength. The broad Standard & Poor’s 500-stock index is up more than 6% so far in 2012, after ending 2011 pretty much where it began. The S&P Energy Index is up 4.25% this year.
Much as in previous booms, however, investors risk jumping in after some of the best gains have been reaped. Indeed, the energy patch can be a tricky place to invest. Surging gas production has been a boon to consumers and companies that use natural gas for heating or to make various products. But all that added supply, along with an unusually warm winter, have sent gas prices down nearly 50% in the past year.
That drop has pressured companies like Chesapeake Energy, the second-largest natural-gas producer, which has seen its stock price fall by more than a quarter in the past year, even as it meets success extracting more gas through new techniques. Cabot Oil & Gas was the top-performing stock in the S&P 500 last year, with a gain of 100%. But so far this year, the stock has dropped about 15%, another sign of the challenges for investors playing this new wave.
It’s also true that environmental scrutiny of this drilling is on the rise. And shale extraction is relatively new, so there remains uncertainty about how long wells will produce.
Natural-gas prices may rebound from current low levels, at least over the long term, as more uses are found for this low-cost energy. But for now, analysts recommend that investors focus on companies seeing growing oil production from innovative drilling methods, rather than those sticking with gas. Two larger independent drillers that some investors recommend: EOG Resources and Continental Resources.
As recently as 2005, few held out much hope for any boom in U.S. energy production. Most experts said producers would see a gradual slowdown of domestic oil and gas production, and billions of dollars were invested in ways to import natural gas from abroad.
But in just the last few years, the new drilling techniques have created a new gusher. Among the innovations: drilling down in the ground and turning horizontally to capture more of the gas and oil trapped in underground shale deposits, and using a mix of water, sand and chemicals to break apart porous rock and release oil and gas.
The new drilling methods are “a completely disruptive technology” allowing companies to double and triple growth in energy production in just a few years, says Dan Rice, manager of the BlackRock Energy & Resources Fund .
Some of the most attractive companies are those that have been able to shift from natural-gas exploration to oil extraction. As recently as 2006, EOG saw 79% of its revenues come from natural gas, and just 21% from so-called liquids, which include crude oil. But the company became worried about future oversupply of natural gas and began to focus on oil. This year, EOG says, it expects to see about 75% of revenues come from liquids, and just 25% from natural gas.
Mr. Rice says shares of both EOG and Continental, which has become a major driller for oil in areas like North Dakota, are inexpensive.
He also is a fan of Range Resources and EQT, companies active in the booming Marcellus Shale region, which ranges through states including New York and West Virginia. Others recommend smaller energy producers, such as Houston-based Oasis Petroleum which could be takeover targets.
Some analysts are most excited about chemical companies like CF Industries. Nitrogen production accounts for about 80% of the company’s sales, according to analysts at Citigroup. And natural gas accounts for about 85% of the cash production costs for CF’s nitrogen production, the analysts said, a reason for optimism on the company.
Dow Chemical, meanwhile, is benefiting from falling natural-gas prices because it lowers the price for ethane, “a key material” for Dow’s ethylene production, the Citigroup analysts say.
A riskier stock with potential upside: Cheniere Energy , which once aimed to be a big importer of natural gas. A glut of U.S. gas forced the company to scrap those plans, but it now is hoping to be the nation’s first exporter of liquefied natural gas.
As natural gas drops, and consumers and power companies depending on natural gas benefit, the chemical industry will as well, Citigroup says, because “the chemical industry consumes about 10% of natural gas” in the U.S.