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Time to Bakken to a Hess Position

Maxxwell A.R. is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Despite the rosy projections heralding the Bakken formation as the United States’ Holy Grail of energy investors, we found a rare piece of bad news when Hess Corp. (NYSE: HES) announced that their wells would produce below the previously expected 60,000 barrels per day (bpd) by year end. The news kept shares downward in a slide that began in late February.

That can be great news when you consider that the company’s fundamentals remain strong. If you are looking for a way to play the Bakken formation, then look no further than Hess. The company has amazing potential to increase production in the Bakken and is currently trading well below fair value, which stands at $56 per share (a 14% premium to $49 per share).

Before we analyze the company’s production let’s look into the swath of land named after Henry Bakken, who farmed the land where oil was first discovered by Hess in 1951.

Why Bakken?

In 2008 the U.S. Geological Service (USGS) completed a study of the Bakken formation and concluded that it contained up to 4.3 billion barrels of recoverable oil. With traditional oil reservoirs the USGS waits at least ten years before issuing a follow-up study to reassess oil levels. However, Bakken is anything but traditional. As a result the USGS is conducting another study a mere four years later, which it expects to complete in late 2013. Some believe the formation has the possibility to be the world’s largest oil discovery in the last 40 years, but Bakken will need to hold over 30 billion barrels of recoverable oil – and possibly as much as 50 billion barrels – to displace the recent discovery off of Brazil. Regardless, it is easier to reach than anything offshore.

The Bakken formation contains about 200,000 square miles of land – about the size of Spain – in North Dakota, Montana, and Saskatchewan. Oil deposits are spread out in thin bands only 70 to 130 feet wide throughout the subsurface shale and dolomite formations. Although oil was first drilled in 1951, the fields have been relatively dormant over the past half century.

That changed when someone had the bright idea to drill down and then horizontally to increase the amount of oil contacted by a rig. Typical rigs can extend 10,000 feet below the surface and then up to 10,000 feet horizontally through the shale deposits. The result: a massive oil rush and estimates of total recoverable oil in the tens of billions of barrels. Production in Bakken has soared from next to nothing in 2005 to over 500,000 bpd at the end of 2011. The chart below shows the growth of North Dakota oil production and reveals that only 100,000 bpd of state production comes outside of Bakken.

<img src="/media/images/user_6293/nd_oilproduction_large.PNG" />

Without the Bakken formation North Dakota would have to stick to massive wind farms and green energy. How boring! Source: Oil and Gas Journal, April 2012

Development of the Bakken formation has the potential to push domestic oil production from 5.7 million bpd in 2011 to levels not seen since 1970 (9.6 million bpd). That would offset a significant amount of our oil imports, which stood at 9.2 million bpd in 2011. Combine that with growing ethanol exports to Brazil, expanding coal shipments to an energy-hungry China, and soon-to-be LNG exports in 2016 and the U.S. could become a dominant energy exporter in the 21st century.

Is it really bad news after all?

I believe the market is overreacting. Hess owns over 8% of all drilling permits in Bakken and had a good explanation for the lousy production. First, the company had a difficult time attaining drilling permits in the first quarter. The process has been slower than usual for all drillers in the region, but seems to be picking up pace now. Secondly, and perhaps most importantly, Hess had to drill on land with less-than-stellar production prospects to keep leases granted under “held by production” rules.

The third reason production has been slower than usual gets next to no attention, but is a very serious concern with very serious consequences that extend beyond the energy sector: water. This report from two years ago was among the first to raise the question of where the estimated 5.5 billion gallons of water needed per year was going to come from. The problem remains and may be a reason companies have had problems attaining drilling permits in the first place. Just a social concern to chew on before jumping into an investment in a potentially destructive industry.

The revised production numbers

Hess revised its year-end target to 52,000 bpd. While not the 60,000 bpd figure investors had expected, it represents an impressive 11% increase over the first quarter and is way ahead of competitors. Marathon Oil Corporation (NYSE: MRO) is expected to produce 38,000 bpd sometime in 2016 while cash-rich, acquisition-hungry Statoil (NYSE: STO) currently produces only 21,000 bpd. The following table compares the yield of the three companies based on average 2012 expected net production (barrels of oil equivalent):

<table> <tbody> <tr> <td> <p><strong>Company</strong></p> </td> <td> <p><strong>Bakken Acreage</strong></p> </td> <td> <p><strong>Bakken Production (bpd)</strong></p> </td> <td> <p><strong>Acres per Barrel (daily)</strong></p> </td> </tr> <tr> <td> <p>Hess</p> </td> <td> <p>900,000</p> </td> <td> <p>52,000</p> </td> <td> <p>17.31</p> </td> </tr> <tr> <td> <p>Marathon Oil Corp.</p> </td> <td> <p>413,000</p> </td> <td> <p>27,500</p> </td> <td> <p>15.02</p> </td> </tr> <tr> <td> <p>Statoil</p> </td> <td> <p>375,000</p> </td> <td> <p>21,000</p> </td> <td> <p>17.86</p> </td> </tr> </tbody> </table>


As you can see, Hess is no worse than its peers in developing its land. Should Hess reach its expected peak production of 82,000 bpd in 2016, it would have a yield of 10.98 acres/bpd compared to Marathon’s 10.87 – essentially the same. Let’s now look at a table of the Hess’ growing production (barrels of oil equivalent) from Bakken:

<table> <tbody> <tr> <td> <p><strong>Period</strong></p> </td> <td> <p><strong>Bakken Production</strong></p> <p><strong>(bpd)</strong></p> </td> <td> <p><strong>Average Selling Price (per barrel)</strong></p> </td> </tr> <tr> <td> <p>First quarter 2010</p> </td> <td> <p>16,000</p> </td> <td> <p>$63.62</p> </td> </tr> <tr> <td> <p>First quarter 2011</p> </td> <td> <p>42,000</p> </td> <td> <p>$87.22</p> </td> </tr> <tr> <td> <p>First quarter 2012</p> </td> <td> <p>47,000</p> </td> <td> <p>$89.92</p> </td> </tr> </tbody> </table>

The overlooked…

When investors were busy whining about the announcement they forgot to peer into natural gas numbers from Asia. While gas production only increased 5%, prices increased 18% which meant Hess raked in $567 million more than the year ago period. But go ahead and keep complaining about something that was out of the company’s control.

Foolish bottom line

As the largest land owner in the Bakken formation Hess will continue to increase production from its growing fleet of rigs. Ironically, the setbacks could work out in the company’s favor in the future. The price of oil will continue its downward trend with European countries double-dipping into recession. Therefore, the company’s oil will be more valuable at future, higher prices. Maybe it is better off sitting in the ground…

It is easy to see that Hess is in a pretty good position and an excellent play in the Bakken formation. Production from Bakken will continue to rise – even if it does occur at a less optimistic pace. Furthermore, all of the company’s explanations for weak production are easily validated. Hess has done everything in its control – acquire land and competitors, build capacity, etc – to create value, but the market punished the company for events that lay outside of its control (drilling permits, water allocation). The result is a rock-solid company trading well below fair market value. 

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