For Natural Gas Producers, It's All About Oil

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The low price of natural gas tossed shares of US independent producers into the garbage. Some escaped the wrath of Mr. Market temporarily, by shifting drilling to wet gas opportunities. Others have more radically shifted their focus to unconventional oil shale opportunities. Regardless of the exact method, most are working hard to raise the mix of liquids in their production.

Shareholders of companies that have made that transition successfully, like Pioneer Natural Resources (NYSE: PXD) and EOG Resources (NYSE: EOG), should be pleased with the result. Others that are now in the midst of that transition could prove an interesting opportunity for those willing to jump on board.

When you look at a chart of the independents, there’s a perfect correlation between relative performance and their production mix. More gas means poor performance. More liquids means better performance. Figure1 below shows the last five years’ performance for shares of Pioneer, EOG, Devon Energy (NYSE: DVN), Chesapeake Energy (NYSE: CHK) and Encana (NYSE: ECA).

<img src="/media/images/user_13017/nattieschart1_large.jpg" />

The balloon boxes on the chart show the latest quarter’s percentage of production from natural gas. Companies that began the move to liquids earlier are naturally less leveraged to nat gas, and have fared much better in the last three years. Pioneer, with its strong Eagle Ford and Permian holdings, redirected their capex budget toward liquids in 2010. The result’s been a steady increase in liquids production. Oil production alone more than doubled since 2010. EOG’s nearly tripled oil production since 2010 after emphasizing their liquids drilling in the Eagle Ford and Bakken.

That success has logically led to copycats, and many unconventional oil and gas producers are foregoing nat gas projects and extending their reach into Oil Shales. Chesapeake shifted the bulk of its drilling capex to liquid basins in 2012. Its holdings are extensive and touch virtually every play in North America, but gas remains far and away the bulk of its production. Devon is further along, but remains behind EOG and Pioneer in its transition from gas to liquids.

The percentage of liquids in each of the fives’ production over the last few years is shown in Figure 2. Liquids growth by EOG and Pioneer far exceed other peers, with total liquids topping 40% of production. Chesapeake is making decent progress, but off a very small liquids base. Devon’s been slow to get started, but has the advantage of working off a fairly large base. Liquids account for 37% of Devon’s production and are just starting to climb. Encana, with its strikingly low liquids production remains a pure gas play.

<img src="/media/images/user_13017/nattieschart2_large.jpg" />

Interestingly, Devon looks a little bit like EOG did a year or two ago. After selling off its fringe assets to concentrate on North American onshore drilling, Devon went on a buying spree, collecting acreage in five new basins in the lower 48. Some early exploration results look promising and Devon’s preparing to ramp up drilling in the Mississippian in northern Oklahoma. That combined with stepped up conventional and unconventional drilling in the Permian should boost liquids production further. Devon also reported excellent results from two new liquids-rich Hogshooter wells in the Anadarko Basin. This isn’t yet an area of emphasis, but Devon’s shifting a rig here later in the year. The area bears watching, since Linn Energy has had some excellent success here.

Canadian oil sands projects will be another key driver for Devon’s success. The company has two oil sands projects operating at Jack in Alberta, with a third under construction. Production is down at Jack 1 for maintenance, which curtailed Q3 oil production a bit. Q4 will be similarly affected. Planning and permitting continues for a fourth production facility at Pike, a joint venture with British Petroleum. By 2020, Devon expects oil sand production alone to exceed current total company liquids output.

Those heavy oil projects are still a long way off. The key remains the success of these new drilling efforts in the lower 48. Canadian heavy oil pricing is also currently weak due to excess supply, complicating matters. While the future’s always unclear, guidance is that pricing should stabilize sometime in the first quarter of 2013. There’s also the hope that nat gas prices stabilize. With the industry wide shift to liquids, a number of producers have announced a willingness to allow nat gas production to wane. Devon is in that camp, and will shift rigs from the Barnett and Cana-Woodford as needed to support their new liquids-oriented drilling.

It’s intriguing that there’s such good direct correlation between production mix and share performance at the moment. Sometimes it’s easy to get caught up in more complicated details, when the simple will suffice. Chesapeake has made considerable strides in their liquids program, but I’m uncomfortable with its corporate governance track record. Shares of Devon look poised for a performance like EOG and Pioneer. There’s a lot of potential to unlock. Devon’s reserve base is large and relative to enterprise value, it’s the lowest priced per barrel of reserves in its peer group. “Buy low and sell high” is the value investors’ creed. Right now, investors picking up shares of Devon are definitely buying low, but there’s opportunity only if Devon executes. Investors will be keeping a close eye on its progress in the Permian and Mississippi Lime. Increased oil output from these key plays will be critical to realizing that potential.

JustMee01 owns shares of Linn Energy, but holds no financial position in any other company mentioned above. The Motley Fool owns shares of Devon Energy and has the following options: long JAN 2013 $16.00 calls on Chesapeake Energy, short JAN 2014 $15.00 puts on Chesapeake Energy, long JAN 2014 $20.00 calls on Chesapeake Energy, and long JAN 2014 $30.00 calls on Chesapeake Energy. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.If you have questions about this post or the Fool’s blog network, click here for information.

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