Sorry WSJ and FT, America's Energy Boom Isn't a Bubble

Whenever the new year rolls around, we all like to reflect on the past in hopes of bringing perspective toward the future. Both The Financial Times and The Wall Street Journal did this recently, and they both suggested that the boom in American oil and gas production is a bubble headed for a pop. Do they have a point? Let's take a look at the thinking behind these two articles and why they could be very wrong.

The bubble argument
The boom in oil and gas production has been far from perfect for investors. The major slump in natural gas prices back in 2012 had many natural gas companies on their heels, and the fits and starts in pipeline infrastructure coming online has made for a very volatile environment for refiners. These two recent newspaper articles, though, have taken aim at oil and gas producers. Both of these articles are much more bearish on the future of American-centric oil and gas companies. Here are the arguments they are making:

The returns are not all that great:
Many would consider EOG Resources (NYSE: EOG  )  the best independent oil and gas company on the market. But the Financial Times pointed out that EOG has a return on capital employed, or ROCE, of 11.4%. This is less than half of ExxonMobil's (NYSE: XOM  ) ROCE over the past five years. Furthermore, other independent companies that had more production based in natural gas, like Chesapeake Energy (NYSE: CHK  ) , delivered even worse returns. 

Performance has been overstated:
There are some obvious exceptions, but the overall oil and gas industry has actually under-performed the broader market over the last five years. The Financial Times noted that the exploration and production sector has only risen 16% while the total return of the S&P 500 has been 48%.

Companies need to spend all their cash flow to keep up production: 
Even though drilling practices such as horizontal drilling and hydraulic fracturing are not new, companies have only been able to prove them as commercially viable for about 12 years. Just because unconventional drilling is commercially viable, though, does not mean that it is cheap. In 2012, the cost to complete an average well in the Bakken region was as high as $11.2 million, for a well that loses more than 80% of its production rate in two years. So to actually grow production with these high costs and fast-declining assets, almost every independent has had to finance capital expenditures through a combination of issuing equity, debt, or selling off noncore assets.

Investment is losing its appeal.
For a long time, foreign companies were a major source of capital for independents, but that injection of capital has been slowly dwindling. According to The Wall Street Journal, foreign investment in unconventional oil and gas production in 2013 was $3.4 billion. That may sound like a big number, but it is one-tenth of what they spent in 2011. As these drilling dollars dry up, shale drillers will nto be able to grow production as quickly and will need to secure financing from other regions.

The rebuttal
These are all very valid points, and investors seeking some energy stocks for their portfolio need to be very selective. But before taking these articles to heart and abandoning any investment in the oil and gas space, here are a few things to consider.

Companies can do more with less: 
Now that we are 12 years on, many companies have made these new drilling techniques much more cost effective. One of the best examples of this is Continental Resources (NYSE: CLR  ) . In just two years the company has optimized its drilling program with well spacing, new proppant types such as ceramics, and drilling multiple wells on a single drilling pad. The company has reduced its well completion costs by 30% and expects another 7% reduction by the end of this year. These kinds of cost reductions allow Continental and other companies with similar efficiency programs to maintain production growth while cutting capital expenditures, a perfect combination to increase returns.

Pursuing more shareholder-friendly growth:
Lots of companies over the past couple years have been in a growth-at-all-costs mode, which takes all cash from operations and pours it back into capital expenditures. However, this practice is starting to lose its appeal and companies are looking to live more within their means. Even some young, upstart companies like Halcon Resources (NYSE: HK  ) have said they plan to spend less in 2014 on capital expenditures. As more companies spend less on capital expenditures and reap the rewards of previous drilling programs, investors should see better returns.

Independents are rising while Big Oil is falling: 
It seems incredibly appropriate that the Financial Times article compared ExxonMobil to EOG Resources, because looking at these two companies over the past couple years paints a very different picture. Exxon's stellar return on capital employed is bolstered by its downstream sector, which has older assets that have been depreciated for years. Its 54% ROCE for downstream operations goes a long way in juicing the entire business' return to cover for the upstream side of the business. ROCE for its United States operations last year was a paltry 6.8%.

At the same time, the return on invested capital for EOG Resources has been on a steady increase; between 2011 and 2012 alone the company saw a jump in ROCE from 9.4% to 11.4%. With Exxon needing to pour billions of dollars into over-budget projects like Kashagan and PNG LNG, and EOG continuing to improve drilling efficiency, don't be surprised if that gap continues to close.

Companies are less willing to give up assets for financing:
As the shale boom got its start, many companies bought loads of assets, but they didn't have the capital to develop them and needed to pay lease expenses for unproductive assets. The only way to develop these fields was to bring in foreign partners and private equity to foot some of the bill, so these assets sold at a discount. Now that these independents are on more solid financial footing, they don't need as much of a capital injection, which means they are less likely to part with an asset for a less than stellar price. 

What a Fool believes
These articles are a word of caution that you cannot indiscriminately invest in any company that looks to play America's energy boom. However, it is probably not the "bubble" that they claim. Improved drilling efficiency, more disciplined capital management, and increasing returns suggest the oil and gas boom today may be just hitting its prime. 

The key for any investor is to determine the wheat from the chaff, and this is especially important in the fast changing world of America's oil and gas boom. With so many companies to comb through, though, it could be a daunting task for any investor. Let us help you, we have put together a special report that takes a deeper look at 3 companies that are built to resist any popping bubbles and are here to stay. To find out the names of these 3 companies, check out our special report, "3 Stocks for the American Energy Bonanza." Simply click here and we'll give you free access to this valuable investing resource. 

 


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