Bakken Is the New Black

For years, it was Permian, Permian, Permian. Producers couldn't get enough of the place. Unfortunately, the place could get enough of the producers, and production is stalling out because there aren't enough pipes to move all that oil. As the Permian gets rougher, more and more producers are turning to the Bakken instead.

In this week's episode of Industry Focus: Energy, host Nick Sciple and Motley Fool contributor Matt DiLallo tell investors what they need to know about the biggest Bakken players on the market today. One unique company could give investors exposure to the Bakken without making them worry too hard about the whole "price of oil" business. But the Permian isn't the only one hurting for more pipes. What does this mean for the Bakken in the long term? Just how much oil is in this thing, anyways? Tune in and find out more.

A full transcript follows the video.

This video was recorded on Oct. 25, 2018.

Nick Sciple: Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. Today is Thursday, October 25th, and we're discussing Bakken shale. I'm your host, Nick Sciple, and today I'm joined by Motley Fool contributor Matt Dilallo via Skype. How are you doing, Matt?

Matt Dilallo: Good! How are you?

Sciple: I'm doing well! We've got Halloween coming up around the corner. Do you have any plans for that? What's going on for you on that end?

Dilallo: My wife and I tend to turn the lights off and just watch movies, and avoid all the trick or treaters. That's our plan.

Sciple: I hear where you're coming from. I still haven't figured out what I'm going to wear, but I'm sure it'll make me look ridiculous. Today, Matt, we're talking about the Bakken shale formation. This is something you follow pretty closely. First off the bat, let's just tell our listeners what the Bakken shale is, where it's located. It underlies parts of Montana, North Dakota, Saskatchewan, and Manitoba. Oil was first discovered there in 1951, but production efforts really struggled for the next 50 years until fracking came on board. Do you want to talk about how the Bakken has evolved over the past decade or so, and what fracking has made possible there when it comes to oil recovery and those sorts of things?

Dilallo: Oil companies knew that there was oil there. They just didn't know how to get it out. As they figured out how to do shale plays, they started out in the Barnett Shale of Texas and then moved up to the Marcellus. They figured out that combining horizontal drilling with hydraulic fracturing was the key to unlocking these things. They tested it out in the Bakken in 2003, 2004. Continental Resources (CLR) was the leader out there. They figured it out and it's just taken off since then. They've been tweaking the process, but it has been just phenomenal how much oil they've been able to pull out that region, mostly North Dakota. They pulled out some from Montana. Canada's got a little bit. But North Dakota has just been on fire. 

Sciple: To illustrate these numbers for our listeners, in 1995, the U.S. Geological Survey estimated that the Bakken contained 151 million barrels of recoverable oil. Recently, in September 2018, Continental Resources -- which you mentioned, one of the largest players in the Bakken, which we'll discuss later on in the show -- estimated that there were 30-40 billion barrels of recoverable oil in the Bakken. That's a ridiculous increase in the recoverable oil, which has really been made possible by this hydraulic fracturing. A stat that I saw which blew my mind is that North Dakota is the No. 2 state in the United States for oil production, which is mind boggling. Everybody thinks about Alaska and Texas, but over there in North Dakota, these shale oil plays have really opened up.

What's the Bakken looking like today? What's the production profile? What are the prospects going forward? 

Dilallo: Because oil prices dipped, that really hurt the Bakken. It had pretty high costs, like $12 million to drill a well. As the oil prices went down, companies just didn't have the money to drill. That caused production to fall off during 2016, 2017. I think it peaked at around 1.2 million barrels in 2015. It dipped below a million for a while. But with oil prices rising, and companies were able to cut their costs, they've really started to ramp up drilling up there. The latest peak I saw was 1.3 million barrels. 

A lot of that has come because they've figured out better ways to drill wells. They're drilling them faster, they're drilling them more productively, they're using more sand as they're fracturing. That's allowed them to produce more oil per well, which has made it so much more profitable. I saw a stat from Continental Resources back in 2011. It was less than 20% return on a well. Now, it's 175% return on a well. That's a huge gain in how much they can make on these wells. That's what's driving this production. They think it could reach two million barrels a day eventually.

Sciple: That's 20% of Saudi Arabia's oil production. That's a large chunk of oil coming from a relatively under-appreciated oil play up there in North Dakota. We were talking before the show that as a result of this big spike in oil production in the Bakken, we've seen some pipeline capacity become a little strained. Do you want to talk a little bit about that and what risks that may pose for the play over the next 12 months or so?

Dilallo: Pipelines have been an issue in the Bakken since the beginning. A couple of years ago, they were trying to build what was called the Bakken Pipeline. It was two pipelines by Energy Transfer Partners that would move oil out of the Bakken. But it's very controversial. It made the news. It was delayed for a while. They finally got that online and that's really helped boost production lately. 

However, it's basically full. Initially, it was a 470,000 barrel a day pipeline. It's currently over 500,000 barrels a day because they've been able to make some slight changes. However, with it basically full, they're asking shippers if they want to take some more capacity. If they do, then they're going to make some changes, add some pumping stations, to boost that pipeline. 

In addition to that, you've got natural gas that they used to flare up there, just burn it off, because there were no pipelines. Now, they've got the processing plants and the pipelines to get that out. However, again, that's filling up. Kinder Morgan, they mentioned that they're looking at some natural gas pipeline possibilities. Maybe taking it down the Rockies, maybe going to California. 

The third thing they produce out there is natural gas liquids, NGLs. Oneok is in the process of building the Elk Creek Pipeline, which will move NGLs down the Rockies and also pick up some from Powder River Basin. There's a lot of pipelines that they're building, there's a lot of pipelines that need to be built. There's huge opportunity, especially for income investors that are looking for growth and income. Pipeline companies that are building in the Bakken could be pretty big in the future. 

Sciple: We're seeing all this investment from the pipeline players. It just goes to show that over the long-term, they're expecting oil to continue to come out of this region and for production to continue going forward. 

Let's talk about some of the players in the Bakken that investors maybe should be aware of, maybe should pay attention to, for their portfolios. To start off, let's talk about Continental Resources. It's one of the largest players in the region. They claim to be the largest leaseholder in the Bakken. They also have leading positions in Oklahoma and the SCOOP and STACK plays. What's going on with Continental Resources right now? What should investors pay attention to?

Dilallo: They've been the first mover out there, so they were able to gobble up a bunch land back in the early part of the drilling boom. They've been able to drill. They have so much drillable land out there that they can grow and grow and grow. 

This year, between their Bakken land and their STACK SCOOP play, they can grow production 20-24%, which is phenomenal for a company that size. In addition to that, they can produce cash flow. Back during the drilling boom, companies were just drilling as fast as they could. They were taking on debt, issuing new stock, whatever they could to drill more wells. Now, with returns as good as they are, companies like Continental are able to just produce excess cash and still grow fast. It's great for investors because now they're actually making profits. Continental's case, they might use that money to institute a dividend. It's crazy for shale companies to actually pay a dividend, but that's what they're looking at. They could possibly buy back stock. 

They're also using that money to do some creative things. They're doing a mineral partnership with Franco-Nevada, which is a gold and silver streaming company. It's a $220 million deal that will basically give them funds to drill more wells and offset the capital program. They can use this as another growth vehicle. There's a lot that they're doing out there. 

Well-run. Their founder has been one of the champions of shale, Harold Hamm. He's constantly on things like CNB talking about how great the Bakken can be. He's really done a good job putting together a company that's geared toward that play. 

Sciple: Let's talk a little bit more about this partnership with Franco-Nevada. It was really interesting to me. I saw in one of the more recent Continental Resources' earnings calls, John Hart, their CFO and treasurer, said that this is a first-of-its-kind partnership between a streaming-type resource company and a shale producer. They're partnering together to where Franco-Nevada is going to help purchase the new leases while Continental is going to work along with them to choose the new places that they're interested in drilling. They'll get some investment from Franco-Nevada to help supply that.

When you look at this deal, do you think this is something that could become a trend more long-term for other shale players? What kind of opportunities do you think this provides differently than the way things have been done in the past?

Dilallo: It looks like it could be a trend. It's the second type of these companies that's formed. The other is Viper Energy, which Diamondback Energy formed a couple of years ago. They've used it kind of like an MLP. They've converted it to a corporation, but where they would drop down these royalty acres or acquire these royalty acres, and they'd use that to generate cash flow that they'd pay to investors. It's kind of an income-producing vehicle. In Continental Resources' case, they're going to use this initially as a growth vehicle. They're going to try to buy up some more of these royalties and build up a company that they could turn into an IPO. They could split it off. They have a lot of options for it. It's another way to raise cash. Oil companies always need money. Even though they're generating cash flow now, oil prices take a dip, or they decide to grow faster, they'll need that cash sooner. They're always drilling more wells, and it costs lots and lots of money to do that. So, it's a way to do that and maybe free up some cash flow now that they can use to buy back stock, pay down debts, something like that. 

I do think it'll probably become a trend to watch for investors, especially those that like income, because that's what these are geared toward. 

Sciple: It's a novel way to raise cash. When it comes to the energy game, cash is king, it seems to be the case.

Let's talk about another player in the Bakken region. That's Hess Corporation, HES. Hess has some plays going on in the Bakken. They're also involved in Guyana. They partnered with Exxon (XOM 1.15%) to drill one of the largest offshore discoveries in recent memory. Do you want to talk about what's going on with Hess? What's going on in the Bakken with them? How does the Bakken fit into their overall strategy for the business?

Dilallo: Hess has been an interesting name. They've really reshaped their portfolio the last couple of years. They sold off a lot of different things. They sold off their Utica shale stuff, they sold off a lot of international plays. But they've kept what they think are the best. In their case, it's the Bakken. Hess is one of the better drillers out there. They have a manufacturing process that they've taken toward it, where they're drilling wells focused on cutting costs and really manufacturing oil out there by drilling wells that they have a high probability of delivering certain production growth rates and certain returns. They're using things like the Bakken, Guyana, as the growth engine of the company. They think they can grow production of the Bakken at a 15-20% compound annual growth rate through 2021. They have enough inventory to drill for about 15 years at $60 oil. Higher oil prices free up some more inventory. There's plenty of growth out there. They just added another rig earlier this year, they plan on adding another rig. Lots of growth out in the Bakken.

That will help them in the near-term while they and ExxonMobil ramp up this Guyana find, which is truly amazing. It has loads and loads of low-cost oil out there. Hess sees that as being the next growth driver, probably 2020-2021 when that'll come online. 

They think they can grow cash flow at a 25% compound annual rate for years to come. These two plays are so high-margin, will produce so much money. Hess, between these two, could be a really great long-term oil company, because they can do it at $60 a barrel. Really interesting long-term name.

Sciple: Let's talk a little bit more about, in Guyana, Hess' partnership with Exxon, that relationship there. Exxon is the operator there. How advantageous is that for Hess? That has to be a great resource to have, partnering with such a large oil player like Exxon.

Dilallo: Yeah, Exxon is one of the better companies in the business at drilling for returns. They've been phenomenal over the years at some of the interesting metrics, like returns on capital employed. Because they're so focused on returns, that's what benefits Hess here. Exxon will invest in this play because it's going to produce long-term returns and very good returns. Exxon sees this as being one of the key drivers, along with the Permian, of enabling it to double earnings by 2025. For a company the size of Exxon, that's a huge, huge growth potential. So, for Hess to be a partner on this, it's really a great deal for Hess. Exxon knows how to drill, knows how to produce oil. I like Hess specifically because it's locked in. But you add the two together, and it's a really nice company to follow.

Sciple: When you look at management's presentations, they talk about that Guyana and the Bakken are their growth drivers, but they have some other plays that are more of their cash flow drivers that they use to feed those growth engines. That's their assets in Malaysia and the Deepwater Gulf of Mexico. They're saying those plays are getting them 70% of the cash from operations through 2020, but only 20% of their capex. These are things that don't require a lot of capex to keep throwing off cash, but they can really use those other assets that they have to generate cash, to really invest in those big growth drivers, like you mentioned in Guyana and the Bakken.

Dilallo: Right. That's something that investors should look at when they're looking at oil companies. Some, like Continental, are just focused on shale plays. These pump in a lot of money upfront, and they produce really fast. Then there's longer-term things like offshore, oil sands, LNG. They take a lot of money upfront, and take years before they come online, but then they produce lots of cash and production for years to come. That's what Guyana will be. It's a large upfront investment, but in the future, it'll turn out to be like Malaysia, like the Gulf of Mexico, where it can produce cash flow for years to come with little long-term investment. That's another reason why I like Hess over a company such as Continental. It does have these cash flow drivers, so it'll make more steady income over the years. It just reduces the risk for, if oil prices were to collapse again, we'd see the Bakken shale probably not grow as fast, which would hurt Continental, but it probably wouldn't hurt Hess' long-term growth.

Sciple: We wanted to mention, for folks that are income investors, Hess also has a midstream entity that you can buy shares in. It has a 6% yield. It's been growing distribution at 15%. Strong financials, no debt. Do you want to talk about what opportunity that Hess Midstream vehicle might be for more income-focused investors?

Dilallo: If investors don't want to be exposed to oil prices, Hess Midstream is an interesting way to play the Bakken without having that exposure to oil prices. It basically builds gathering pipelines, which are the need to hook oil and gas wells to the country's midstream pipeline system. It helps Hess be able to get this production to customers. It's basically like a toll booth, and they just collect steady cash flow as volumes flow through. They're able to take that cash flow, reinvest some of it into building more pipelines, more processing facilities, that sort of thing, and then distributing it to shareholders. 6% in today's environment is pretty good, and it's a very safe 6%. They have no debt. They cover their dividend very well with cash flow. They have lots of growth ahead because they're helping Hess, with Hess growing its production over 15%. Those volumes will flow through the midstream pipelines, generating cash flow. They think they can grow that distribution by about 15% a year for the foreseeable future. Add in the potential to help third parties out, and I think it's a really interesting way to play the Bakken without getting all that exposure to oil.

Sciple: Going away, we've talked about how we got here with the Bakken, where the Bakken is today. Looking forward into the future, what's your view of the prospects for the Bakken going forward the next five years or so? And, how does the Bakken relate to the other shale plays in the United States? To the Permian and other places across the country? How do you think investment in the Bakken might be affected by what happens in these other shale plays?

Dilallo: There's been so much talk about the Permian Basin. It's growing so fast. Too fast, actually, because they've run out of pipeline room. That's not going to be solved until next year. Because drillers can't grow in the Permian, those that have assets in other areas will need to either slow down or move that capital to places like Bakken and Eagle Ford. You look at a company like EOG Resources, ConocoPhillips, Marathon, those all own assets in multiple shale plays, including the Bakken. We could see them move some rigs up the Bakken in the next year, at least, especially with how good the returns are up there. I think we'll see some shifting around to other plays, just because you can't grow as fast in the Permian for the next year. And, it just makes sense to diversify. Not only are there issues with pipelines, but there's issues with not having enough service capacity, there aren't enough people on the ground, there aren't enough pumping units, and all those different things that go into tracking a well. There just isn't enough of that in the Permian. There is more capacity in places like the Bakken. I think that'll draw companies. They'll look at returns, and they'll see, "Hey, you can get a really good return in the Bakken. Let's pour some money out there."

Sciple: Awesome, great stuff for our listeners. I think, especially as the Permian continues to tighten, the Bakken is going to continue to look like a compelling oil play going forward. Thanks for coming on, Matt! Anything you want to say going away for our listeners?

Dilallo: I think oil prices are going to be higher in the next couple of years. I'd definitely look at oil stocks. I think the Bakken's a good place to look at with the Permian. Continental, Hess, companies that own multiple shale plays, I think investors can make some money going forward.

Sciple: This is probably a story we're going to continue following going forward. I'll be happy to have you back on the show here as the story continues to develop.

Dilallo: Thanks for having me!

Sciple: Thanks so much, Matt!

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As always, people on the program may own companies discussed on the show, and The Motley Fool may have formal recommendations for or against any of the stocks mentioned, so don't buy or sell anything based solely on what you hear. Thanks to Austin Morgan for his work behind the glass. For Matt Dilallo, I'm Nick Sciple. Thanks for listening and Fool on!