The difficulties that BP and other oil companies face in the wake of the Deepwater Horizon disaster might lure investors' attention away from oil, and toward natural gas. To help investors research natural gas companies, we've pulled a few choice excerpts from a Motley Fool Million Dollar Portfolio article called "The ABCs of Natural Gas E&Ps" by David Meier.
Though Al Gore might not agree, natural gas exploration and production companies -- aka E&Ps -- are a vital link in the energy chain. And they're potentially great for your portfolio, too.
In this guide, I'll show you how this industry works -- the ways domestic E&Ps find and extract natural gas, and what we need to identify the best of the bunch.
But let's start with the most basic question.
What is natural gas, anyway?
Like oil or coal, natural gas is a fossil fuel -- the energy-rich result of eons of extraordinarily high pressure on a primordial ooze of animals and plants. It's colorless, odorless, and emits fewer pollutants than its fellow fuels -- though as a greenhouse gas, it's still harmful to the environment.
The main component of natural gas is methane, which has an array of uses, from generating electricity to incineration to manufacturing chemicals, plastics, pharmaceuticals, and much more.
How can we profit from this complex yet critical industry? To answer this, I'll walk you through how E&Ps find, collect, and distribute natural gas -- and what separates the best operators from the rest. Pumped to learn more? Let's go!
4 basic steps of exploration and production
To keep things nice and simple, I've separated what a natural gas E&P does into four steps:
- Step 1: Where's the Gas? Getting access to land that contains natural gas.
- Step 2: Shake It Up, Baby: Determining how much natural gas might be in the ground.
- Step 3: Drilling for Dollars: Drilling wells to access the gas.
- Step 4: Coming Down the Pipe: Moving the gas out of the ground and to a distribution center.
Now, let's dig a little deeper into each step in the process.
Step 1: Where's the gas?
Although the temptation to unleash a "pull my finger" joke is overwhelming, that's not the kind of gas I mean. Before it can do anything, an E&P needs access to land with underground natural gas reserves.
Deep below the earth's surface, there are two kinds of rock formations that may contain natural gas. Conventional natural gas comes from wells where gas tends to flow freely from porous rocks and sandstone. Unconventional gas, on the other hand, is packed tightly in rock formations such as shale and coal beds. E&Ps have to break through these rocks to release the gas.
What we're looking for: Ideally, the E&P will acquire productive lands with quality reserves at attractive prices. We can measure this directly by comparing acquisition costs to the volume of reserves, or indirectly by seeing the cash flow and returns the reserves generate.
Step 2: Shake it up, baby!
Next, the E&P determines where and how much gas is in the ground. Drilling wells requires a significant investment, so the more gas the company can find, the better. This is the crux of the exploration part of the equation.
Historically, E&Ps employed geologists to examine rock formations and compositions, find the energy reserves, and guide the drilling process. But this was inefficient. So when seismic technology was discovered, it moved the earth for E&Ps -- literally.
Seismic exploration involves shaking the ground, recording the energy waves that reflect off the geological formations and return to the earth's surface, and converting those waves into an image of what's below. E&Ps employ companies such as Dawson Geophysical (Nasdaq: DWSN) and CGG Veritas (NYSE: CGV) to gather this seismic data.
We're mainly interested in three kinds of reserves:
- Proven reserves: The E&P is reasonably certain that it will recover these reserves (probability greater than 90%).
- Probable reserves: The E&P is more likely than not to recover these reserves (probability greater than 50%).
- Unproven reserves: Technical, contractual, economic, or regulatory uncertainties preclude the E&P from classifying these reserves as proven.
What we're looking for: Unsurprisingly, we prefer E&Ps with a high percentage of proven reserves (a bird in the hand, and all that) -- so long as the land is acquired at a reasonable cost.
Step 3: Drilling for dollars
Now it's time to drill wells and start production! Drilling is difficult, expensive, and quite fascinating (in my opinion -- engineer here).
First, the rig is set up. These giant structures tower into the sky, and hold and control all of the drilling equipment. The rig drills a hole, known as a wellbore, deep into the ground. The well casing comes next. This is a tube that's inserted into the wellbore and then filled with cement; tiny explosives are used to make holes in the casing and the surrounding rock formation. We're getting close! Finally, the rig uses extremely high pressure to pump air, sand, water, or gel into the casing, into the holes, and into the rock. This process, called fracturing (or fracking) splits the rock further, allowing gas to flow into the well casing.
Once the gas is flowing, we have production! The E&P hooks up the completed, fracked well to a gas meter and connects it to a pipeline.
Many companies touch this drilling process. E&Ps use contract drillers such as Helmerich & Payne, Nabors Industries (NYSE: NBR), and Patterson-UTI Energy to set up, operate, and tear down the drilling rigs. Stock Advisor selection National Oilwell Varco (NYSE: NOV) and Baker Hughes supply equipment for the rigs. Then you have companies such as Schlumberger (NYSE: SLB) and Halliburton (NYSE: HAL), which provide products and services to help make those drilling rigs as productive as possible.
Step 4: Coming down the pipe
Once the gas starts flowing, where does it go? That depends on demand.
If energy demand is high, an oil conglomerate or utility will buy the gas, and the E&P will transport it to the buyer via a network of pipelines, collect its revenue, and start the whole cycle again. Many larger E&Ps own their own pipelines, while smaller E&Ps must pay to get access. There are even some companies such as Spectra Energy (NYSE: SE) that focus entirely on the distribution side, charging E&Ps a toll to access their vast pipeline system.
What we're looking for: Buyers and sellers negotiate contract prices for gas, based on the spot market prices of natural gas on exchanges such as the NYMEX Henry Hub. High natural gas prices mean more revenue for the E&P.
Picking winners
There are many factors at play when it comes to valuing an E&P. By drilling down (ahem) to the most critical, we can understand which elements have the greatest impact on returns and cash flow. Ideally, an E&P will have:
- Plenty of natural gas reserves.
- A low cost of finding that gas, drilling for it, and producing it.
- Low decline rates.
- The ability to sell gas at high prices via good hedge contracts.
The Million Dollar Portfolio team also put together a Foolish glossary of E&P terms, including the NIMBY-ish "BANANA," an acronym for "build absolutely nothing anywhere near anyone," and the crucial "decline rate," which is a measure of the change in the volume of gas produced per day over the life of a well.
