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2 Producers Switching to Oil for Better Returns

By Callum Turcan - Oct 16, 2013 at 10:27AM

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Bill Barrett is switching to oil from natural gas to move its bottom line back into the green.

Bill Barrett ( HPR ) has had a rough few years as plummeting natural gas prices have eaten away at its profits and forced it into the red. Now Bill Barrett wants to show investors it can change and is focusing 100% of its capital expenditure budget on oil.

Product mix
Barrett's production stream was 95% natural gas and 5% oil in 2008, and that was great until natural gas prices crashed. For 2013, management is guiding for 25% of its output to be oil and 7%-9% natural gas liquids with the rest natural gas.

In order to hit that target Barrett is focusing on different liquids-rich plays, like the Denver Julesberg Basin, which houses plays like the Niobrara and Wattenberg. In this area, most of Barrett's recoverable reserves are oil.

With 12.5 million barrels of recoverable oil equivalent and 509 net locations to drill, there is a good possibility of strong oil production. Production currently stands at ~3,000 barrels of oil equivalent per day. Management plans on increasing that further with four rigs operating in the area to complete 65 gross wells in 2013. Most of those wells are going to come online in the second half of the year, with only ~20% completed so far. This could provide a strong growth catalyst within the next six months for cash flow. 

Explosive growth, albeit off of a very low base, could enable Barrett to switch from an unprofitable natural gas company to a profitable oil producer as long as the growth runway is long enough. To maximize its growth runway Barrett is investing in multiple plays. Another oil-rich play Barrett is investing in is the Uinta Basin in Utah and Colorado. Barrett has 47 million boe of recoverable reserves with 639 net locations to drill in the play. With production at 6,740 boe/d there is plenty of room for growth.

The company has a long way to go before it can be consistently profitable, but it has made numerous improvements. It sold off some natural gas assets to pay down its credit line and use its cash flow for growth.

In the Uinta play oil production is up 105% in the past two years while well completion costs are down $1 million per well. This is promising news, but as an investor I would wait through a couple more earnings releases to make sure everything is going smoothly unless you are willing to take on the additional risk. Barrett has promising prospects, but waiting a few months could reduce this risk.

The switch
Another company that got burned by plummeting natural gas prices and is undergoing a similar reconstruction is Chesapeake Energy ( CHKA.Q ).

Chesapeake Energy spent 87% of its capex budget on dry gas and 13% on liquids in 2008. In 2013, only 13% of its capex budget is being spent on dry gas and 87% is being spent on liquids production as oil prices recover and natural gas prices remain low.

This is a complete turnaround, and it's crucial that it pays off, because if it doesn't Chesapeake will be in dire financial trouble. Chesapeake has been running off of asset sales and debt for the past few years to undergo the transition as capex spending outstrips operating cash flow. If the transition doesn't work then that debt will choke off future plans for growth.

2013 has been a good year for Chesapeake as oil production is up 25% year over year while capex spending is down 46%. This has almost closed the gap between spending and operating cash flow and is why management is forecasting that it won't need asset sales to make it through 2014.

Part of its plan that's working is the Eagle Ford play. Chesapeake's ~380,000 net acre position in the Eagle Ford has seen production rise to 85,000 boe/d, and Chesapeake still has over 3,800 drilling locations in the area.

I wouldn't be a buyer of Chesapeake because the risk reward story doesn't pan out. If in 2014 Chesapeake isn't profitable it will be in serious financial pain, and the recent run-up won't be justified. If it does meet that level then this company will have justified the run-up but will need to prove to investors that it can maintain a stable financial position.

Final thoughts
Oil is where the profits are and it's always a good idea to take advantage of higher margins. Pure natural gas players got crushed when natural gas prices plummeted during the financial crisis and shale plays boosted production upwards, but now they are making a comeback through investments in liquid assets.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis – even one of our own – helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.

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