Why You Should Take the "Moneyball" Approach To Energy Investing

Source: WPX Energy Media Relations

In the past 15 years, the way we look a sports has been completely turned on its head. It all started with the advent of new metrics for analyzing baseball -- now known as "sabermetrics", Moneyball. That type of thinking has permeated almost every major sport, and is even starting to take hold in the non-sports world as well. One industry in particular is starting to reap immense results from this thinking: oil and gas. Let's take a look at how the sabermetric-savvy companies like Halliburton (HAL 1.11%) and Core Laboratories (CLB) are turning conventional drilling wisdom on its head, and how investors taking the moneyball approach to energy could pay off in the long run.

Drilling & fracking for drilling & fracking's sake
One of the overwhelming advantages that has allowed the moneyball approach to make its way into other aspects of business and industry is that this approach looks beyond the conventional wisdom to better evaluate outcomes. In baseball, the novel concept was buying wins versus buying players. In the case of oil and gas, it's more about investing in a return on what is produced rather than the total produced. 

Ever since hydraulic fracturing started taking off here in the U.S., the entire industry has been on a quest for more: More wells, more fractures per well, more length to horizontal drilling. This has made drilling rather easy, but at the same time it may not be the most economical process. To give an example, here is a layout of Rosetta Resources' drilling plan for some of its acreage in the Eagle Ford shale.

Source: Rosetta Resources Investor Relations

Notice how everything is evenly spaced with nearly identical lateral lengths. The reason that this isn't the most economical method is that the shale formation these wells are drilling into is likley not of homogeneous thickness and consistency. This means that not every well needs to be drilled to the same length as the one next to it, or even at all sometimes.

Working with Devon Energy, Halliburton is starting to show the effect this is having on the bottom line for producers. Devon was finding that only one in 11 wells drilled in the Barnett was producing at an economic rate. To alleviate this issue, the two companies have reevaluated the way Devon selects the location of a new well. Rather than focusing on even spacing for complete coverage across the entire acreage, Halliburton has Devon focused more on well location selection, such that the wells drilled will tap the reservoir in a way that will extract the most oil and gas with the minimal amount of wells. This type of thinking has not only allowed Devon to drill less, but is also helping it achieve a 50% production improvement at those drilled wells.

The same issue with drilling is also rearing its head in the fracturing of wells. It goes back to the same idea that applying the "more is better" technique may not be the most economical method for stimulating wells. Core Labs CEO David Demshur has gone on record saying that Core's research into hydraulic fracturing shows that more than 80% of fracturing stages in a well flow little to no additional oil into the well bore and are unnecessary. The region that suffers from this the most is the Bakken region of North Dakota. 

Add those two things up, and you have an industry that is ripe for more efficient operations. Companies like Core and Halliburton are in the process of developing new data analysis tools that can better identify these inefficiencies and will likely profit from them. Considering the amount of drilling activity today, these new analysis tools are likely to become huge profit drivers for these companies in the future

Taking  to their benefit
Moneyball tactics aren't just for industry experts. Everyday investors can even take some of those very ideas and apply them to energy investments. One of the metrics that has been en vogue for evaluating the operational success of a company is cost per well. From an investor's standpoint, though, this metric isn't a very good reflection of what we are looking for: A return. One of the major drivers of reducing the cost per well is that many wells are being drilled from a single pad. But looking back at Halliburton's example in the Barnett, what's the point of driving down the cost of a well if it isn't producing anything? 

There are numerous ways that investors can look at statistics in the energy industry and find metrics that are more in line with their interests. For instance, instead of looking at the cost per drilled well, one way that investors could evaluate wells is by comparing the cost of that well to its estimated ultimate recovery. Not only does this give a number that more directly correlates with the expected return on a well, it also helps to give an apples-to-apples comparison across shale formations in the U.S.

Below is data collected by Bloomberg from various shale formations in the U.S. showing the average well cost from multiple operators in a given shale formation as well as the total well cost divided by the total amount of estimated recoverable oil from those wells. 

Source: Bloomberg Industries, authors calculations

By no means is this a perfect metric. It doesn't really take into account that oil is produced from a well over time, and it can only really evaluate one well at a time. But since most investors don't have a discounted cash flow model sitting around at home, it works as a rough gauge of what a well translates to in production costs. 

What a Fool believes
The addition of hydraulic fracturing as a tool exploration and production companies can use for extracting oil and gas has sent companies on a quest to drill as fast as they can and boost production. While that sounds great, it may not necessarily be the best thing for investors looking to make a return on investment. Contributions from companies like Core Labs and Halliburton will make exploration and production companies a little smarter about how they extract oil, and will likely make them a decent chunk of change in the process. Still, as investors we need to sometimes look beyond just the juicy numbers like production growth and declining well costs and see if those numbers will translate into earnings in our pockets.