How to profit from the shale revolution in Latin America

What do the Russian government and Greenpeace have in common? They both fear the spread of America's shale gas revolution. The former worries that if shale takes off elsewhere it will weaken its position in the market, while the latter dreads the supposed environmental consequences of global shale production.

I'm sure you have all heard about shale gas by now, but just to recap, shale gas is natural gas trapped within shale rock formations. Over the past decade, new drilling methods and a process called hydraulic fracturing (fracking'), which involves pumping a mix of pressurised water, sand and chemicals underground to crack underground rocks and free the gas. Producers now have access to gas that was once uneconomic to extract.

So far the 'shale revolution' has been largely confined to the US, where there is so much of the stuff, there has been a glut. This has helped to drive prices of natural gas to new lows in recent years.

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But attempts to launch it elsewhere have failed. For example, after wasting millions of dollars drilling failed wells in Poland - supposedly Europe's best shale prospect ExxonMobil pulled out of the country last year.

Fracking is not without its risks

In the US, the shale revolution has been nothing short of a miracle. And it promises to grant energy independence to the world's biggest oil importer. Indeed, thanks to shale, the US is set to overtake Russia as the world's biggest gas producer in 2015 and Saudi Arabia as the world's biggest oil producer by 2020.

The energy transformation is boosting America's economy and giving the government new geopolitical strength. It's even helped to cut the country's C02 emissions as the country's power plants switch from coal to gas. So, why aren't other countries following suit?

Well, like most miracles', shale energy comes with several strings attached. The extraction technique, fracking', involves pumping millions of litres of water and chemicals at high pressure to fracture underground rock formations to release trapped gas. And not everyone is prepared to do it.

For example, the French have banned it over fears that it may contaminate underground aquifers. In the relatively densely populated UK, 'Nimbyism' threatens to slow fracking development, as local communities recoil against the idea of heavy industry despoiling quiet rural spots. Even in places like China, where the government is often prepared to ignore environmental worries or Nimbyism, shale gas is far from certain. In this instance, the problem is water scarcity. China has the world's biggest shale gas reserves and it could sustain a widespread fracking campaign. But experts are uncertain if fracking will take off there.

But Russian oil ministers and Greenpeace activists can't breathe easy just yet. Because Latin America has the perfect conditions for shale gas and I've found one company that looks like it's about to spark the revolution over there.

Why Latin America is built for shale

As a whole, and with the obvious exceptions that mark most generalisations, Latin America has far fewer problems than are found elsewhere in the world. It has sizeable shale deposits, governments and companies that have long worked with the extractive industries, many sparsely populated areas where Nimbyism is less likely, and an abundance of water. Broadly speaking the financials also look good too. The region's strong economic growth means that there is growing domestic demand, while its Atlantic and Pacific coasts give it handy export access to the European and Asian markets, where gas sells for a higher price than it does in North America.

But Latin America is a vast place, so there is bound to be a lot of variation. So it's worth analysing the different opportunities available in each country.

Argentina's huge shale bounty

Thanks to the 2010 discovery of the Vaca Muerta field (translates literally as 'dead cow' field - odd name, I know), Argentina now has the third-biggest shale gas deposits in the world and the fourth-most shale oil.

Estimates vary but energy consultant IHS reckons the country has 6,037 trillion cubic feet (tcf) of gas and 1,135 billion barrels of oil in place. To give that some context, Britain's entire annual gas use comes to about 3tcf. Now it's worth noting that only a small portion of that gas is likely to be extracted. America's Energy Information Administration (EIA) reckons that around 802tcf of Argentina's shale gas is "technically recoverable" even so, it's still a huge amount of gas.

But despite the massive reserves, I don't think Argentina represents the best bet for New World readers. In 2009/2010, I spent five months in the country writing a report on Argentina's oil and gas sector for a US oil magazine. Socially it was great - I love Argentina and enjoyed the chance to travel out to the oil provinces. But workwise it was a nightmare. Off the record the oil execs would moan that President Kirchner's price controls and taxes meant it made no sense to invest in new production, while on the record they were too worried about upsetting the government to say anything interesting for my report.

But although the experience may not have produced the best writing of my career, it did make a deep impression on me. I hope the country does find a fair way to exploit its amazing bounty and some of my Argentinian friends can benefit. But I don't think it will be easy for small, international private investors like us to profit from it.

Three energy giants with huge prospects

Next up is Mexico, which the EIA estimates has 545tcf of technically recoverable reserves. The situation also looks promising on the government side of things too. A few months ago I heard Francisco Salazar, president of Mexico's Energy Regulatory Commission, speak at London's annual Latin American Investment Forum. He stressed that the government was keen to push shale development. Moreover, he suggested that, while the constitution bans private-sector oil companies owning Mexican hydrocarbon reserves, it may be easier to get firms to develop the country's shale fields.

But despite this optimism, I don't think it's the right option for investors just yet. One of the biggest challenges Mexican shale gas faces is US shale gas. America's established oil infrastructure and service companies give US producers a big advantage over any Mexican rivals. Indeed, an Inter-American Development Bank report on shale gas estimates that it costs five times as much to drill a shale gas well in Mexico as it does across the border in America. That means it's cheaper for Mexican industry to import cheap US gas than to worry about developing its own. Of course those dynamics will change over time especially if America starts exporting to higher price Asian markets but for now at least it's a barrier for investors.

Latin America's other energy giants, Brazil and Venezuela, both have lots of shale gas but neither seems rushed to exploit it at the moment. It's estimated that Brazil may have 245tcf of recoverable shale reserves, the third-highest in the region. But at present it is locked into the technically and financially challenging task of exploiting its huge sub-sea oil basins and can't afford to be distracted by shale. Venezuela is believed to have 167tcf of technically recoverable reserves but it's unlikely they will be exploited anytime soon. After all, with conventional oil and gas production below pre-Chavez levels, despite the massive reserves, Venezuela's national oil company has other priorities.

My favourite shale oil prospect

In regional terms, Colombia is a shale energy minnow but I actually think it offers far better prospects for shale investors. Let me tell you why. IHS estimates Colombia's shale could hold more than 3,000tcf of gas. Of this, the EIA believes that around 55tcf could be recoverable, with up to another 6.8 billion barrels of shale oil. As always, these figures need to be treated with caution but to put it in context, it's in a similar ballpark to the UK, where recent estimates hint at 1,500tcf in total with perhaps 10% of that recoverable.

Another positive for investors is that Colombia really needs shale energy. At present it is an oil exporter but with rapid growth stoking demand, it's estimated it may be importing oil by 2017. If the EIA's figures are right, shale could triple Colombia's oil reserves. Another plus is that the country has a great track record in managing extractive industries and establishing fair rules for private-sector firms and international investors.

The Colombian government offers a 40% discount on royalties from non-conventional projects and has raised the price ceiling for its crude tax. It has also worked to improve the bureaucratic processes for unconventional projects.

As David R Mares notes in an Inter-American Development Bank report on shale gas, this is a strategy that Colombia has already used with some success with conventional oil - "provide an attractive environment for investment and they will find reserves and produce".

A small company with big potential in Colombia

Canacol Energy (TSE: CNE) is a tiny, Canada-listed oil firm that owns acreage in Colombia and Ecuador. The firm has 22 million barrels of oil (boe) of proved reserves, made up of a mix of conventional and shale oil and gas. Once you throw in probable and possible reserves, the firm could be sitting on more than 52 million boe around 90% of which is in Colombia.

The firm has a real mix of assets with light oil, heavy oil and natural gas. It's currently producing about 8,000 barrels per day from these fields, which is helping to fund its efforts to explore the rest of its 2.5 million acres of concessions. And from our point of view it's this exploration that is the most exciting aspect.

The company has five exploration and production contracts covering 250,000 acres across one of Colombia's most exciting shale basins, the Middle Magdalena Valley, located in central Colombia. These assets have caught the attention of experienced international shale operators who are keen to come to Latin America. ConocoPhillips, Exxon Mobil and Shell are already partners in the firm's shale operations.

I interviewed Canacol co-founder, Luis Baena, on the sidelines of the recent Colombia Inside Out conference in London. Like most top management he does a pretty good job of selling his company, and produced a barrage of statistics to prove why his company is better value for New World readers than his competitors. But while it normally pays to treat management investor talks with a fair dose of scepticism, his arguments resonated strongly with me. He pointed out that the firm had benefited from picking up cheap acreage since 2008.

Now, as interest in Colombia's oil and gas sector grows and surrounding factors, such as security and infrastructure, improve, the value of that acreage is going up. For example, its first deal, with Exxon, valued Canacol's shale acreage at around $774 per acre. The most recent deal, this time with ConocoPhillips, put the value at $3,000 dollars per acre.

Yet even at these prices it's still far below levels in the US where an acre can swap hands for $15,000. As with any small firm, this is a risky bet, but one with plenty of upside.