Dig up big profits in Britain’s shale gas revolution

Britain has some of the largest shale gas reserves in the West. Backing the firms set to tap them could prove lucrative. Matthew Partridge tips the best shares to profit.

Britain has some of the largest shale gas reserves in the West. Backing the firms set to tap them could prove lucrative, says Matthew Partridge.

Not so long ago, if you'd mentioned the term fracking' to the average British consumer, there's a good chance you'd have got little more than a blank look.

But now, almost everyone has heard of the revolutionary and controversial technique for extracting oil and gas from once hard to reach shale deposits.

Subscribe to MoneyWeek

Subscribe to MoneyWeek today and get your first six magazine issues absolutely FREE

Get 6 issues free

Sign up to Money Morning

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Sign up

Hydraulic fracturing' to give the method its full name is not new. It was first used in 1947. The 1970s energy crisis also led to a resurgence of interest in fracking, with some American and Canadian oil wells using it.

However, it's only in the last decade that high energy prices, combined with new developments in drilling techniques, have made tapping into reserves of shale oil and gas viable.

The shift has already had dramatic consequences, particularly in America. Oil and gas production in the US has surged. On some measures, it recently displaced Saudi Arabia as the world's largest oil producer, or is about to.

Domestic energy prices have tumbled too, as a result of a glut of natural gas coming to market (while oil is a global market, gas is trickier to transport, and so US gas prices are now far lower than those in other countries).

The impact of this shale revolution' is still being felt both within America and across the globe, and offers plenty of opportunities for profit for smart investors.

Britain's shale treasure trove

But it's not just the US. Unsurprisingly, other countries are keen to emulate America's success and develop their own reserves. Britain may be one of the nations in pole position to do so. In fact, there is strong evidence that Britain has some of the largest shale gas reserves in the Western hemisphere.

This summer, experts from the British Geological Survey (BGS) announced there could be up to 2,281 trillion cubic feet (tcf) of gas in the ground beneath Lancashire.

To put that into perspective, even using the more conservative central estimate of 1,329 tcf, the Bowland-Hodder shales hold just a little less than the equivalent of the total proven oil reserves of Saudi Arabia.

Of course, as the BGS made clear, there is a lot of uncertainty around these figures. We won't know exactly how much gas there is until more detailed drilling and exploration takes place. But what makes the BGS view so compelling is that the group has no reason to exaggerate.

In fact, in the past, the BGS has repeatedly criticised oil and gas companies for making over-the-top claims. So if it agrees that there are large gas deposits to be had, then they almost certainly exist.

Northwest England is not the only area with huge shale potential. There are several such belts. One stretches from Crosby in Yorkshire down to southern England. Another runs from Hatfield to the Severn Estuary region including both Swansea and Bristol. And there are smaller areas within Midlothian in Scotland and Fermanagh in Northern Ireland.

While not all of these will prove fruitful, there is certainly the potential for Britain to become a major player in the world energy markets.

Fracking has, of course, caused controversy, even in the US, and the idea of planting drilling rigs in densely populated areas of Britain has predictably caused a stir.Recent protests in the Sussex town of Balcombe demonstrate that there is substantial opposition to fracking, especially in areas close to developments.

However, overall public opinion at least for now remains on the side of development, with the latest polls suggesting that the majority of people support shale gas.

With Britain facing energy shortages, and bills extremely high on the agenda, all three main parties agree it will become a key part of Britain's energy supplies, and the government is eager for British shale gas reserves to be tapped.

A temporary ban (see below) on fracking was lifted last December, and this summer Chancellor George Osborne announced that he is cutting the tax on onshore exploration to 30%. Not only is this new rate far below the 62% top rate applied to North Sea production, and the 82% levied on other offshore fields, but it is also one of the lowest such taxes in the world.

To try to reduce opposition from local voters, 1% of revenues and a fee of £100,000 per well will go directly to the communities affected by development.

Michael Fallon, the energy minister, has already issued 170 licences to enable exploratory drilling to take place, and he expects up to 40 wells to be operational within two years.

America's new industrial revolution

But the biggest beneficiary of the changes wrought by fracking remains America. Due mainly to fracking, the amount of crude oil produced by American oil fields has risen by 50% in the last six years. That means production is back to levels that were last seen at the start of 1990.

Fracking has also had a dramatic effect on gas prices. Measured by the Henry Hub spot price, they are now a quarter of what they were at their peak seven years ago.

At the current level of around $3.50-$4MMBtu (millions of British thermal units), prices are low enough to be massively beneficial to consumers and companies, but just high enough to remain profitable enough for explorers and to fund further drilling.

The biggest winner from all this has been the US manufacturing industry. Cheap gas means cheap energy, and that's very attractive to energy-intensive businesses.

Indeed, the International Energy Agency (IEA) believes the US will maintain its competitive edge over Asia and Europe for the next two decades, reports the Financial Times. "Although the IEA expects the US to start exporting more of its gas the high cost of shipping it overseas [will] mean that importers pay a higher price than domestic customers."

The IEA expects Japanese and European gas prices to still be twice as high as America's by 2035. That's actually a big improvement over the gap today, but clearly it's still a big advantage for America.

As a result, and combined with factors such as rising wages in countries like China, the US is likely to benefit from reshoring' (companies returning from overseas) for years to come. That should also result in healthy ongoing demand for natural gas from shale sources, even if prices do pick up from here.

And it's not just energy-intensive manufacturers who can use cheap gas to cut costs. Gas is making inroads into the last bastion of oil's dominance the transport sector. If the gap between oil and gas prices remains at these sorts of levels, drivers and businesses could save a fortune by converting from petrol and diesel-powered vehicles to ones that run on natural gas.

Already more than half of all new rubbish trucks in America run on natural gas, and companies such as Procter & Gamble and logistics group UPS are growing their natural gas fleets.

Companies are able to use their own fuelling depots, but on the private driver side, uptake of natural gas vehicles is hampered by a lack of natural gas stations. However, the rapid growth in the number of trucks switching has resulted in a parallel increase in the filling station network.

Clean Energy Fuels, founded by oil explorer T Boone Pickens, already has more than 400 fuelling stations across America. As these networks continue to expand, this should encourage those who have so far resisted the change to reconsider it.

Investing in boom towns

Other big beneficiaries include the local economies of shale boom' states, such as North Dakota. Thanks to the Bakken formation, the state's crude oil production has shot up sixfold in six years. As a result, it is now close to overtaking Texas to become the largest oil producer in the US.

This has had an electric effect on the local economy, drawing hordes of oil workers to the state, and turning the areas next to the rigs into boom towns. Restaurants are mobbed, with fast-food workers earning far higher salaries than they would do elsewhere.

There is also a shortage of housing, meaning big potential profits for companies trying to meet this need.

And with growth in output outstripping the pipeline infrastructure available to carry oil and gas around the US, American energy firms have been forced to transport a growing amount of oil by rail the amount of oil transported by rail has gone up tenfold since 2008, with around 100,000 carloads shifted every three months. Canadian companies have also moved 4.3 million metric tonnes of oil in the last three years.

Of course, pipeline construction will inevitably start to catch up. However, rail firms are betting on the boom continuing, investing in more track and terminals. You can find out how to profit from all this below.

How dangerous is fracking?

Fracking uses large quantities of water to force underground deposits of oil, gas, or even (in a few cases) uranium to the surface, and to improve the productivity of existing wells.

Opponents have pointed out the fact that in a few cases in America the process has been linked to the contamination of groundwater supplies, by the chemicals used in the process.

Most notoriously in Britain, preparatory drilling was blamed for several earthquakes in Blackpool in spring 2011, leading to a temporary moratorium.

However, research carried out by government body Public Health England suggests that water supplies are safe, provided there is a minimal amount of supervision.

As for earthquakes, a study carried out by Professor Richard Davies of the University of Durham, funded by a consortium including the European Commission and the Royal Society of Chemistry, concluded that fracking "causes as much seismic activity as falling off a ladder".

Perhaps the most convincing evidence that fracking is safe comes from the fact that it has already been taking place on a small scale in mainland Britain for decades.

Indeed, the Beckingham Marshes oil development in Nottinghamshire has been fracked four times between 1963 and 1989. It currently produces 300 barrels of crude oil and one million cubic feet of gas daily, enough to power 21,000 houses.

Overall, the Royal Academy of Engineering estimates that 200 oil wells in Britain have employed fracking at some point in order to boost their flow.

The six stocks to buy now

If you're looking to play the potential of British shale, then David Stevenson of The Fleet Street Letter newsletter suggests Aim-listed British energy firm IGas Energy (Aim: IGAS).

Having acquired licences to develop oil and gas in a 300-square-mile area in the Bowland basin, it announced in the summer that it had found around 102 tcf of reserves, although the total could end being 170 tcf.

It is now in the process of negotiating deals with major industrial firms in the area who might allow it to use their land in return for cheap energy.You can find out more and read about David's other tips in The Fleet Street Letter.

Several American energy companies have invested heavily in shale gas. Devon Energy (NYSE: DVN) is among the most conservatively valued, according to US financial paper Barron's. It trades on a price/earnings (p/e) ratioof 11, and offers a dividend yield of 1.5%.

Devon was hit both by the drop in the price of natural gas in recent years, and a fall-off in demand for oil from the Canadian oil sands, which it is also involved in. However, the company's decision to sell many of its overseas assets to focus on more profitable crude oil, and a rebound in prices, has stabilised the situation.

Devon has been able to pay off debt, and acquire extra fields, which should enable its production levels to grow at a double-digit rate for the foreseeable future. The share price remains 15% below where it was five years ago, as Barron's points out "rival companies are up an average of 72%" over the same period of time.

Transporting the oil produced by fracking cheaply and quickly is a major problem for energy companies in the US. However, it is good news for American Railcar Industries (Nasdaq: ARII). The company makes freight containers and hopper cars (a type of rail car used to transport bulk commodities).

Thanks to the shale boom, it has been able to expand its tank car (a type of rail car used to shift oil) business. It also has ambitious plans to establish a global presence, starting with a joint venture in India.

As a result, revenue has surged by over two-fifths in three years, leading the stock to go up by over 25% since the summer. However, despite this, it still trades at a p/e ratio of below 12.

Another good all-round play on the increasing infrastructure needed for transporting natural gas around the country is Plains All American Pipeline (NYSE: PAA).It has a network of over 18,000 miles of oil pipelines serving various parts of the US and Canada, including the Bakken shale and Eagle Ford shale fields.

It has a subsidiary that owns several terminals that store natural gas and process it into liquids suitable for transporting by truck, and has also bought additional natural gas holdings from BP. It trades on 16.8 times forward earnings, but offers a decent yield of 4.5%.

A risky play on the increasing demand for natural gas vehicles is Clean Energy Fuels (Nasdaq: CLNE). The company builds and runs fuelling stations providing both compressed and liquefied natural gas, and makes related equipment.

Last month, the company signed a deal with industrial giant GE to provide financing for companies that want to convert their existing fleets to trucks that run on natural gas. Don't bet the house on this one, but if natural gas vehicles take off in a big way, it should benefit.

As for profiting from those US states that are most involved in the shale bonanza, you could try Investors Real Estate Trust (NYSE: IRET).

This Reit (real-estate investment trust) is in a great position to benefit from the influx of oil workers to North Dakota. A third of its residential apartments are in the energy-rich state, which faces a shortage of affordable family accommodation in certain towns.

The company plans to grow its number of properties in the state substantially, with two further complexes due to open in 2014. It has also acquired substantial land holdings in the area, which should give it even more opportunities. The company offers an attractive yield of 6%.

Dr Matthew Partridge

Matthew graduated from the University of Durham in 2004; he then gained an MSc, followed by a PhD at the London School of Economics.

He has previously written for a wide range of publications, including the Guardian and the Economist, and also helped to run a newsletter on terrorism. He has spent time at Lehman Brothers, Citigroup and the consultancy Lombard Street Research.

Matthew is the author of Superinvestors: Lessons from the greatest investors in history, published by Harriman House, which has been translated into several languages. His second book, Investing Explained: The Accessible Guide to Building an Investment Portfolio, is published by Kogan Page.

As senior writer, he writes the shares and politics & economics pages, as well as weekly Blowing It and Great Frauds in History columns He also writes a fortnightly reviews page and trading tips, as well as regular cover stories and multi-page investment focus features.

Follow Matthew on Twitter: @DrMatthewPartri