Shale oil and gas: the greatest growth story of the coming decade

A British-based fund is one of the best ways to play the theme, says David C Stevenson.

What's your view on unconventional' sources of oil and gas especially shale? If you'd asked that question of most investors a few years ago, it would have elicited nothing more than baffled silence. But in the last 18 months everything has changed.

Tales of shale

Newspapers are abuzz with tales of America gaining energy independence courtesy of its huge reserves of unconventional' gas and oil, which are being liberated from shale rock formations by new drilling techniques.

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Many economists reckon that this energy feeding frenzy has knocked a few percentage points off US inflation rates over the last few years, as well as creating anything from a few hundred thousand to more than a million jobs (depending on who you talk to).

Official figures show that production of shale gas has risen to around 26 billion cubic feet per day (bcf/d) in 2013, compared to just 4 bcf/d in 2007. If this growth rate accelerates, the Energy Information Administration, a US government statistics agency, expects roughly half of all American natural-gas production to come from shale by 2020.

Canada is also big in unconventional oil and gas. But shale isn't just a North American story. British TV news is full of stories about a government desperate to kickstart shale exploration, egged on by experts who maintain that we in Britain have quite possibly the biggest reserves of shale gas anywhere outside of America.

The effect of shale gas on the price of crude oil is also squeezing the profit margins of the big UK-based integrated energy majors. For investors the main challenge of tapping into the unconventional' story is working out who to believe. The pessimists will tell you that it's almost always more complicated than the headlines suggest.

Firstly, there's that term unconventional', which actually includes many other forms of energy extraction beyond shale gas such as methane bed extraction and (dirty) tar sands in Canada. Natural-gas extraction costs may be plunging, but tar-sands overheads are still extraordinarily high.

And even within the core area of shale gas and shale oil, we have vastly contrasting stories. Companies such as Royal Dutch Shell are struggling to make money from their businesses tapping into the stuff in North America. That's because as industrial engineering techniques are introduced to the industry, net costs are collapsing. That makes it easier for rivals to enter the market, driving down profit margins. It's also helped to drag down natural-gas prices over the last few years (although prices have ticked up in recent months).

Many commentators also worry that many shale-gas platforms suffer rapidly diminishing returns from old well heads (in other words, there's a big drop off in production within a relatively short period after the initial discovery), which constantly forces producers to hunt for new sites.

Yet these concerns aren't echoed across the whole sector, especially not among the growing army of feisty independents operating in mature fields in America. In fact, internal rates of return (IRR) may even have risen considerably from a year ago.Then the average IRRs in the Marcellus and Utica shale the most productive and lucrative shale plays in America were thought to range between 12% and 30%. Yet these numbers may in fact be underestimating the potential for profit from shale.

American website Seeking Alpha (flagged up in a recent report from Cantor Fitzgerald) looked at the top ten American shale fields by profitability, using their annualised IRR as a yardstick.

The numbers are startling: the Marcellus Super Rich (in Pennsylvania and West Virginia) produced a return of 74%, followed by Utica Liquids Rich (Ohio) at 73%, Eagle Ford Liquids Rich (Colorado) at 66%, and Mississippian Horizontal East at 60% (these numbers were compiled from reports of various shale energy firms).

New players

Given these extraordinary returns, it's no surprise that many new players in the sector have tried to look for new shale hot spots. The UK is one, but we're hardly alone: Poland, Turkey and Argentina are also potential hotspots.

But don't let this international rush blind you to the brutal reality international exploration may be exciting, but it's almost completely irrelevant when compared to the huge North American sector. And of course it does help that all of this unconventional oil and gas is sitting in the US and Canada, both super-safe, trusted jurisdictions.

The only challenge in North America apart from the obvious one of dragging yet more hydrocarbons out of the ground and then burning them off into an already warming atmosphere seems to be working out how to get the stuff onto global markets, via new pipelines and natural-gas shipping infrastructure.

Tread carefully

To me, the unconventional energy scene is the great growth story of the next decade. It also spills out into new energy infrastructure investments, and even intersects with next-generation cleaner technologies that, for instance, allow US lorries to run on liquefied petroleum gas (LPG). But finding a way to play this collection of big stories' is very tricky, especially at the level of individual stocks.

For example, I'm reluctant to buy individual independent unconventional producers because I have no way of understanding the individual operational risks of which there are plenty.

I've always preferred the oil-equipment and services suppliers, and regulated infrastructure plays, but I can understand why many investors would still like to access the core oil-and-gas exploration-and-production stories. The trouble is, funds that track this sector are in very short supply.

Most existing conventional energy fund managers, such as Tim Guinness over at Guinness Asset Management (one of the highest-rated managers in this area), have invested heavily in this sector, but unconventional equity plays are usually mixed in with various integrated energy companies and state-owned oil majors in Brazil, Russia, India and China (the Brics).

Some investors are tempted to play the shale theme by investing in natural-gas futures trackers instead. These are issued by the likes of ETF Securities and Boost ETP (both offer pure-play trackers as well as leveraged and short versions).

But I'd steer clear of these unless you are a very experienced energy investor who can second-guess where these futures markets are heading (which rules most of us out).

The best fund in the sector

But here in Britain there may be an interesting, newish play that gives you focused exposure to the sector via an experienced fund manager.

UK-listed, closed-end fund New City Energy (LSE: NCE) has been mentioned in passing before in this column, largely because it's had a rough old few years as oil prices have fallen back.

The fund is now quite small, and although it produces a very welcome dividend yield (currently above 5%) it has been trading at a rather chunky discount to net asset value (NAV the value of its underlying assets), largely because it's been trying to make profits by investing in conventional listed, mid- and small-cap exploration-and-production businesses a tough world that isn't getting any easier because of all this cheap shale gas.

But the management of New City Energy has realised a change was needed, and has decided to refocus the fund onto unconventional oil and gas. The portfolio has largely been restructured, and hopefully the managers will be looking to raise some fresh cash on the market, which should bolster sentiment.

Meanwhile, you still get a useful dividend yield of around 5.5%, and a very concentrated chunk of holdings in outfits such as Canada-listed Vermilion Energy (TSE: VET).

This C$6.1bn market-cap business pays a 4% dividend yield (many of the unconventionals produce very generous dividends), and has existing production in Canada, Europe and Australia. It's also the top conventional oil producer in France, giving it a competitive head start in continental Europe.

Another big holding is PHX Energy Services (TSE: PHX), a much smaller business (C$400m market cap), which again produces a generous yield of more than 6%. It provides horizontal and directional drilling technology and services, with operations in North America, as well as Peru, Colombia, Albania and Russia.

According to New City Energy, as unconventional resource plays are developed outside North America, the provision of drilling services will be absolutely crucial.

Two tempting ETFs

The only alternatives to this London fund can be found in America, in the form of two exchange-traded funds (ETFs), both of which can be bought via British stockbrokers.

The first is First Trust ISE-Revere Natural Gas Index Fund (NYSE: FCG), which tracks an equal-weighted index of companies that "derive a substantial portion (more than 50%) of their revenues from the exploration and production of natural gas".

The average price/earnings (p/e) ratio of the companies in the fund is 17, with a price-to-book ratio of 1.6 and price-to-cash-flow of four. Top holdings include Magnum Hunter Resources, Penn Virginia Corp, Ultra Petroleum and Cabot Oil & Gas. The fund returned 25% over the last 12 months.

Another American ETF firm offers a broader take on the theme (the First State fund is clearly very focused on natural gas). The Market Vectors Unconventional Oil and Gas ETF (NYSE: FRAK) is one I hold in my self-invested personal pension (Sipp).

This ETF invests in businesses within an index that tracks everything from coal bed methane and coal seam gas stocks, through to shale oil and gas as well as something called "tight natural gas, tight oil and tight sands".

This ETF is overwhelmingly American and Canadian-focused 78% and 21% of holdings respectively and was also up 26% last year. Top holdings in this fund include EOG Resources, Occidental Petroleum, Anadarko, Hess and Pioneer Natural Resources.

The Market Vectors ETF tends to have broader, more large cap appeal, while the First State ETF is much more mid-cap focused with an obvious natural-gas bias.