Shale Oil

We are now entering the next stage of the shale oil boom and the second wave of profits could dwarf the initial windfalls.

No longer is the United States a dormant player in the world of energy. Crude production in the U.S. reached a 25-year high in 2013, with over 8 million barrels produced daily.

In fact, U.S. oil production in 2013 grew at the quickest pace on record and has climbed from a low of 5 million barrels a day in 2008 to 8.075 million barrels per day as of December 2013.

In 2014 the U.S. will produce 8.54 million barrels per day, according to the Energy Information Administration. And the International Energy Agency now predicts the U.S. will be the world's largest oil producer by 2015, five years earlier than originally thought.

The increase is due, of course, to the exploitation of unconventional sources such as shale and tight oil.

But the first phase of the U.S. energy revolution is pretty much over. The good news for investors is that the second phase has just as many profit plays as the first, if not more.

We'll get to the best of those in a minute, but first let's explore how one technology is changing everything. 

Cost of Drilling Cut 50%

The first stage of the energy boom saw U.S. oil independents, such as Continental Resources (NYSE: CLR), conduct exploration and spend roughly $53 billion on an acreage buying spree in the lower 48 to secure drilling rights in the most promising locations. Today, there are approximately 10,000 wells a year drilled in the U.S.

That phase, while not finished, is fading into the background. As early as last spring, Chesapeake Energy said that all of the major untapped oil deposits in the continental U.S. had been found.

Now, the second phase of the U.S. oil revolution is beginning... a phase that will be led by technology.

Technology will be the key component in this phase due to the fact that oil is tougher to extract from shale rock than conventional ways. Because unconventional oil is harder to extract it is more expensive to produce than conventional oil.

In fact, shale oil is about 20 times more expensive to extract than to get oil from Middle East fields. 

U.S. shale oil wells are different too than offshore wells, which can cost upwards of $100 million each. Onshore shale wells cost only $10 million initially. But these wells have a rather steep production rate decline, so continued drilling is required to sustain the output from the field.

But that does not mean independent oil companies cannot still turn a profit.

In 2012 Continental Resources reported a profit increase of 72% on the back of a 58% rise in oil production.

Other independent energy companies weren't as fortunate...

Independent U.S. oil and gas producers ended last year with an average cash flow deficit of $1.5 billion. This does not compare well with the world's major oil producers which ended 2012 with an average cash flow surplus of $386 million.

This poor performance brought pressure to companies' management, much as it has in the global mining industry. The pressure from shareholders is for companies to reduce their operating costs.

Technologies, including quicker and longer horizontal drilling and improved imaging data, aim to improve not only the flow of oil but also companies' bottom lines.

3D modeling of underground formations will help oil firms in predicting the nature, exact location and permeability of reservoirs. Longer drilling bores moving sideways through the length of an oil field puts it in contact with a larger area of oil-containing rocks than a simple vertical well does.

One example of a company employing the latest drilling techniques is Newfield Exploration (NYSE: NFX). The company is now drilling horizontal wells as much as two miles long. This is 10 times the length of the wells drilled at start of the shale revolution. This has, in the past 18 months, cut the cost of its drilling in excess of 50% to about $1,000 a foot.

Noble Energy Inc. (NYSE: NBL) is drilling in the Denver-Julesberg Basin in Colorado with 9,000 foot horizontal bores. The company estimates each well drilled there will yield the equivalent of one million barrels. This is up from an estimate three years ago of just 40,000 barrels using previous technologies.

Advanced technologies are already aiding U.S. independent oil companies in reducing costs.

Last year, the average well cost Continental $9.2 million to drill. It expects soon that cost to fall to $8.2 million. Continental is among the top 10 in petroleum liquids production in the U.S. That is thanks largely to its industry-leading lease holding position in the Bakken. The company plans to triple production and proved reserves by the end of 2017 through expansion in the Bakken as well as fields in Oklahoma.

Even troubled Chesapeake Energy is benefiting from the use of new technologies. According to the company's website, the cost of drilling a well in Ohio's Utica Shale has fallen from $8.5 million to $5.9 million. Drilling wells is also speedier according to Chesapeake. The time to drill a well in the Eagle Ford shale fell to 18 days from 25 days a year ago, with the ultimate goal being 13 days.

Bottom line for investors?

The U.S. shale oil revolution is far from over. The spreading use of new techniques and technologies will keep domestic oil production competitive even if the global price of oil falls.

And most U.S. energy production estimates are probably conservative.

In fact, according to the U.S. Geological Survey, the Bakken and Three Forks formations, which span parts of North Dakota, South Dakota and Montana, hold more than double the recoverable crude oil than estimated just five years ago.

The latest estimate says there are 7.4 billion barrels of recoverable oil in the two formations. The U.S. Geological Survey added that the formations also hold 6.7 trillion cubic feet of natural gas as well as 530 million barrels of natural gas liquids.

North Dakota reported that oil producers in the Bakken shale formation increased their total oil output to a record 727,149 barrels a day last April. This production level represents an increase of 33% from April 2012.

These advancements in drilling and production have led to huge profit opportunities for one energy sector in particular.

Park Money in the Midstream

If you want to make money in the oil and gas markets, the best way is to be in the center of the supply chain.

You see, midstream companies perform an extremely important function. They provide the link (through pipelines, storage facilities, etc.) between upstream fields such as the Bakken and downstream functions such as refining, processing and distribution.

As natural gas prices slowly rise in response to additional usage in power production, for feeder stock in petrochemical production and the advent of both liquefied natural gas (LNG) exports and LNG /CNG (compressed natural gas) usage for vehicle fuel, midstream companies able to bridge both oil and gas transit will benefit most.

The midstream market segment is largely dominated by companies that operate as master limited partnerships (MLPs).

These are simply the best holdings in the midstream. Many master limited partnerships today trade on the stock exchanges just as regular stocks.

The difference is that MLPs allow profits to flow through directly to the partners, without paying corporate tax. Investors buying a MLP will receive a fixed percentage of the partnership. This usually translates directly into a higher than average dividend, sometimes significantly higher.

I favor those MLPs that are beginning to emerge, which are expanding into more midstream activities and/or are focused on a specific product.

The hands-down best MLP and midstream stock is Access Midstream Partners L.P. (NYSE: ACMP).

Access is made up of assets formerly held by Chesapeake Midstream Partners L.P., including some strategic facilities in the Eagle Ford, Utica, and Niobrara liquid-rich basins. The acquisition was completed in the fourth quarter of 2012.

ACMP is a midstream oil and gas service provider headquartered in Okalahoma City, OK, carrying a 3.7% dividend.

The partnership is now announcing a potential expansion moving forward, with annual positive improvements in both EBITDA and capital investments, along with "sustained 15% annual distribution growth for years to come," according to CEO Mike Stice.

The company's assets generate fixed fee revenues from their long-term contracts, and the company is not directly exposed to fluctuating commodity prices.

The company has raised is dividend every quarter since it started issuing dividends in 2012 and is currently part of my Energy Advantage portfolio.

Since i first recommended it to my subscribers, it has climbed 37% and shows no signs of slowing down.

As the production balance between oil and gas stabilizes, ACMP will be sitting in a good position to profit.

For investors looking for broad exposure to the MLP sector, you can invest in the JP Morgan Alerian MLP Index ETN (NYSE:AMJ), which yields 4.82%.

This fund is balanced a bit more toward pipelines. And it's also balanced slightly more toward gas than oil, compared to other major ETN competitors. What's great about AMJ, is that it gives you exposure to the Alerian MLP Index - a market-cap weighted, float-adjusted index established to provide investors with the ability to track the entire oil and gas MLP sector.

The Alerian MLP index is comprised of 50 companies, including several of our favorite MLPs such as Kinder Morgan, Enterprise Products, Magellan Midstream, Martin Midstream, and Genesis Energy.

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