The Secret to Getting Texas Rich

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Pauline Stanley
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1 The Secret to Getting Texas Rich

2 The Secret to Getting Texas Rich WE are poised for a rebound On March 22, 2017, John Paisie, executive vice president of oil industry research firm Stratas Advisors, spoke these words to a collection of U.S. oil industry executives at the Midland Country Club in Midland, Texas. And I believe he was correct. The Organization of the Petroleum Exporting Countries (OPEC) forced its member nations and some key allies into cutting production for They agreed to a cut of 1.2 million barrels per day. That should have been enough to push crude oil prices higher. And it did crude rallied from around $27 per barrel in January 2016 to a sustained price around $50 per barrel for the latter half of 2016 and most of However, that could end soon. See, the rally in oil prices allowed many U.S. producers to open the spigots again. U.S. production bottomed in August 2016 at 8.6 million barrels per day. It climbed back up to 8.9 million barrels per day by December 2016 (according to the latest data from the Energy Information Administration). That s a 3% increase 300,000 barrels per day in just three months. That bump in U.S. oil production will likely push prices down slightly which is great. We are going to speculate on a U.S. oil producer. Lower oil prices in the short term will give us the perfect opportunity to buy at an even better price. You see, our speculation isn t about the short-term oil price. We re buying because the industry s costs are finally falling, and the price of oil will go up in the next year or two. By lowering costs, the producers become more profitable. So when oil prices begin to rise again, the companies profit margins will increase even further. Time for a Rally in Oil? Oil is a cyclical commodity. That means prices rise and fall over time. You might remember when oil prices plunged to the teens back in the 1990s, then soared to over $140 per barrel in After that, they plummeted into the mid-$20 range as recently as To see what I mean, take a look at the chart below: 1

3 The red arrows denote price cycles. They last as briefly as two years, but they can go as long as seven years. The table below puts these cycles into a more interesting perspective: The Cyclical Nature of Oil Price Cycle Periods Duration Rise Fall June 1990 to December years 142% -65% December 1993 to December years 88% -59% December 1998 to November years 231% -50% November 2001 to January years 332% -33% January 2007 to February years 184% -77% February 2009 to February years 235% -76% As you can see, oil prices can rise and fall rapidly. For example, from January 2007 to February 2009, the price went from about $51 per barrel to $145 per barrel on the way up. It then fell to about $34 per barrel, hence the moves indicated in the table: up 184% and then down 77%. While I don t expect prices to plummet back to $27 per barrel anytime soon, I think a fall is possible in the near future. But that won t derail the uptrend none of these cycles go straight up. The Permian Basin U.S. Shale s Next Big Thing The Permian Basin is a huge geologic structure that sits under West Texas and Southeastern New Mexico. It s a giant, 86,000-square-mile basin nearly a third of the size of the Lone Star State itself! with a ridge in the middle. 2

It was historically a prolific oil-producing region. In 1921, the Santa Rita No. 1 well became the first commercial oil well in the area. It flowed for 70 years.

4 It was historically a prolific oil-producing region. In 1921, the Santa Rita No. 1 well became the first commercial oil well in the area. It flowed for 70 years. From 1921 to 2012, conventional oil fields in the Permian Basin produced about 29 billion barrels of oil and 75 trillion cubic feet of natural gas. However, in 2012, when the industry moved to unconventional shale, the basin exploded with untapped resources. The Permian Basin is all that remains of a tropical ocean lost in geologic history. A warm, lively ecosystem once flourished in the huge basin. Over millions of years, the basin filled with layers of rich organic material. Those layers became shale deposits. Eventually, sediment buried the basin and covered the organic material. After millions of years of compaction and heating, it turned into oil and gas. The Permian Basin contains not one, but seven, shale units rich in oil. In 1995, the U.S. Geological Survey estimated that the basin holds over 100 billion barrels of oil. However, operators dispute that claim. The CEO of Pioneer Natural Resources has said he believes the Permian Basin could hold 75 billion barrels of oil. That would put this basin second only to Ghawar in Saudi Arabia on the list of the world s largest oil fields. The World s Second-Largest Oil Field The Delaware Basin comprises the western side of the Permian Basin. It s a nearly mile-deep bowl of shale layers roughly 4,800 feet thick. It contains nine discrete shale layers full of oil. The larger Midland Basin makes up the eastern side of the Permian basin. A central platform separates the two sub-basins. The Midland Basin is only about 2,800 feet thick. However, it contains 15 shale layers. That thickness is what makes the Permian Basin so special. You see, even our most prolific shales, like the Eagle Ford in East Texas, are only a few hundred feet thick at most. The Bakken Shale in North Dakota averages between 10 feet and 120 feet thick. A recent study showed that a group of just four of those layers of the Permian Basin the Wolfcamp 3

5 Formation appear to hold 20 billion barrels of oil. That s nearly equal to seven years of oil production from the entire United States. The Permian Basin will likely remain a major oil producer for another century at the least. That s what makes it the oceanfront real estate of the oil industry: It s expensive to lease ground there, which means it s hard to break in. As recently as February 2017, rental rates for land in the Permian Basin ran to $60,000 per acre. That s a 4,900% increase in just four years. Imagine if the value of your house went from $50,000 to $2.5 million between 2013 and That high cost of entry puts up a huge moat around the companies already working in the Permian. Outsiders either pay up or stay out. The problem is that the oil price isn t giving us that big lift yet. Companies in the Permian are drilling. Iraq and Iran continue to fight with Saudi Arabia, putting even more barrels on the market. So far in 2017, the oil price has stayed flat. But U.S. production isn t. Oil production in the Permian and other U.S. shales is up 8% so far in The way to play this today isn t with a pure producer; it s with the companies that do the work the companies that drill the wells, put the wellheads on and hook them up to the pipelines for production These are the drilling service companies. Today, there are 577 rigs drilling in shales around the U.S., and 66% work in the Permian. Rigs continue to move into the region. Over the past month, we saw rigs move from the Eagle Ford shale in Southeastern Texas to the Permian. Companies are drilling there. The Permian saw six of the giant, directional rigs move into the area over the last month. The tide turned this summer. After six months of zero work, one private drilling company began signing two-year contracts. That s a great sign that the market warmed up. And it means earnings improvement for drilling companies this winter. The Service Providers We Want to Own The single best drilling company in the Permian and in the U.S. is Helmerich & Payne (NYSE: HP). Helmerich & Payne is the most active U.S. land driller. It operates 30% of the active alternating-current, aka AC drive, rigs the most modern style of drill rigs. These modern rigs need less maintenance. They re also faster and lighter to move. That means lower operating costs. AC rigs remain in high demand, with 80% to 90% of them working today. And the ones that aren t working are older models that aren t up to the current specifications. The proof is in HP s fleet schedule: In 2018, over 80% of the company s rigs will be working. Nearly all of its rigs are under contract for That means we have a comfortable cushion of work and earnings for the company. It could take that long for the oil price to stabilize. Q Q Q Q Q4 2017* Revenue $332 Million $369 Million $405 Million $498 Million $488 Million EBITDA** $143 Million $72.2 Million $83.9 Million $110 Million $112 Million Debt $492 Million $492 Million $492 Million $493 Million $493 Million Cash $957 Million $950 Million $871 Million $790 Million $613 Million Data from Bloomberg; *Estimates; **Earnings before interest, taxes, depreciation and amortization. H&P s fiscal calendar runs from October, so Q4 data is the end of September. 4

6 As you can see, HP s management runs a great company. It has modest debt and lots of cash. Revenue and earnings are up from last year. From the end of 2016 to the end of 2017, the company should grow revenue by 47%. That s great news. It comes in part because HP dedicated itself to running the best rigs. A driller is only as good as the drilling rigs it has running. If a drill rig sits in a yard, it becomes a liability. Parts rust, hoses rot, electronics corrode. The market actively hates drilling companies that have idle rigs. We know that by looking at something called price-to-book-value ratio. That s the ratio of the price of the company versus the cost of the equipment the company owns. The priceto-book shows us how much value the market places on the company s equipment. In the case of drillers like HP, it s the value of the rigs. The lower the price-to-book, the less value the market places on the equipment. For HP, the price-to-book ranged from 1 times the value of its rigs to 2.7 times the value. You can see the spread in the chart below: HP Price to Book Just Started to Recover As you can see, when oil prices were high, the price-to-book ratio was much higher. But even in early 2017, it was near 2. The average value since 2013 was 1.6. Today, the price-to-book value is 1.3 times. That means HP s share price could come up 25% just to get its price-to-book value even. To get back to 2, HP s shares must go up at least 50%. That would just put HP shares back up to $80, where they were at the beginning of the year. That s quite possible over the next few months. Take a look: 5

7 However, we could easily double our money in HP with a small move higher in oil price. The great thing about HP is that it pays us to wait. Helmerich & Payne is a well-run company. It has one of the best balance sheets of any drilling company. It takes some of that cash and pays us a dividend every quarter. It paid out $0.70 per share for the last five quarters. That works out to $2.80 per year, a 5% yield to hold this driller and wait for the oil market to improve. Action to take: Buy Helmerich & Payne (NYSE: HP) up to $58 per share, and use a 25% trailing stop. Please don t put your stops in at the market. Use a simple spreadsheet to track your trailing stops. Good investing, Matt Badiali Editor, Real Wealth Strategist 6

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The Secret to Getting Texas Rich

The Secret to Getting Texas Rich MATT BADIALI S Real Wealth Strategist The Secret to Getting Texas Rich W E are poised for a rebound On March 22, 2017, John Paisie, executive vice president of oil industry