The New Drill Masters

May 31, 2007 (From Barron's via Dow Jones Newswires)

Don't try to tell Mike Bahorich that finding oil and gas is impossible. When Apache started exploring for new reserves in Egypt in 2001 after buying out the operating interest in the Khalda field from its partner Repsol, Bahorich, the company's executive vice president for exploration and production technology, was told by industry veterans that shooting three-dimensional seismic images -- a common way of detecting pockets of hydrocarbons -- wouldn't work in a desert environment. If true, that meant that the only way to figure out if there was oil under the Egyptian sands was costly and inefficient: drilling one hole in the ground after another, randomly and blindly.

There had to be a better way, Bahorich figured. He called in specialists in complex data sets to study the "noise" that the 3-D surveys were yielding as a result of shifting sands and long-buried rivers. "We ended up building a new program to analyze the data we had," Bahorich explains. The result? Apache's 2003 discovery of the Qasr natural-gas field in the area was its largest find ever, with reserves estimated at 2.3 trillion cubic feet, and the company is now the third-largest energy producer in Egypt, with production there accounting for a fifth of its production revenues.

It pays to be technologically clever in the energy business. In what is becoming a race to replace rapidly depleting oil and gas reserves, technology is increasingly playing a decisive role. "The easy oil is gone; the next barrel is always going to require more technology to extract," says Geoff Kieburtz, managing director and oilfield service analyst at Citigroup. That means Apache (ticker: APA) has lots of company in its battle to be the best at finding and applying those new technologies, from giants like Royal Dutch Shell (RDS) and ExxonMobil (XOM) to lesser-known players like Chesapeake Energy (CHK). Oil-services companies like Schlumberger (SLB) also are focusing intently on these new approaches, which range from new seismic technologies to "underpressure drilling," a way of extracting more oil from complex geological structures.

The winners will be those that can deploy the newest technologies to boost their reserves markedly at a time when most rivals are fighting just to replace production.

Lloyd Byrne, an energy analyst at Morgan Stanley, has found that since 2003, those companies able to boost reserves to the greatest degree saw an average 303% stock-price gain, while those that fared worst at this task rose 159%, buoyed mostly by the commodity price. "Companies like EOG Resources or Devon Energy are delivering the results, and investors are willing to pay up for that," says Byrne.

Still, investors don't have to pay lofty valuations for stocks like EOG (EOG) and Devon (DVN), which is why Byrne has Buy ratings on both. He believes EOG, now trading at around $75.88 a share, down from a 52-week high of nearly $80 last spring, after a selloff in natural-gas prices, is worth closer to $84 a share. Trading at 16.4 times earnings, it's a bargain, Byrne believes. He cites the company's demonstrated ability to deploy new horizontal drilling technologies to open up entirely new natural-gas reserves in the difficult-to-drill Barnett Shale region in Texas.

John Dowd, an energy analyst at Fidelity and manager of the Boston-based firm's Select Energy (FSENX)and Select Energy Service (FSESX) funds, says that companies like EOG that are able to boost their reserves at a greater rate than the industry as a whole fall into a sweet spot. "Anything with acreage positions that will benefit from the application of new technology is attractive," Dowd says. "deepwater exploration companies, natural-gas producers in the shale areas and unconventional resource plays like the oil sands will be the biggest beneficiaries."

Many energy companies believe the biggest discoveries will be found offshore -- in waters thousands of feet deep in areas ranging from the Gulf of Mexico to the coast of West Africa. A few years ago, it would have been hard to identify these fields, much less develop them economically. Now higher prices and technology advances are making deepwater exploration one of the hottest areas in the industry. But it's still extremely expensive. "The incentive to use new time-saving technologies is the greatest in deep water, so it's where you're going to see the most rapid acceptance of new ideas," says Fidelity's Dowd.

So, which companies could be best for investors?

Smaller producers will probably get a bigger lift from technologies than the oil giants. Byrne, for his part, likes Devon Energy. Not only does it have extensive deepwater holdings in the Gulf of Mexico, but it is also a player in natural-gas shale and has a stake in heavy oil production in Canada's oil sands. "So they are really a play on new technologies across the board," he says. Byrne believes that Devon's stock, now hovering around $76.27, is worth closer to $83 a share, based on current energy prices.

Ironically, it may be toughest for investors to profit from technological innovations by backing the companies responsible for developing many of them. Over the past decade or so, the burden of research and development investment has fallen increasingly on the balance sheets of the oil-service companies: the businesses that conduct seismic surveys, undertake geological studies, develop and operate drilling rigs and monitor production. "But service companies have had little success in moving from a fee-for-service compensation model to an incentive-based model," says Judson Jacobs, director of up stream technology at Cambridge Energy Research Associates. "The big prize is the increased production that results from technology; it's very difficult to create a sustained competitive advantage through technology."

The exceptions occur where companies dominate certain industries, or show an ability to roll out a series of technological innovations. Dowd is keeping an eye on service companies that specialize in providing deepwater and subsea drilling technologies, such as Cameron International (CAM) and FMC Technologies (FTI). FMC, which is working on technologies to separate water from oil at the ocean floor, has just won a $200 million contract to supply Norsk Hydro (NHY) with subsea systems.

"It's only recently that service companies have started to get paid for their technology, and then it's only selectively," Dowd notes. "The more a new technology reduces the amount of time spent drilling," the more willing a client is to pay up. Offshore, where wells can cost $500,000 a day to drill, using new technologies to cut drilling time and boost the likelihood of success carries far more value, Dowd says.

Then there is Weatherford International (WFT), an oil-services company that boosted R&D spending to $150 million in 2006 from $84 million in 2004 and now accounts for more oil-field technology patents than any company other than Halliburton (HAL). A major focus of these efforts has been in what is known as underbalanced or near-balanced drilling, a technology that exerts less force on the geological structure being drilled and enables producers to get more oil or gas out without contaminating the field with fluids used in traditional drilling.

"Weatherford has remained by far the dominant player in this business, which is in great demand by producers in areas where they are moving from exploration to enhancing recovery rates at existing fields," says Ole Slorer, an oil-fields-service analyst at Morgan Stanley. Two years ago, revenues from underbalanced and related drilling activities generated $150 million in revenue for Weatherford; today that figure is closer to $500 million, Slorer calculates.

Giant Schlumberger could also be a winner. The company's WesternGeco division has pioneered what is known as "Q" seismic, a way of using sound waves to improve measurement of geological formations and faults. "If you think of traditional seismic surveys as like listening to a piece of music played by an orchestra in a recording, then Q seismic would be as if you were recording each instrument individually and blending them to make up the whole piece," Slorer says.

Importantly for Schlumberger, it doesn't turn over the raw data to the exploration companies that commission these surveys. "It does the analysis itself, and delivers the results to the clients, which boosts the intellectual value of what it is doing," Slorer explains. "So they may not get some clients that want the data and to do the processing themselves, but they will get a lot more higher-margin business from clients that want the higher-quality results that so far only Q seems to be delivering."

The rewards for any of these companies are likely to be incremental, rather than revolutionary. CERA's Jacobs says that there probably are no giant oil fields remaining to be discovered -- "elephant" discoveries will be few and far between. But as even the Saudis turn to new kinds of multilateral horizontal drilling technologies to maximize recovery rates at their now-mature fields, CERA calculates that new technologies could prolong the life of the oil-based global economy.

"There is still a lot of oil and gas there for the taking -- more than many skeptics might believe," Jacobs argues. "But it's 'found' oil -- it lies in reservoirs that have already been discovered, and it's going to take more and more effort to get to the surface. The companies that do it will be rewarded, however." Investors may hit some pay dirt, too.

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