Dave Landry's Market in a Minute - Monday, 12/2/13

In today's energy market, investors often try to distinguish between oil plays and natural gas plays, but the distinction is often moot -- most of today's wells produce a healthy amount of both.

The key to finding winning investments is to focus on the relative productivity of a firm's well.



Let's focus first on natural gas (we'll shift the discussion to oil in a moment).

The natural gas market appears to have settled into long-term equilibrium. You'll surely see short-term spikes in prices when the weather gets especially cold (as increasingly appears to be the case this winter).

But unless we have strongly overestimated that amount of untapped oil and gas remaining in our shale regions, then supply increases will be the likely result of any upward move in natural gas prices.

As a result, gas prices may move into the $4 to $4.25 per thousand cubic feet (Mcf) area, but much more upside than that is unlikely. In fact, the natural gas futures market doesn't anticipate a move up above the $4.50 mark until January 2019.



To be sure, gas prices in the $3.50 to $4.50 range explain why share prices of many gas producers remain in a funk. But even at these lower prices, some gas producers are extremely profitable. And it's all about geography.

As geologists have come to realize, some shale regions produce gushers with very little drilling effort. That helps keep expenses very low and enables firms operating in these areas to make ample profits even if gas prices fall to the lower end of the price range noted above.

The most productive shale regions in terms of natural gas production: the Haynesville and Marcellus shales. According to a recent report by the Energy Information Administration (EIA), these two regions are seeing robust output from every new well deployed. "Drilling productivity has increased 50% annually in the important Marcellus gas play and 30% annually in the Haynesville play," notes Barclay's Tom Driscoll in a recent report.

Driscoll thinks the productive output in the Marcellus Shale is leading to solid output and profit gains for Noble Energy (NYSE: NBL). (Incidentally, I am a big fan of this company, thanks to its additional exposure to exposure to massive natural gas fields off of the coast of Israel.)

Changing Dynamics In Oil Productivity

This month, the International Energy Agency released the 2013 version of its annual World Energy Outlook. Not surprisingly, the horizontal oil boom that has given birth to an oil production renaissance in the United States played center stage in the report.



However, some of what the IEA had to say about the U.S. horizontal boom may have caught some people by surprise.

The IEA sees the horizontal boom making the U.S. the world's largest oil producer by 2015. No surprise there -- the media is all over that story.

But the IEA also said that the horizontal oil boom will peak by the year 2020. (But it's only just begun!) After 2020, the IEA sees American production hitting a brief plateau before heading back into permanent decline. That doesn't sound like an oil boom -- in the grand scheme of things, it's barely a blip on the long-term radar.

I don't entirely agree with this view from the IEA, which I think massively underestimates the entrepreneurial spirit of the energy industry.

After all, the renaissance in U.S. oil production wasn't led by supermajors like Exxon (NYSE: XOM) and Chevron (NYSE: CVX) -- it was led by the independent producers that brought innovation and an entrepreneurial spirit to the problem of producing oil from tight and shale oil reservoirs.

While the supermajors were off looking for oil deep under the ocean and in unstable countries, companies like EOG Resources (NYSE: EOG) "cracked" the shale oil code back here in the United States.

Along with cracking the code, these companies also locked up big acreage positions in the best horizontal oil plays. That real estate is going to reward them for decades.

EOG has large land positions right in the heart of both the Bakken and Eagle Ford oil plays. Over the past five years, this has allowed for a great run of production and reserve increases for the company.

What I think the market doesn't appreciate about EOG and other horizontal oil producers is that their best days are still in front of them.
This horizontal boom is still young, and the technology and techniques being applied are changing quickly. Given the amount of oil trapped in these horizontal oil plays, small improvements in technology and best practices can result in huge increases in the amount of oil these plays ultimately produce.

Let's consider EOG and its Eagle Ford assets. Initially in 2010, with well results and technologies then available, EOG thought it would be able to recover 900 million barrels from its Eagle Ford acreage in South Texas. Things have changed since then.

Last year, EOG said that instead of 130-acre well spacing, the optimal well spacing will actually be 40 to 65 acres. More wells per acre means that more oil can be recovered. Thanks to this tighter spacing, EOG expects the amount of recoverable barrels in its Eagle Ford acreage will actually be 2.2 billion barrels -- a mind-boggling increase of 1.3 billion barrels.

In the Eagle Ford, EOG is sitting on 27.9 billion barrels of oil. The initial assessment of 900 million recoverable barrels assumed a recovery factor of less than 4%. Even with disclosed increase to 2.2 billion barrels, that recovery factor is still under 8%.
For investors, the key is to focus on the companies that own the land that has the oil in place. EOG has a lot of that land and in exactly the right places.

Risks to Consider: The main risk to any commodity producer is the price of the commodity it produces. EOG's revenues are weighted toward oil, so any drop in the price of that commodity will directly impact cash flows and reserve values.

Collect 790% More Income Than Dividends Alone

For 41 weeks in a row, the options trades I've recommended to my Income Trader readers have been profitable. And on average, my readers are collecting 7.5% in "Instant Income" every 48 days. So far, we're 32 for 32 when it comes to closed trades.

How am I doing it? It's actually pretty simple... but it requires some investors to leave their comfort zone.

Options are one of the most misunderstood corners of the financial world. Many investors steer clear of options because they have a reputation for being risky, but that's not always the case...

My strategy involves selling options on undervalued stocks. And as I've mentioned here, here and here, selling "put" options is one of the most effective income strategies in the world.

But today, I want to tell you about a different strategy -- selling covered calls.

A covered call strategy involves selling call options on stocks that you own. This allows you to generate income from selling options while benefitting from the potential upside by owning the stock. The downside risk is partly reduced by the income generated from selling options, which offsets potential losses in the stock.

If you're a little confused by that, don't worry. An example of a trade you can make today should help clear things up.

Aetna (NYSE: AET) is one of the largest health insurers in the nation. It is also a value stock that is trading with a price-to-earnings (P/E) ratio of about 13, about average for its industry. Despite the average valuation, AET is expected to grow faster than other large insurers, with earnings growth expected to average 10% a year over the next five years.

As health insurance stays in the news, traders can be expected to look at companies like AET, and the stock could be volatile. That creates an opportunity for short-term gains.

AET is currently trading around $67.75. Traders can buy 100 shares of AET and immediately sell a call option expiring in January with a strike price of $70 for about $1 per share, or $100 per contract, since each contract controls 100 shares.

A call option gives the buyer the right to buy 100 shares of stock for a predetermined price (the strike price) at any time prior to the expiration date. Call sellers have an obligation to sell the shares if the buyer exercises their right to buy the stock, which they will do if the stock price is above the strike price when the option expires.

In this case, if AET is above $70 when the call expires on Jan. 17, the buyer will exercise the option and you will have to sell your 100 shares at $70. Your profit on the trade will be equal to the difference in the sale price and the purchase price ($2.25 in this case) plus the option premium of $1 for a total of $3.25 per share. That would be a return of 4.8% in about two months, or 54 days to be exact.

If AET is below $70 in January, you will have the opportunity to sell another call option and generate additional income. The current price of the option is about 1.4% of the stock's price. Selling an option for that amount every 54 days would generate income of about 9.5% a year. AET also pays a dividend for a yield of 1.2% a year. The combined income of 10.7% a year is almost nine times as much as owning the stock alone -- that's a 790% increase. And this income could offset any potential losses in AET.

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Quote of the day

Wes Gray, ?(L)isten to really smart people, since it is entertaining, makes me feel more intelligent, and gives me overconfidence for multiple predictions; however, avoid trading based on the projections of highly confident smart people.? (Turnkey Analyst)

Chart of the day

361 Capital Weekly Research Briefing

361 Capital portfolio manager, Blaine Rollins, CFA, previously manager of the Janus Fund, writes a weekly update looking back on major moves, macro-trends and economic data points. The 361 Capital Weekly Research Briefing summarizes the latest market news along with some interesting facts and a touch of humor. 361 Capital is a provider of alternative investment mutual funds, separate accounts, and limited partnerships to institutions, financial intermediaries, and high-net-worth investors.

361 Capital Weekly Research Briefing
November 25, 2013

Timely perspectives from the 361 Capital research & portfolio management team
Written by Blaine Rollins, CFA