June 20, 2014

Energy guru, investment banker and author Tom Petrie discusses some of the revolutionary implications of hydraulic fracturing on the U.S energy sector.

Consuelo Mack: This week on WealthTrack, the Energy Revolution! With oil and gas production increasing rapidly in various parts of the country financial thought leader and energy guru Tom Petrie tells us what it means for energy independence, the economy and national security, next on Consuelo Mack WealthTrack.

Hello and welcome to this special energy edition of WealthTrack, I’m Consuelo Mack. Are we in the midst of an energy revolution? Is it possible that the U.S. could become energy independent with all of the enormous economic and national security implications that would entail? Before I discuss those questions with this week’s guest some perspective might be helpful.

Until the recent shale oil technology revolution the common wisdom was that U.S. oil production had peaked in the late 1960’s/early 1970’s. Called Hubbert’s Peak after M. King Hubbert, the oil geologist who predicted it in 1956, oil production, which had been increasing since the 1900’s was expected to peak as known oil reserves were depleted. Until recent years Hubbert’s Peak was believed to be a fact of life. Then came game-changing technology called hydraulic fracturing or fracking, a process that injects fluids, mostly water, under high pressure into horizontally drilled oil or gas wells. That fracking process forces apart or fractures tight rock formations releasing previously inaccessible oil and gas reserves. The difference in U.S. oil and gas production from fracking is huge. In oil alone, the international energy agency predicts production which had been declining for decades will soar especially in desirable light crude from those tight rock formations. The impact on natural gas production is also enormous. By some estimates it is expected to increase 30-40% from current levels. According to independent research firm Cornerstone Macro increased domestic oil and gas production has already had a dramatic impact on energy imports. Imports have fallen by almost half to the lowest level in more than two decades.

This week’s financial thought leader guest has spent over four decades in the oil and gas industry as an analyst, investment banker and advisor to energy companies and governments and has just written a book about it. He is Tom Petrie, chairman of Petrie Partners, a boutique energy-focused investment banking firm and his book is “Following Oil: Four Decades of Cycle-Testing Experiences and What They Foretell about U.S. Energy Independence”. During those forty years Tom has been vice chairman of Bank of America Merrill Lynch. Co-founder and partner of his previous energy investment banking firm Petrie Parkman and in his analyst days was voted number one oil analyst for eight years running in the exploration/independent oil sector by Institutional Investor Magazine. I began the interview by asking Petrie why he believes we are indeed experiencing an energy revolution.

Tom Petrie: This is a period where there are some major game changers going on in the energy supply. What we now have is a situation where the outlook for the next one, two, possibly three decades is much brighter than we thought it was 10 years ago. That’s revolutionary. It’s a game changer because the model for finding and developing new supplies of oil and gas in North America has totally shifted and …

Consuelo Mack: From what to what?

Tom Petrie: From a situation where we thought we were in irreversible decline. That was the mode we’d been in actually for the last three decades.

Consuelo Mack: Right, the Hubbert’s Peak.

Tom Petrie: The Hubbert’s Peak to a mode where we’ve indefinitely postponed that. In fact, we’re going back to…we’re on the way to getting back to the old peak achieved in 1970 for U.S. production of oil and other liquids, and in all likelihood we’re going to have a period of plateau at those high levels for quite a period to come, certainly into the next decade, possibly into the next two decades.

Consuelo Mack: What about gas? You mentioned oil. What about our gas output?

Tom Petrie: That’s even more important. That’s a big part of this revolution as well because gas is actually more environmentally friendly, less carbon, and they supply elasticity is such that the resource potential is 10-fold greater than we thought it was 10 years ago, 10-fold greater. That’s unimaginable prior to some of these new developments.

Consuelo Mack: So that means that we have 10 times more gas that we can produce ultimately …

Tom Petrie: The ultimate potential.

Consuelo Mack: … than we thought we had 10 years ago.

Tom Petrie: That’s right.

Consuelo Mack: You have been following oil, and you write about it in your book, “Following Oil: Four Decades”, and you have written about the fact that we’ve had other big changes occur on the energy scene before that didn’t pan out. So why are you confident that this change, in fact, this shale oil will pan out?

Tom Petrie: The technology that’s come along is very impressive, number one, but most importantly the basic model has changed. The old model, the technical model spoke to the idea that oil or gas is generated in one part of the earth’s subsurface, migrates out of that area into much higher quality rock, the high porosity, high permeability. So it could flow to the surface rapidly. The problem is you had to get the timing right. You had to actually generate it, get the timing right and trap it somewhere else. That’s the product of three probabilities. That’s a one in six chance that you’re going to get what you want. In this case we’re going back to where it was generated in the first place.

Consuelo Mack: So original fields or original … ?

Tom Petrie: It’s called source rock. It’s where it was generated or exactly right next door. We’re not taking this long-range migration notion, and basically for the first 140 years of the oil business and the last 100 years of the gas business, we were working with that old model, but now we’ve drilled most of those cases where it did migrate and was trapped, but now we’ve said let’s go find where the source rock is ubiquitous in a basin, present over a wide area. Let’s go in and with the new technology let’s figure out how to break apart that rock where it’s generated, and as long as the breaking apart takes less energy going in than comes out via multiple, two, three, four, five, six times, then we’ve got a new model.

Consuelo Mack: So it’s economically feasible now with this new technology.

Tom Petrie: Exactly, and this is a revolutionary thing. It took years of innovation by a number of different people. George Mitchell of Mitchell Energy gets a lot of credit for it and deserves because he was persistent in the face of adversity in pursuing it down in Texas near Fort Worth in what’s called the Barnett Shale.

Tom Petrie: Suddenly there was awareness if it works in this shale called the Barnett Shale near Fort Worth, maybe it’ll work in the Fayetteville Shale in Arkansas. Maybe it’ll work in the Haynesville Shale in North Louisiana. What about the Marcellus all through Appalachia? Then within a year, less than a year, 12 other shales were being pursued by the industry, each looking to see whether it would work there. Two thirds of those shales proved to be successful, and today they’re being developed.

Consuelo Mack: So let’s talk about kind of the mother lode of all shale oil development. Is it the Bakken field? Is that what it’s called in North Dakota?

Tom Petrie: Arguably it is because it’s oil up there, not gas, and oil has greater utility right now, but it’s also the Marcellus in Appalachia. The Marcellus in Appalachia has the potential before the end of this decade, probably well before, two or three years before the end of this decade could rival the output of the Emir of Qatar’s gas which is the third largest source of gas in the world. Now it’s not as large a resource, but its productivity is so high that the Marcellus could rival that of Qatar, one of the major gas exporters in the world. To go back to your point, the Bakken …

Consuelo Mack: In North Dakota.

Tom Petrie: … in North Dakota could be somewhere between two and four times as big as Prudhoe Bay in Alaska. Unimaginable 10 years ago. The Eagle Ford in Texas will not be as big as the Bakken, but the productivity of the wells and the proximity to market, economically it’s almost as significant. And then in Colorado we have the Niobrara. Regionally it’s very important for the economy of the Rocky Mountains. So there’s a series of these opportunities now to be pursued, and they’ve now moved from the evaluation stage to the economic development stage, and that’s why I have some confidence.

Consuelo Mack: So the headlines, of course, that we read about frequently are the environmental concerns of fracking. So address that.

Tom Petrie: There are real environmental impacts. Anybody who would argue otherwise you have to wonder where they’re coming from. When I said we want to break the rock apart that takes energy in. It is a process of breaking the rock apart, so you hear about concern about earthquakes. You hear concern about the water that’s being used. You hear about methane leaks. These are all issues that the industry knows about and is looking to address.

Consuelo Mack: And they’re real concerns.

Tom Petrie: They are, and they’re valid concerns. So it does in cases where this development is occurring near housing developments and so on, they will be disturbing to a degree. Now the importance of this is that it’s a relatively short period to actually do it. It’s typically less than 90 days to drill a well. It’s a fairly short period of a week or so in most cases, sometimes maybe two weeks to actually do the fracking, and then they move out, and it’s relatively undisturbed thereafter, but there are concerns. The environmental issues are less some of the asserted ones. For example, the concern about drinking water from an aquifer which is typically less than 1,000 feet into the earth’s surface, and where this occurring typically a mile to two miles in the earth’s surface. Usually there’s quite a layer of impermeable rock where the actual risk of one interfering with the other. The hydrocarbons interfering with the water is very, very low and very manageable.

Consuelo Mack: What are the tradeoffs?

Tom Petrie: In terms of environmental issues, the tradeoffs are that we have to deal with how the water that’s involved in the process is treated. We have to deal with methane leaks. We have to deal with any other environmental impacts that are talked about, but those are the big ones. Return water from fracking can be treated in a way where it’s bio-remediated. That means we eliminate the presence of the fossil remnants that are in that material. There are oil and gas-eating enzymes that can be applied and you end up with water that’s cleaner than drinking water from a bottle of drinking water.

Consuelo Mack: What is your view of the U.S. energy policy if there is one now, and this has been a frustration of yours over the years as well, that we don’t seem to have an energy policy. Do we need one, and what’s the state of it now?

Tom Petrie: Well, all economic policy making in this country is the subject of what can be sold to Congress and then sold to the President who’s going to sign what Congress creates, and as we’ve seen in recent times with a lot of legislation, what Congress creates is … as somebody said, “the definition of a camel is a horse designed by a committee”, and some of our legislation meets that definition. So ideally we want policy that recognizes the economic and technical realities of the situation. What’s interesting about the transformation that we’ve started this discussion with is it didn’t come because of an ideal policy. It came because policy had relaxed to a degree in terms of regulatory constraint, and there was a bubble-up innovation on the technical side that brought forth this new supply elasticity. We’re just coming to grips with that. So hopefully you start with something that’s the equivalent of the Hippocratic Oath. Do no harm. Now when you say do not harm environmentally, it’s one thing. When you say do not harm in terms of supply availability, there’s a dynamic tension there, but the ideal is a policy that recognizes let’s not create artificial constraints on the availability of supply.

Consuelo Mack: What could derail the energy revolution?

Tom Petrie: Well, there’s a couple things. There’s some big decisions to be made this coming election in my state. In the state of Colorado there are a lot of initiatives by those who would like to derail the use of fossil fuels much more radically than is probably going to occur naturally over the balance of this century, and so there’s initiatives that would say let’s have local decisions on whether you can frac or not. It turns out the local decisions at the town level, the municipal level certainly appeal to those who like NIMBY-“not in my backyard”, but the nature of the resource is a very valuable resource for all the citizens of a state. So Colorado is a good test case of this. Basically the potential is probably three to five billion barrels of oil that could be developed over the next one to three decades. The economic benefit of that would be probably half a trillion dollars. That’s a large number. We’ve learned to talk in trillions post the financial meltdown, but a half a trillion in the state of Colorado, there’s no close second.

Consuelo Mack: Alone.

Tom Petrie: There’s no close second. This is not a Hertz and Avis. It’s Hertz and the next one is mom and pop rental car, and so that amount of economic benefit to be constrained because each and every community chooses to say we don’t want it in our backyard is a big, big decision. So there are a lot of things that come from that.

Consuelo Mack: People are talking about the U.S. could be energy independent in the foreseeable future. Is that a likelihood?

Tom Petrie: I’d say it’s a worthy goal. Barrel for barrel independence is not critical. It’s more important that we actually achieve a workable connection in the global markets, and the term I would rather use is energy secure, and you get to energy security well short of being barrel for barrel independent. We’re still consuming 17, 18 million barrels a day even today with conservation down from a high of 21 million barrels a day, and maybe on its way to 15. We’re at eight million barrels a day of production, on its way to 10, 11, maybe 12. At 11 or 12 million barrels a day with growing gas production and exports and with this improvement in the balance between what we could export in the way of high-value oil and import lower, we would be highly energy secure in my view at something like 11, possibly 12 million barrels a day, and I think that’s a much better goal than the idea of saying, well, if we’re consuming 15, we’ve got to produce 15.

Consuelo Mack: The investment implications for this energy revolution. How do we make money from this?

Tom Petrie: Well, number one, it’s happening as we speak. In our markets you hear things about an improved manufacturing capability in the United States. One of the biggest areas where we still have a competitive edge bar none over the rest of the world is in our development of technologies to exploit oil, and it’s been a competitive edge for years, but the new innovations are largely occurring here, and the manufacturing of equipment to do it are largely occurring here. Some of the very best drilling technology exists in the United States, some of the innovations you see. I’m on the board, full disclosure. I’ve been on the board of Helmerich & Payne. Helmerich & Payne has come up with innovative drilling technology that has cut drilling time and improved penetration rates and reduced drilling costs dramatically, and their capabilities then have knock-on benefits to the likes of Caterpillar and a whole lot of other manufacturers of the equipment. So we’re seeing a broad capability in the oil service arena with job creation that goes way beyond the people who are on the site drilling the well, and that’s going to continue. Most of these innovations are causing foreign companies to come here to learn about this.

Consuelo Mack: So you are no longer an oil analyst. You have been an investment banker for a long time, so you cannot recommend individual companies.

Tom Petrie: That’s right.

Consuelo Mack: But who are the major players, Tom?

Tom Petrie: In categories, number one, the upstream sector still matters, and it’s the most important. So the better positioned companies in the upstream sector.

Consuelo Mack: Upstream meaning …

Tom Petrie: Meaning the companies that are involved with raising the capital and putting it to work to develop new sources of production in the major plays in the Bakken formation of North Dakota, in the Eagle Ford formation of Texas, in the Permian Basin of Texas. Those three big areas are the ones that are going to develop three to four million barrels a day in the U.S.

Tom Petrie: Secondly, there’s the service sector and all the big names.

Consuelo Mack: Oil service.

Tom Petrie: The oil service sector. All the big names in the oil service sector are very focused on what they’re doing to develop that.

Consuelo Mack: The drillers, the …

Tom Petrie: These are partly drillers, partly fracking companies that specialize in analyzing and developing techniques to frac and develop those resources. Those names are well known, so these are not recommendations, but they’re the large capitalization such as Schlumberger, Halliburton, Baker Hughes, et cetera. Those are the companies that specialize in figuring out how to go down there, break the rock apart, do it economically and turn it over to the upstream companies. Now there’s another great set of opportunities and that’s in the midstream. Most of the midstream sector lends itself to companies that are involved with pipelines and involved with gathering systems, and much of that fits into the MLP category, and there’s a whole class of …

Consuelo Mack: Master limited partnership.

Tom Petrie: That’s right, master limited partnership yield companies, and those are situations where that’s another category worth looking at if an investor is looking for yield with some growth, and each of those have a lot of merit.

Consuelo Mack: You have investment rules that you have developed over the last 40 years for investors who want to invest in energy. Number one, why should we invest in energy as investors and energy companies?

Tom Petrie: We should invest because energy is one of the main drivers of economic growth throughout our economy, throughout the global economy, and it’s demographically driven. We’re in a world today of seven billion people. When I was born, the planet had two and a half billion people, so we’ve almost tripled. Between now and 2030 we’re going to add almost another billion people. Between now and 2050 we’ll probably add two and a half billion people. So the demographics are a big, big part of that. The other part is economic growth doesn’t occur without some degree of energy growth, and so that’s a compelling reason to be represented in this sector. That said, it’s also cyclical and it’s my number one rule, and we have to keep that in mind. It’s also geopolitically driven. There are times when geopolitical events overwhelm us. That happened in 2008 and ’09 when we had the financial meltdown. Oil went from 147 to $35 in less than a year. It didn’t stay there. It’s powerfully self-correcting, and we will get those times again, so the other rule to remember is the time to buy is when everybody hates it, and right now we’re in a sweet spot. It’s fine. It’s not at the high. It’s not at the low, and I think there will be opportunities in the sectors we talked about, but if I had one area today to focus on, it would be natural gas because we’ve got probably more of a tailwind than a headwind on pricing, and we’ve got supply elasticity that is 10-fold better than it was a decade ago.

Consuelo Mack: One investment for a long-term diversified portfolio. What would you have us all own some of?

Tom Petrie: Some representation in upstream natural gas, one of the better suppliers of gas. Again, I can’t make individual recommendations, but that’s the fertile area today. You can be a contrarian in gas. We’re less than two years away, about a year and a half away from opening up U.S. deliverability of natural gas to the global market. That is going to be transformational. It’ll be very rewarding to companies that help provide that connectivity and that also reach back into the producers of the gas in the major basins.

Consuelo Mack: Tom Petrie, you’ve had a fascinating career which is in your new book, “Following Oil”, which is going on the WealthTrack bookshelf recommendation list, and it’s also great to have you back in the investment banking business with Petrie Partners, so thanks very much for joining us, Tom.

Tom Petrie: Thank you. Good to be here.

Consuelo Mack: At the close of every WealthTrack we try to give you one suggestion to help you build and protect your wealth over the long term. This week’s action point is: read Tom Petrie’s book “Following Oil”. If you are invested in energy stocks and most of us are either actively or passively, and are interested in an extremely knowledgeable insider’s view of the events that have rocked and shaped the oil and gas industry over the last 40 years this is the book for you. Tom covers it all from his extremely well connected vantage point of energy analyst and advisor to major industry players as well as policy makers and regulators. He also provides a rational and realistic view of how to balance the growing energy, environmental and national security concerns we face. “Following Oil” is being added to our WealthTrack bookshelf.

Next week we will be starting our tenth season of WealthTrack and we are doing so by helping the women in our lives achieve financial security. Two of our award winning WealthTrack women financial advisors will give us advice on how to build a financial plan that works in different stages of our lives. We will also discuss the role of prenups in the WealthTrack Women section of our website.

Have a great first of the summer weekend and make the week ahead a profitable and a productive one.

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