Oil and Gas Investor sat down with Brian Gambill, managing director, Capital Goods & Equipment, at the Rochester, N.Y. money management firm Manning & Napier.

Gambill is a specialist in the commodities market. He shared some timely thoughts on the price of oil, its impact in producers and drillers and how investors may want to play the oil drilling market.

OGI: How are improved manufacturing technologies impacting price declines for oil and gas drillers?

Gambill: Let’s talk about North American gas first. During the last four to five years gas production surged due to substantial improvements in horizontal drilling and hydraulic fracturing technology.

In each prolific basin, E&P operators identified and acquired acreage positions, then began a series of ‘science experiments’ to determine the most optimal way to extract these unconventional shale resources. The most prolific basin, the Haynesville Shale, accounted for the majority of production growth since 2007. In fact, production not only from the Haynesville, but from other large basins including the maturing Barnett and the rapidly growing Marcellus, created a significant surplus of natural gas in storage.

That, combined with an unusually warm winter last year, drove natural gas prices to around $2/mcf, a level where no E&P operator can make money. Break-even costs in the Haynesville are in the $4/mcf range, and as such, capital allocation and rig activity have plummeted during the past six months. Ultimately, this will help to correct the market as supply increases begin to slow, and eventually begin to decline.

Meanwhile, demand for natural gas is expected to increase during the coming decade given a variety of factors:

1. EPA-mandated coal plant substitution, which favors the construction of combined-cycle natural gas plants.

2. Increases in industrial demand as manufacturers take advantage of this incredibly cheap resource.

3. Increases in the small, but rapidly-growing transportation sector.

4. Ultimately the liquification and export of natural gas, expected to occur later in this decade.

The combination of less supply and greater demand should support gas prices in the $5-$6/mcf range, which is closer to the marginal cost of production. While we don’t expect these prices to occur until the middle of the decade, in order to have a healthy market, producers need to see prices high enough to entice production, and consumers need prices low enough to accommodate future demand growth.

Unlike North American natural gas, oil is a global commodity, and as such, is dictated by global supply and demand.

That said, North American E&Ps have begun ‘manufacturing’ oil using the same technologies as they use with natural gas. U.S. oil production, after decades of decline, is surging and is expected to continue significant growth over the next decade. But the U.S./Canada is an anomaly. Global supply growth is stagnant, excluding North America, and as such, global demand (largely demand from emerging markets like China) has been met by drawing down OPEC’s spare cushion of excess oil capacity.

Unlike North American gas, oil fundamentals are tight and support prices in the (approximately) $90/bbl + range. North American E&Ps are in a great position of being able to grow their domestic oil and liquids production and get paid based upon a tight global market that is otherwise supply-constrained.

OGI: How are improved discovery procedures lowering operating costs for drillers?

Gambill: Again, we need to disaggregate North American gas with global oil.

Improved discovery procedures helped to identify massive U.S./Canadian gas reserves, which in turn, lowered the cost of gas production. But that story is over, at least for now, as $2-$3/mcf gas does not incentivize anyone to look for more reserves. The market is telling us to stop looking and to curtail production.

In North America, drilling for unconventional oil is quite capital-intensive, thus E&P costs have risen over the last 2-3 years. That said, costs should begin to decline during the next several years as operators will largely be finished with inefficient ‘held-by-production’ drilling, and they concentrate on more efficient ‘pad drilling’ production. In terms of the evolution of costs, North American oil is several years behind natural gas.

Global oil production is a much different picture, where instead of ‘manufacturing’ oil in known oil/liquids reserves, companies need to:

1. Explore for oil using seismic.

2. Then drill discovery and appraisal wells.

3) Draw up development and production plans.

4. And ultimately produce the oil.

The timeline of a new discovery being translated into actual production can easily take around 5-10 years In terms of operating costs, the marginal cost of oil production has continued to increase significantly during the last 10 years, and we see little sign of this cost pressure abating in the near term.

OGI: What should investors look for when investing in oil drillers that are struggling to find new reserves?

Gambill:
Investors need to identify companies that have attractive positions in big oil/liquids producing basins.

Next, investors need to monitor the company’s capital spending trends to see if they are getting ‘bang for the buck.’ Almost every company will brag about being low-cost producers or having extraordinary potential reserves, but if these management teams don’t have credible plans or if it costs them too much to extract the reserves, investors should take this into consideration.

OGI: How will the shift to natural gas, especially here in the U.S., start to crest $100 per barrel again? Will natural gas production rates suffer?

Gambill: More oil drilling, which should occur with prices anywhere over $80/bbl, will lead to higher production of associated natural gas. Associated gas production is important to monitor because new pipeline and processing infrastructure in the Eagle Ford, Bakken and Marcellus could add to the natural gas supply glut. If associated gas production is too strong, it could overwhelm potential production declines in dry-gas basins such as the Haynesville.

OGI: You’ve said that oil and gas M&A activity is on the upswing here in the U.S. Why so, and what level of activity do you see in 2012 and 2013 in terms of M&A landscape?

Gambill: The cost of finding reserves is increasing, with global Finding and Development (F&D) costs in the $25-$30/bbl range.

Some of the biggest energy producers are also facing declining production, or the prospects for declining production in terms of a shortage of opportunities/projects. This combination makes for a very interesting M&A market over the coming several years, whereby it’s now cheaper to ‘Buy’ oil/gas reserves on Wall Street than to ‘Build’ reserves organically.

It’s also easier to process and transport these reserves in North America, especially given the remarkably robust infrastructure. When a company discovers oil in deepwater, it could take years and several billions of dollars to develop and transport it, but in North America there is a ready and easy-to-access market.

OGI: With the energy lifecycle changing considerably in recent years, how can you extract the most value and identify the best point of entry?

Gambill:
Most investors are evaluating macro risks and the prospects for a global recession during the next few years, and pricing in a high probability of oil price weakness. As a consequence, valuation metrics, whether it is price-to-book or enterprise value to barrel of oil equivalents, are very compelling. There are many E&P companies that are cheap on a Net Asset Value/Reserves basis. There are also good risk/reward opportunities in the Oil Services sector. Investors can’t be afraid to ‘climb the Wall of Worry.’ Consider the possibility of running several different dynamic scenarios and ‘stress test’ the potential candidates. For example, run income statement, cash flow, and balance sheet models using a Base case scenario and a Bear case scenario, where the Bear scenario is a global recession. If your company passes the Bear scenario stress test and does not take on too much debt or has to write down too many reserves, it could be a candidate for purchase.

OGI: What are the strongest energy sectors for investors going into autumn, 2012?

Gambill:
We like North American E&Ps and global oil service companies.

With the E&Ps, we think natural gas supply/demand fundamentals look attractive into 2013-2014, barring a major global recession. And many of the companies have attractive growth prospects and are trading at low levels in terms of Net Asset Value/Reserves. There has been some recent M&A, which is supportive to the group overall, and we expect more going forward.

Global oil service companies, especially those that have been subject to major market disruptions in the North American gas industry, also represent some attractive risk/reward opportunities. While the near-50 percent collapse in gas-related rig activity continues to hurt near term oil service fundamentals, eventually when gas prices move above $4/mcf, operators will start to re-evaluate gas-related drilling plans. This should tighten the domestic services market.

Globally, oil service providers are seeing higher leading edge pricing on small contracts. However, the biggest underlying driver, is that in order to accommodate global oil demand (and rebuild OPEC’s cushion of spare capacity), capital spending levels must increase.

Higher sustained levels of capital spending would be a positive surprise to the market and could lead to much higher margins and earnings. Barring a global recession, we expect that higher activity levels will eventually lead to better pricing and much higher margins.