Energy investors peering into 2011 might see a tale of two commodities. On the one hand, oil pricing is poised to experience the best of times. With prices expected to hold steady at already comfortable levels or to trend up slightly, operators and investors alike are shifting capital at a frenzied pace into oil and liquids-rich projects. Conventional basins, liquids-endowed gas plays and experimental oil shales are receiving the bulk of those new investments.

But with so few operators having a majority of their pro­duction in oil, are all available stocks being fully valued?

On the other hand, gas is expected to languish in what many insiders consider the worst of times, especially when measured against a historic spread in the ratio to oil, at 25-to-1. Can it go any wider?

Shale-gas plays coming online have flooded the market with an unexpected voluminous supply that will last for decades. The rush to hold acreage bought at top-of-market prices, international joint-venture partners with open pocketbooks, lingering well-placed production hedges, and compelling margins fueled by low finding and development (F&D) costs continue to motivate operators to build value while adding to supply.

Says one industry insider, "It looks like producers are going to continue to oversupply the market."

So might 2011 be an age of wisdom, or an age of foolishness, for an upstream energy investor? Three analysts give their views.

Where's the Pullback?

2011 appears to be littered with bearish indicators, acknowledges James R. Crandell, senior commodities analyst with Barclays Capital in New York. "We see a lot more supply potential in 2011 than demand potential."

Crandell, whose team analyzes gas macro factors, forecasts an average price deck of $3.94 for natural gas through 2011, a view toward the low end of the analyst consensus.

Demand should grow by 1 billion cubic feet (Bcf) per day in aggregate, he estimates, but is muted by several declining factors.

Following a hot summer in 2010, weather-driven power demand will likely pull back based on 10-year averages. Industrial demand growth should also slow as the economic recovery levels out, while residential and commercial demand stays flat.

The only real source of demand growth for 2011 is displacement of coal in the power sector, he anticipates, which should overwhelm the weather effect. "This is a necessity based on how weak natural gas prices could become without this added source of demand. In 2011, gas prices are going to be inordinately weak and will need this source of demand to help balance the market."

The most dynamic part of the balance equation, however, continues to be supply.

"Supply has been defined by all the producer motivations and technology that drive supply growth. A turnaround in prices must, therefore, come from a turn in producer actions." And while Crandell is not predicting that producers will forever oversupply the market, "there is no sign of a meaningful drilling cut on the horizon," he says.

The current gas-targeted rig count stands about 960 and will steadily drop by four to five rigs per month throughout the year, ending at just above 900, he anticipates. Yet he pegs 850 as the maximum number of rigs needed to keep production flat, "so a number over 900 should keep the U.S. production profile on a growth trajectory for the entirety of 2011."

How much? Crandell projects some 2.1 Bcf per day more in 2011.

"Demand is not the savior for natural gas in 2011," he emphasizes. "The rig count would have to be pulled down dramatically to take the market from a mode of production growth to a mode of production decline."

Barclays estimates storage levels at the end of March will top 2 trillion cubic feet (Tcf), a record high further pressuring prices. Likewise, by October end, the storage fill could level at 4 Tcf, again signaling a very high fill at the end of an injection season.

Rig rates alone don't define the supply side. Rig efficiency and decline rates add to the equation. Even with fewer rigs running, companies are pushing initial production (IP) rates and estimated ultimate recoveries (EURs) higher with improved drilling and completion technologies. Add to that a glut of drilled but uncompleted wells—maybe as high as 3,000, according to one service industry executive—which would have to come online before the effect of dropped rig rates would be felt.

What's motivating gas-focused operators to drill while all indicators shout otherwise?

Liquids-rich drilling. In areas like the Eagle Ford shale and the Granite Wash, companies are drilling gas wells but reaping more revenue from the liquids component. Still, gas IP rates are relatively high, and a large amount of gas production is being brought online along with the more profitable liquids.

HBP (held by production) drilling. Vast swaths of acreage are being drilled in resource plays despite negative margins, to avoid lease expirations. "Many producers don't want to drill this acreage at $4 because it might be a $5 all-in well," says Crandell. Producers are focusing on short-run costs when deciding on drilling. Given that many costs are sunk, producers today are sinking $2 into a well that produces $4. "If producers didn't drill, they would have to re-lease the land and incur additional cost. Their expectation is gas prices could rise to $6 in a few years and make this land economic again."

Hedges. Gas production hedges put in place in 2009 are protecting operator returns in the current environment, and with 43% of volume hedged going into 2011 and rising, the same phenomenon is likely to persist. "We don't expect with the amount of hedging done that it will be a major driver in lowering rig count," Crandell says.

Joint-venture drilling carries. International entities partnering with U.S. independents are far less concerned about price today, because they are exporting shale technology tomorrow. And the drill-it-or-lose-it mandate to retain funding spurs operators onward. "It's very much a full-steam-ahead effort to drill these wells under the JV structure."

Says Crandell, "We don't see the opportunity for recovery in 2011 unless producers really change their tone."

Full Shale Ahead

Analyst Rehan Rashid, with investment-banking firm FBR Capital Markets, concurs that the outlook for natural gas through 2011 is bleak—he targets $4.50—and is surprisingly upbeat about the lackluster prognostication. He firmly believes that such pain is a natural cause and effect when the industry is experiencing a paradigm-shifting revolution as it is in the shales.

"Any structural adjustment is brutal. This is a once-in-50-years opportunity," he asserts. "It's irrelevant where the gas price is today. It's about companies being able to put together the franchise, and the development platform that can go after both gas and oil shales. It's still not too late."

With an estimated 1,000 Tcf of future supply locked in shale reserves, Rashid, FBR managing director and head of energy research, suggests the industry is poised for a reset, with oil and gas shale development following the same pattern as conventional resources during the past century. "History is going to repeat itself. We're going to go through the same growth cycle that we went through in the U.S. 30 to 60 years ago."

In the short term, marginal demand is driving his price-deck estimate. Demand is assumed to be flat while incorporating 3 Bcf of coal-to-gas switching. "Otherwise, you are way oversupplied," he warns. For supply to balance, "we need $4.50 or lower to price out some of the marginal supply out there." If that holds, a balance should occur during second-half 2011.

But the Washington, D.C.-based Rashid takes a contrarian view, less interested in agonizing about prices but eager to discuss margins. "It's not the absolute gas price that matters; it's the margins and implied cost of capital. Current aberration aside, margins should be held reasonably steady with continued improvements in technology."

As such, one of his favorite names is Fort Worth, Texas, operator Range Resources Inc., a gassy play. With some 900,000 acres in the Marcellus shale, the company exhibits scale, technical expertise and improved cost structuring. And it is just beginning its growth profile in the play, modeled at 35% through 2015. Rashid has it earning $8 per share at that point, compared with $0.50 today. "Why wouldn't I want to buy that kind of growth rate?"

Investors in general, though, have qualified gas as a space not worthy of investment at present and have left in droves, instead rewarding companies shifting to oil and liquids-rich assets. "Oil is definitely more favored," Rashid agrees, "and I wouldn't disagree too much. But in that broad-brush move toward oil, don't forget the value that you get with a name like Range."

He adds, "I wouldn't say to buy natural gas as a contrarian play; I still want scale, I still want quality. But in that rush to oil don't forget highly scalable, highly valuable franchises. Range is a 60-Tcf franchise, which is 10 billion barrels trading at less than $1 per barrel today. It's silly cheap. To get a franchise like Range at current valuation, you just buy it, put it away and go home."

What about the ongoing flood of gas from shale plays? Pondering the quadrillion-cubic-feet resource potential purported to exist in shales and the resulting overall 400-year reserves-to-production (R/P) ratio, Rashid's view is clear: drill it and drill it now.

"It is incumbent upon those companies to collapse the R/P ratio and to pull those cash flows forward. Give up price to get volume." It may not seem like such E&Ps are earning high internal rates of return today, but as development scenarios in multiple plays are rolled forward, with the resulting impact on net asset values, "I'll take a lower rate of return now," he states.

The present-day gas glut resulting from shale drilling will abate only when conventional assets are priced out of the market, which can't come too soon, says Rashid. Conventional gas assets account for some 80% of supply, a massive amount that "needs to go away." At or below his $4.50 price deck, "that's all we need to get shale gas to go from 8 Bcf a day today to 45 Bcf in 15 years."

Gas drilling through low prices pulls the normalization forward, and that's a good thing. "Why should a company like Range, where all-in costs are approaching $1.50, slow down at all when you've still got gas supply out there that needs $5.50 to $6? Economic rationalization is what is being facilitated."

He is equally as optimistic about the viability of shale oil, counting on technology to drive productivity growth. "If shale gas is for real, why won't it be the same for shale oil? The only missing link is technology." Conversations will center on the Permian Avalon and Bone Spring, the Bakken, the Barnett combo, Eagle Ford and Niobrara, to name a few. How big are those resources and how producible? E&Ps should act now to move in the oil-shale space and help answer those questions, he says.

Investors, too, are focused on oil in shales more than gas, expecting an exploratory trend with valuation upside for early movers. The exploratory value is just beginning to be understood and assigned.

"Buy only high-quality names on the oily shale side," Rashid advises. "And follow the headlines. Whoever comes up with the next best headline should outperform."

In this space he likes Pioneer Natural Resources Co. Along with attractive assets in the Eagle Ford condensate window, the company is redeveloping a 100-year-old asset—the Spraberry—with new fracturing technologies and horizontal drilling. "Pioneer remains the best way to play the sustainability of oil," says Rashid. "It should continue to outperform."

For similar reasons, he chooses Rosetta Resources Corp., a small-cap company with exploratory acreage in the Alberta Basin's Bakken. "Based on the progress we've seen, we continue to think the Alberta Bakken has good potential to be like the Williston Basin Bakken. We want to continue to be exposed to that."

So resolute is his confidence in resource plays, he contends operators should also continue to stockpile quality shale acreage and then bestow plentiful capital on it. "It's a mistake not to." He suggests companies should prudently use higher leverage to drill it, and if gas-focused, hedge and produce against that. If unable to follow that path, they should bring in a joint-venture partner and retain most of the platform and upside.

"If you sell, you're leaving a lot on the table and not giving technology credit to take recovery levels higher."

What should investors be alert to going forward? "2011 is when you'll see massive outperformance on the oil-shale side, and recognition that gas is not that bad."

Gas Upside

"It's painful to be a gas-focused company right now," says Johnson Rice & Co. equity research analyst Ron Mills. "Investors are punishing gas-focused companies. They prefer more oily names."

Domestically, most independent companies still produce large quantities of gas, he notes, "and because they have such a large gas component, low prices are people's greatest concern."

Investors don't have high expectations for a gas-price recovery into next year, he says. Concerns include operators' ability to fund activity out of cash flows, whether shortages will be funded out of equity or debt, and the effect of bank redeterminations in the spring, should price remain stagnate. "If we continue to see the gas-to-oil ratio in the 20-to-1 range, you will likely continue to have greater demand for oily investments."

But New Orleans-based Mills sees a sunnier future ahead for gas stocks—and opportunity for bold investors. His price deck for 2011 is $5, roughly 15% above the 12-month strip price, suggesting a more bullish stance than most.

Why so? First, the increased drilling in liquids-rich plays, from 5% to 17% of the U.S. total gas rigs, has attracted equipment from some gas plays. And while gas is still being produced, on a prorated basis it is less than a pure-gas model suggests. "We should start to see gas supplies impacted by that," says Mills.

That, combined with a leveling out of drilling efficiencies as experienced in the last two years and a drop-off in the backlog of uncompleted wells, will begin to affect supply numbers.

"We're set up for an improvement in gas prices toward the second half of next year."

And rather than advising clients to get out of gas and completely into oil, he recommends moving some capital back into gas names. "Given my outlook, that creates an intriguing opportunity on the gas side."

He's quick to highlight Comstock Resources Inc., a Dallas-based company that is virtually 100% gas exposed and completely unhedged. No surprise, it was one of the poorest performers in 2010. Yet, the company has quality management, quality assets in the Haynesville/Bossier and Eagle Ford plays, and a strong balance sheet with nothing drawn on a $500-million revolver, he notes. It also holds 4.8 million shares of Stone Energy Corp. that can be monetized at will, creating financial flexibility.

"They would be one of the biggest beneficiaries of an improving commodity environment for gas."

Mills expects unconventional names to further receive a premium from investors over conventional names, as unconventional plays are largely devoid of geologic risk. "Investors have been willing to pay a higher multiple for unconventional players." Thus, higher-quality, lower-cost operators will benefit.

Conversely, conventional-focused operators will continue to face pressures. However, when surveying his list of 20 covered companies, Mills cannot find many that are purely conventional players. "They've done what you would expect: almost everyone has rotated into unconventional plays."

Another favorite: Houston-based Petrohawk Energy Corp. has leading positions and is one of the lowest-cost operators in both the Haynesville and Eagle Ford shales, providing the company flexibility to transfer between gas and liquids spending. In recent years, however, the company has been beset with financing questions as it has built these positions.

"Although they are outspending cash flow, between noncore asset sales like the Fayetteville and additional sales of midstream assets, they should be able to bridge that gap in 2011."

Yet while Mills sees upside in selected gas names, investors do prefer oils, he concedes. Valuations of oil and liquids-rich companies are being driven up by the "scarcity premium," due to the lack of names in the space. "There are not as many opportunities."

Mills IDs Brigham Exploration Co. as an oil-focused stock with significant upside. The company has built a large acreage position in the Bakken and Three Forks plays in the Williston Basin that, as the company continues to prove up the infill drilling capability, should drive asset-value growth. The analyst makes this prediction even though the stock has gained some 400% since its March 2009 low.

"Over that time a lot has been proved up about the Bakken, and we're just scratching the surface on the Three Forks opportunity below the Bakken."

Because of the limited data on the Three Forks and on infill spacing, investors are placing a higher risk on those opportunities. "As the company continues to execute and investors lower their risk profile, that's what drives that stock to continue to work. Brigham presents a compelling opportunity in 2011."

In addition, a rare oily small-cap company that he likes is Gulfport Energy Corp. Virtually all oil, it holds salt-dome projects in Louisiana, assets in the Wolfberry and a 25% interest in a private company with significant exposure to the Canadian oil sands. And with a market cap of $700 million, "it's one of the few real small-cap oil names and is attractively priced on today's evaluation basis—and holds this long-term oil opportunity in the oil sands."

So how should investors position themselves for 2011?

"It will remain challenging," says Mills, "but there will be opportunities in both oil and gas names." Oily names will continue to benefit from a higher than historical oil-to-gas price ratio, "but opportunities do exist in the gas names."