A Presidential Order That Could Save Energy Drillers

By: Joseph Hogue of Street Authority

In his six years in office, President Obama has stressed his support for strict environmental regulation. He has expanded powers for the Environmental Protection Agency and has repeatedly deferred approval for the Keystone XL Pipeline System.

One key stat: The number of oil and gas leases approved during the first three years fell by more than 40%, compared to the final three years of President Bush’s administration. Drilling permit approvals on federal lands fell by a similar amount.

In addition to the regulatory headwind, falling oil prices are also impeding drilling permit activity. Against this one-two punch, some analysts are questioning the emergent theme of U.S. energy independence and shale production.

But is an unlikely supporter about to throw the sector a lifeline?

Is the U.S. Energy Revolution Dead?

Though OPEC thus far remains steadfast in its output quotas, the global energy picture still appears to be poised for long-term supply shortages. Energy firm BP Plc (NYSE: BP) forecasts a global production deficit for every period from 2015 to 2035 as global economic growth continues to require more energy. Total liquids consumption is forecast to increase at a 0.8% annual pace to 4.97 million tons of oil equivalent in 2035, while production may only grow by 0.6% annually to 4.82 million tons of oil equivalent over the period.

Cheaper oil this year will likely lead to increased near-term consumption and decreased production as producers pull back on capital investment. Along with the already forecasted deficit in supply, this should help to support energy prices as we head into 2016. I am not betting on a speedy return to $100 per barrel prices, but the recent drop in prices seems to be more a function of trader sentiment than real supply-demand fundamentals.

And just when you thought U.S. production was doomed, an unlikely hero may be coming to the rescue.

Sources reported to the New York Times that the Obama Administration will announce a proposal to open drilling in the Atlantic outer continental shelf (OCS) from Virginia to Georgia. The move is seen as a balance to a proposed ban in some areas around Alaska.

The Bureau of Ocean Energy Management estimates 4.72 billion barrels of undiscovered recoverable oil and 37.5 trillion cubic feet of undiscovered recoverable natural gas in the Atlantic OCS. Water depths in the nine conceptual plays range from 100 feet to 10,000 feet, with drill depths from 7,000 feet to 30,000 feet. Since a 2011 report, the bureau increased its estimated resource average by 43% for recoverable oil and by 20% for recoverable gas.

While the President’s plan to offset drilling in the Atlantic OCS with limits in Alaska is sure to be met with Congressional backlash, real economic benefits to the offshore plan could make it a reality. A 2013 study by the National Ocean Industries Association found that drilling could spur $195 billion in investment and add 1.3 million barrels of oil equivalent per day of domestic production.

Lease sales would probably not be held until 2017 with production still a decade off, but the move to drill in the Atlantic could help support sentiment for some of the currently down-trodden explorers, providing a long-term upside to industry valuations.

Meanwhile, domestic drillers are beginning to take steps to lower production, which as I wrote above, should help oil prices to eventually strengthen. BHP Billiton Ltd (NYSE: BHP), for example, announced last month that it will reduce its rig count by 40% at U.S. shale fields. Royal Dutch Shell Plc (NYSE: RDS-A) plans to slash spending by $15 billion over the next three years.

Moves like these should help to support investor sentiment and the longer-term outlook could send names with U.S. Gulf or potential Atlantic OCS exposure higher.

A pair of potential beneficiaries stand out.

Diamond Offshore Drilling, Inc. (NYSE: DO) provides contract drilling services with a fleet of 45 offshore rigs, 13 of which are rated for ultra-deepwater. Shares trade for 1.0 times book value, well below the 3.1 average multiple over the last decade. The company signed a major deal with Hess Corp. (NYSE: HES) in 2014 that could eventually be worth $1 billion and extend over seven years. Not only does Diamond Offshore stand to benefit from any drilling in the Atlantic OCS, it also has a long history with PEMEX, which could drive contracts as the Mexican energy market opens.

Marathon Oil Corp. (NYSE: MRO) previously held a lease to explore the Atlantic OCS region before federal regulations changed. The company won a Supreme Court ruling in 2000 to recover money paid for the leases. MRO currently operates or has an interest in three wells in the Gulf of Mexico and is likely to bid on any new leases available off the U.S. East Coast.

Marathon acquired acreage in Eagle Ford and Bakken over the last few years, but still has a relatively smaller position in shale compared to peers. Shares trade for 0.9 times book value, well below the 1.4 average multiple over the last decade.

Risks To Consider: Production in the Atlantic OCS is still likely a decade away and low energy prices promise volatility for the rest of 2015. Investors need to be ready to wait out weak sentiment for exploration companies while profiting from long-term demand.

Action To Take -- Take advantage of the sell-off in exploration and drilling companies by acquiring shares of such firms that will benefit from increased U.S. production and long-term energy demand.

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