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The Inside Story on Natural Gas from a Texas Wildcatter

By Larsen Kusick, analyst, Phase 1 Investor
Monday, June 27, 2011

Longtime readers know natural gas is one of the few cheap assets left after the huge post-credit-crisis boom in stocks and commodities.
We've covered several ways to profit, including dividend-paying natural gas royalty trusts, "PUD" hoarders, and E&P partnerships.
One of the strongest trends we've been following in the world of natural gas is "fracking." This is a specialized drilling technique that has revolutionized natural gas production... and has made a few investors rich. (One pick in this space, Carbo Ceramics, has just about doubled since we wrote about it last August.)
But controversy has been building around this technique. And recent headlines are especially troubling. So we sat down with one of our best energy contacts to see if this is a short-term setback... or a trend-killer. 
Before we get to the answer, here are some basics: "Fracking" is short for "hydraulic fracturing." It's the process used to crack open vast underground rock formations to release the oil and gas inside.
Basically, you drill a well and pump in a special fluid. The fluid creates cracks in the rock and holds the cracks open so you can get the gas out. About 99% of the fracking mixture is water and sand. But there are chemicals mixed in, and environmentalists are claiming fracking contaminates ground water.
That argument is gaining traction. Just last week, Texas governor Rick Perry signed a bill that requires drillers to disclose the chemicals they use in the fracking process.
If this headline came out of California, no one would bat an eye. Texas is a different story. It's home to America's energy industry. When Texas starts bringing down the regulatory hammer, energy investors must take note.
So we asked our friend Cactus Schroeder for the inside take. Cactus is a true "wildcatter" ­– an independent oil explorer – from Abilene, Texas.
Cactus has been seeing the buildup toward new regulation for awhile. He says it's all part of a bigger trend that the drilling industry is going along with. In short, they're trying to stay ahead of the game by being open with the public.
He pointed out that one of the big oil-services companies, Halliburton (HAL), has already released everything it puts into its hydraulic fracturing fluid. "You can pull that up on your Google search without any problem."
It makes sense. Fracking has revolutionized the drilling industry. It's turned uneconomical wells into productive, profitable projects. There's no way oil and gas drilling companies will put this golden goose at risk. They're going to work to get the public on their side and the government off their backs. So they're being proactive about publishing information. As Cactus said, "The public companies are particularly sensitive about trying to create the best public image they can."
Cactus also told us researchers at the University of Texas have been commissioned to do a study on the environmental effects of fracking. He added, "I think it's getting blown out of proportion a little bit... Once they do that study and it's released, I think you'll see a lot of that concern go away."
And he compared fracking to coal mining: "Those coal mines are just below the surface mining, so they're very close to groundwater, whereas the wells that we're drilling are 9,000, 13,000 feet deep. And it's nearly an impossibility [to affect the groundwater supply]."
Cactus believes once the public realizes how safe fracking is – especially compared to something like coal mining – the controversy will die down.
So the "inside story" on the fracking regulations is that there's nothing to worry about long term. And the recent pullback in oil prices is opening up an opportunity to get into the sector much cheaper than earlier this year.
Two names to look at are Halliburton and its peer in oil services, Schlumberger (SLB). Both companies are giants in the industry ($43 billion and $111 billion in market cap, respectively). And fracking is the fastest-growing part of their businesses. In its latest quarterly results, Halliburton's fracking division grew revenues by a whopping 62%. Schlumberger's gained 44% versus the same period last year.
This huge growth is flowing straight to the bottom line. Halliburton's fracking unit generated $477 million in income, up 177% year-over-year. Schlumberger's fracking division made $528 million in income during the first quarter. That's more than triple compared to last year.
So investors who missed the run up in fracking plays from last year should watch any weakness in these big names over the next month or two. Be ready to pull the trigger if oil prices work their way down toward the mid-$80 level. That's where we can take advantage of overreaction to the short-term situation in order to profit from the bigger long-term trend.
Good investing,

Further Reading:

"There's still risk here," Frank warns about natural gas. "But the big trend is in our favor. And with prices down 25%-35% from their recent highs, we have a great risk-reward setup, especially for today's difficult market." Find out why Frank's buying natural gas stocks right now.
"Carbo Ceramics is expanding," Matt wrote back in August. And it "looks like a huge winner as fracking continues to grow." He was right. Since that original write-up, Carbo Ceramics is up 100%. Check it out here: How to Invest in America's Biggest Energy Trend.

In The Daily Crux
Market Notes
Gold trades below $1,500 for the first time in over a month.
U.S. dollar index is looking to break downtrend... sitting near three-month highs after making a "stand at 73" in May.
China Mobile surges to a two-month high on rumors of a deal with Apple for the iPhone.
Mobile phone leaders Research in Motion and Nokia both plummet more than 25% over the past month.
Market Watch
Symbol Price
S&P 500 1268.45 -1.2% +18.1%
Oil (USO) 35.81 -0.6% +4.1%
Gold (GLD) 146.26 -1.4% +20.6%
Silver (SLV) 33.36 -2.9% +82.7%
U.S. Dollar 75.28 +0.6% -12.2%
Euro 1.42 -0.5% +15.1%
Volatility (^VIX) 21.10 +9.4% -29.1%
Gold Stocks (^HUI) 500.99 -2.6% +5.2%
10-Year Yield 2.87 -1.4% -8.0%

World ETFs
Symbol Price
S. Korea (EWY) 62.51 +0.4% +33.0%
Taiwan (EWT) 14.60 -1.6% +27.4%
S. Africa (EZA) 66.97 -1.5% +25.1%
Israel (ISL) 16.60 -0.4% +23.1%
Singapore (EWS) 13.23 -0.6% +21.3%
USA (SPY) 126.81 -1.2% +20.4%
Russia (TRF) 20.82 -0.4% +20.2%
Canada (EWC) 30.00 -1.4% +16.5%
Lat.America (ILF) 49.05 -0.5% +15.2%
Japan (EWJ) 10.12 +0.6% +8.2%
India (IFN) 28.82 +0.9% +5.4%
China (FXI) 41.64 +0.9% +4.3%

Sector ETFs
Symbol Price
Oil Service (OIH) 140.91 -2.5% +46.7%
Internet (HHH) 71.68 -1.8% +37.6%
Basic Mat (IYM) 75.63 -0.7% +35.8%
Telecom (IYZ) 24.23 -1.0% +29.3%
Retail (PMR) 20.57 -1.3% +29.3%
Industrials (IYJ) 67.18 -1.1% +27.5%
Transportation (IYT) 94.41 -1.6% +25.8%
Real Estate (IYR) 58.76 -0.1% +25.5%
Consumer Svcs (IYC) 70.13 -1.2% +25.5%
Semis (PSI) 16.14 -1.8% +25.3%
Health Care (IYH) 71.99 -1.2% +22.7%
Biotech (PBE) 21.70 -2.1% +22.1%
Big Tech (QQQQ) 54.38 -1.7% +21.1%
Media (PBS) 14.38 -0.8% +20.4%
Software (PSJ) 25.34 -1.1% +20.4%
Big Pharma (PPH) 69.40 -1.4% +20.2%
Utilities (XLU) 32.80 +0.3% +19.2%
Water (PHO) 18.59 -0.8% +19.1%
Defense (PPA) 19.61 -0.7% +16.9%
Construction (PKB) 12.68 -0.9% +14.9%
Insurance (PIC) 15.75 -2.1% +11.3%
Financials (IYF) 54.13 -0.7% +6.9%
Alt. Energy (PBW) 8.69 -0.6% +1.2%
Nanotech (PXN) 8.34 -0.2% -5.4%

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