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Fill Er Up
New York: December 21, 2009
By John Stephenson

Last week, the beleaguered North American natural gas business got some welcome news as the world's largest company made a massive bet on a commodity most people thought was down and out. On Monday, Exxon Mobil Corp. announced that it had agreed to acquire XTO Energy of Forth Worth, Texas for $31 billion in stock. XTO is a major player in North American shale gas, a form of unconventional energy that requires dense, gas-bearing rock to be cracked apart using unique technical procedures. With the acquisition, Exxon Mobil gets nearly 45 trillion cubic feet of natural gas reserves and vaunts itself into the big leagues of natural gas production.

With the acquisition, Exxon Mobil has ignited a fire under the share prices of the other large independent oil & gas players in North America and triggered a guessing game about which companies may be next. It also helped Exxon Mobil solidify its reputation of being a counter-cyclical investor. In a conference call with analysts, Exxon CEO Rex Tillerson made it clear that this acquisition was meant for the long-term—by building the company's asset base for the next 20 to 30 years.

Natural gas is increasingly the fuel of choice for power providers—emitting less greenhouse gas pollution and is more economical than nuclear or coal power plants. Yet in spite of the many benefits of natural gas over competing fuels, prices for natural gas have been stuck in the basement for some time now.

Until now, the shale plays have been dominated by larger independent oil and gas producers such as EnCana, Devon , EOG Resources and Chesapeake Energy Corp. Based on the price that Exxon paid for XTO, many of these names could be worth 30 percent more than their current valuations.

Yet in spite of the hefty premium paid by Exxon to acquire XTO—many doubt that the super majors, such as BP and Royal Dutch Shell PLC and Total SA, will enter the land rush by acquiring large shale gas reserves. In part, Exxon's abrupt move into shale gas is a desperation move.

In the 1980's, Big Oil moved into Russia, Venezuela, West Africa and other remote and often inhospitable regions of the world in the hope of extending their reserve lives (reserves divided by current production). Many of these host governments have turned their backs on the capital and technological expertise of Big Oil, preferring instead to pursue a nationalization of their oil assets. Big Oil has had little choice, but to abandon many of the most promising regions of the world. As a result, Big Oil controls just 15 percent of the world's oil reserves and has an average reserve life of only twelve years.

Absent major new resource finds on their existing acreage or a major corporate acquisition, Big Oil would be facing a rapidly declining production profile in little more than a decade. And that has many investors worried. While oil has jumped more than 70 percent over the last year, Exxon's stock has gone nowhere.

And while an investment in a major shale gas player such as XTO may help with Exxon's immediate problem of a short reserve life it may not help increase long-term profitability. As recently as two years ago, oil and gas analysts were sounding the alarm that North America was facing severe declines in the production of conventional natural gas and may become captive to costly liquefied natural gas (LNG) imports to meet demand.

But a technical revolution has been occurring over the last few years, which has transformed the North American natural gas business and, in the process, unlocked an abundance of gas. Geologists have long understood that there were massive quantities of gas trapped in tight spaces within various rock formations. But up until late 2006, most geologists considered it just too expensive to liberate gas from either shale rock or tight formations.

Some enterprising oil and gas men decided that instead of drilling straight down into the reservoir, a greater volume of the reservoir could be accessible by first drilling down and then across. Horizontal drilling turned out to be a panacea for companies such as XTO that specialized in unconventional reservoirs. But when coupled with a later innovation which allowed exploration and production companies to conduct localized cracking, or fraccing, of the rock did production volumes increase substantially.

Today, previously uneconomic gas fields are a beehive of activity as exploration and production companies have been utilizing horizontal drilling and hydraulic fraccing techniques to liberate vast quantities of gas. And with so much new gas coming on stream, natural gas prices have fallen from their lofty high of $14 to just $5.75 per thousand cubic feet today.

While the acquisition of XTO Energy has breathed new life into the natural gas business, it is probably too early to jump on the bandwagon yet. With North America now swimming in natural gas, prices will remain depressed for the foreseeable future. As I point out in my book Shell Shocked: How Canadians Can Invest After the Collapse , oil is a global commodity and demand is increasingly coming from Asia and other rapidly developing parts of the world. Investors looking to prosper in the energy sector are encouraged to favor oil-weighted exploration and production companies over natural gas weighted companies for the foreseeable future.

StephensonFiles is a division of Stephenson & Company Inc. an investment research and asset management firm which publishes research reports and commentary from time to time on securities and trends in the marketplace. The opinions and information contained herein are based upon sources which we believe to be reliable, but Stephenson & Company makes no representation as to their timeliness, accuracy or completeness. Mr. Stephenson writes a regular commentary on the markets and individual securities and the opinions expressed in this commentary are his own. This report is not an offer to sell or a solicitation of an offer to buy any security. Nothing in this article constitutes individual investment, legal or tax advice. Investments involve risk and an investor may incur profits and losses. We, our affiliates, and any officer, director or stockholder or any member of their families may have a position in and may from time to time purchase or sell any securities discussed in our articles. At the time of writing this article, Mr. Stephenson may or may not have had an investment position in the securities mentioned in this article
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