Drilling for Unconventional Gains

Looking to get in on the latest surge in energy prices -- or to diversify your bets in the sector? Consider taking the unconventional approach.

Called resource plays in industry jargon, unconventional exploration firms drill where the big boys won't anymore, using so-called fracturing techniques that release and gather gas that is tightly embedded in rock. Essentially, they use an injection of some type of fluid or gel into rock such as coal bed methane, shale and tight-gas sands, in order to release entrenched gas.

Here's how it works: Typically, big players such as BP(BP) and Royal Dutch/Shell(RD) abandon oilfields after the initial exploration phase ends. Until recently, natural gas was too cheap to justify unconventional exploration and those fields would lie fallow.

But natural gas prices have risen nearly threefold since early 2000, when they traded around $2 per thousand cubic feet, prompting a wave of investment in unconventional exploration. The average total production costs among those in the unconventional peer group was $3.15 per thousand cubic feet in 2004, and the average finding and developing costs was $1.79 per thousand cubic feet, according to research from JP Morgan and Wachovia. With a selling price of $7.13 based on Monday's close, the profit potential is huge for companies such as Quicksilver Resources(KWK) and Southwestern Energy(SWN).

"Unconventional gas is a very good macro market," says David Anderson, portfolio manager at Palo Alto Investors, a hedge fund that manages $550 million, 40% of which is dedicated to energy shares. "Smaller exploration companies learnt how to increase their proven reserves by 10% to 20% while keeping their costs low."

Anderson looks for companies "which have mastered a certain area, where the engineering is good and the assets are good." His favorite pick in the group is Ultra Petroleum(UPL), which Palo Alto Investors owns.