The market’s enthusiasm for this IPO stems from its operations in the Bakken Shale, an oil-producing region of North Dakota and Montana that’s arguably the most exciting US onshore oil field. (See the Oct. 20, 2010, issue Rough Guide to Shale Oil.) For the most part, oil produced from the Bakken is of an extraordinarily high grade, equivalent in quality or better than West Texas Intermediate (WTI), the US benchmark.  Many wells in the Bakken generate decent rates of return even with oil in the $50 per barrel; at current oil prices, returns on investment can exceed 100 percent.

The Bakken is an unconventional field just like the Barnett, Haynesville and Marcellus Shale. What makes an oil or natural gas play unconventional? Conventional reservoir rocks such as sandstone feature are highly porous and permeable, boasting many pores capable of holding hydrocarbons as well as fissures and interconnections through which the oil or gas can travel. When a producer drills a well in a conventional field, oil and gas flow through the reservoir rock and into the well, powered mainly by geologic pressure.

Shale fields and other unconventional plays contain plenty of hydrocarbons but lack channels through which oil or gas can travel. Even in shale fields where there’s plenty of geologic pressure, the hydrocarbons are essentially locked in place.

Producers have developed and refined two major technologies in recent years to unlock the natural gas and oil trapped in shale deposits: horizontal drilling and hydraulic fracturing.

A horizontal well branches off laterally from an initial vertical drill hole, exposing more of the productive layer to the well. Fracturing, or stimulation, increases the permeability of the reservoir rock, allowing natural gas to flow from the reserve rock into the well. This process involves pumping large quantities of water and a small percentage of chemicals into the rock formation at high pressure, producing a network of cracks. The inclusion of a proppant–typically sand, sand coated with ceramic material or ceramic material–ensures that these passages remain open.

Over the past several years, US producers have perfected these techniques in a number of prolific shale gas plays. More and more of these operators are applying the same techniques to a handful of established and emerging shale oil plays.

Producers have found that long horizontal wells–“long laterals” in industry parlance–and huge multistage fracturing jobs maximize output from shale deposits. For example, in the Bakken producers routinely drill laterals that exceed 10,000 feet in length, a distance of nearly two miles. Plenty of producers do fracturing jobs in more than 30 stages, and a few are contemplating fracturing projects of 42 stages or more. As technology and drilling techniques evolve, output and efficiency continue to improve.

Oasis Petroleum own roughly 300,000 acres of leasehold in the Williston Basin of Montana and North Dakota. This is the only region where the company operates, so the stock is one of the few pure plays on the Bakken. Oil accounted for more than 93 percent of the company’s output in the third quarter of 2010, an attractive production profile at a time when oil prices should continue to climb and natural gas prices remain depressed.

In the third quarter, Oasis Petroleum had 17 wells enter production, drilled eight wells that are awaiting completion and wasin the process of sinking four other wells. Management expects the company to have drilled 44 wells in 2010–the firm will announce the exact number when it reports fourth-quarter results in February.

Oasis Petroleum has farmed out stakes in some of its wells but still retains an average working interest of more than 75 percent in the wells it had drilled. The firm also operates 85 percent of its wells.

The company continues drill aggressively. In 2010 Oasis Petroleum spent $243 million, the majority of which went to its drilling program. This year management expects to spend about $440 million to drill 69 wells and retain an average working interest of about 68 percent.

The company has seven rigs working on its leasehold and has agreements that allow it to fracture at least five wells per month. Halliburton (NYSE: HAL) and other major services companies have noted a shortage of fracturing capacity in shale oil fields; having secured fracturing services in advance, Oasis should meet its drilling and production targets.

The company has found that 10,000-foot horizontal wells with 28 fracturing stages yield superior returns and estimated ultimate reserves. The company’s 2011 capital budget calls for costs of $6.8 to $7.2 million per well, up from an average of $6.6 million in the first half of 2010. Much of this increase stems from a tight market for fracturing and other services, but management noted in its third-quarter conference call that service costs appeared to be moderating.

Oasis Petroleum’s acreage is located in the West Williston and East Nesson areas. 

The company plans to devote 80 percent of its 2011 budget to drilling in West Williston, a region on the periphery of the Bakken’s core that accounts for more than half the company’s net acreage and output. Six of the company’s seven contracted rigs operate in this area.

The company reported that wells in its West Williston leasehold flow at an average rate of 567 to 969 barrels of oil equivalent per day (boepd) during the first seven days of production. Over 60 days, the production rate averages 359 to 613 boepd. Management estimates the amount of recoverable oil at 400,000 to 700,000 barrels per well.

This gibes with the experience of Continental Resources (NYSE: CLR), the leading acreage holder in the Bakken. Although some of the Continental’s wells in the play’s core produced at an initial rate of more than 4,000 boepd, management noted that that average 30-day production rate of its wells was about 623 boepd–in line with Oasis Petroleum’s findings in West Williston. Similarly, Continental Resources estimates that its average well contains recoverable reserves of about 518,000 barrels of oil equivalent from each well drilled.

Based on an average 60-day production rate of 30,000 barrels, Oasis Petroleum’s wells would generate about $2.4 million worth of oil–assuming prices of $80 per barrel. Even if the company’s wells cost $7.2 million to drill–the high end of expectations–these wells quickly cover their costs and offer attractive rates of return. In the third-quarter conference call, management observed that early results suggest that at least a portion of its West Williston wells would be profitable with oil at $45 to $50 per barrel.

With average 60 day production rates of 329 to 529 boepd and estimated ultimate reserves of 350,000 to 600,000 barrels, returns on Oasis Petroleum’s wells in East Nesson aren’t quite as impressive but still represent a worthwhile endeavor. In 2011 the company plans to spend $51.4 million in the Nesson play.

Oasis has successfully ramped up production over the past few years, a trend that should continue.

Source: Oasis Petroleum

In the third quarter of 2010, Oasis Petroleum produced an average of 5,507 boepd, up by nearly 150 percent compared to the third quarter of 2009. The company is also in a good position to at least double its output over the coming 12 months.

Oasis Petroleum is in good financial shape, with no net debt, a $120 million revolving line of credit and about $270 million in cash. Management expects that its drilling results should enable warrant an increase to its credit line in early 2011. The company will need that cash, as the $200 million or so of cash flow it will generate in 2011 won’t fully cover its planned $440 million in spending.

That Oasis Petroleum is outspending its cash flow isn’t a major concern. Unlike many shale gas operators, the company isn’t drilling to secure leaseholds; most gas producers are at best only modestly profitable with gas prices at current levels.

And every well that Oasis Petroleum drills demonstrates the quality of its acreage and allows it to increase its production and proven reserve estimates. Strong internal drilling results and solid well performance fin neighboring acreage should serve as an upside catalyst for the stock. Most of the region’s major producers are likely to outline additional well results as they report earnings over the next few months.

Shares of Oasis Petroleum have enjoyed quite a run since the IPO, raising questions about valuation.  The company’s current enterprise value–the total market capitalization, plus net debt–is about $2.41 billion, and the firm should produce 7,600 boepd in the fourth quarter.

Brigham Exploration owns similar assets, grew its third-quarter output by an almost identical 144 percent year over year, and is expected to produce about 8,100 barrels of oil per day in the fourth quarter. However, Brigham’s enterprise value comes in at $3.31 billion. On a comparative basis, Oasis Petroleum appears cheap.

The stock trades at about 10.5 times 2011 earnings before interest, tax, depreciation and amortization (EBITDA), while shares of Brigham Exploration trade at 11.6 times forward EBITDA. Meanwhile, Continental Resources trades at 10.4 times 2011 EBITDA, reflecting the company’s size and maturity; it takes a lot more earnings growth to move the needle for larger companies. Bottom line: Shares of Oasis Petroleum don’t appear overvalued.

The stock should also benefit from two upside catalysts: rising oil prices and a slew of drilling results due out over the next few months. As I noted in Road Map for 2011, oil should overcome the occasional pullback to eclipse $100 per barrel in the first quarter and touch $120 per barrel later this year.

Disappointing drilling results or a 10 percent correction in oil prices could touch off a short-term selloff in the stock, but investors should increase their exposure to oil-leveraged producers on dips.

Oasis Petroleum rates a buy under 33 in the Gushers Portfolio.