The Permian Basin is located in western Texas and extends into the neighboring portion of southeastern New Mexico.

Source: Permian Basin Petroleum Association

One of the most prolific onshore US oil plays, the Permian Basin has undergone a remarkable renaissance over the past decade.

Drillers sank the first wells in the Permian Basin in the early 1920s, but the field’s heyday didn’t come until the 1940s and 1950s, when prolific output from the Spraberry trend helped to fuel the Allied effort in World War II. At the height of its glory days, wells in the Permian yielded initial production (IP) rates of more than 600 barrels of oil per day (bbl/d), but IP rates had dwindled to between 40 and 70 bbl/d by the 1990s.

Drilling activity in the Permian Basin has picked up in earnest in recent years. According to data from Schlumberger (NYSE: SLB) subsidiary Smith Bits, the Permian Basin at the end of the third quarter boasted more active rigs than the Bakken Shale and the Eagle Ford Shale, two of the nation’s hottest liquids-rich plays.

In the week ended Dec. 16, the overall rig count in the Permian Basin reached 477 units–a 35 percent increase from year-ago levels. This graph, which tracks the weekly rig count in the Permian Basin, demonstrates the extent to which drilling acitivity has picked up this year.

Source: Baker Hughes

Through the first 10 months of 2011, the Railroad Commission of Texas has issued almost 8,850 drilling permits in the Permian Basin, up 32.6 percent from the number issued through the 10 months ended Oct. 31, 2010.

The recent resurgence of interest and drilling activity in the Permian Basin over the past few years has halted the steady production declines of the 1990s and early 2000s and even led to a slight uptick in oil production in the Texas portion of the play.

Check out this graph of annual oil production from the three Railroad Commission districts that encompass the Texas portion of the Permian Basin.

Source: Railroad Commission of Texas

We expect oil output in the Permian Basin to rise slightly once again in 2011 and to continue to recover. Targa Resources Partners LP (NYSE: NGLS), one of the leading providers of gathering and processing services in the Permian Basin, noted that a surge in drilling activity has put the MLP on pace to connect a record number of wells to its gathering lines in the region. Meanwhile, pipeline owner Southern Union–which was recently acquired by EnergyTransfer Equity LP (NYSE: ETE)–announced that the firm would go ahead with the construction of a gas- processing plant in the region and associated gathering and compression assets to meet rising demand.

Why the Permian? Why Now?

Several overlapping trends account for the resurgence of activity and oil production in the Permian Basin.

First and foremost, the region continues to benefit from sustainably elevated oil prices and upstream operators’ ongoing efforts to increase their exposure to oil- and NGL-rich plays at the expense of dry-gas fields such as the Haynesville Shale in Louisiana. This shift in emphasis represents simple economics: A glut of natural gas from the nation’s prolific shale plays has kept North American gas prices hovering near a record low at a time when oil prices have remained elevated.

Although wells in sexier unconventional plays such as the Bakken Shale and the Eagle Ford Shale generally boast superior IP rates, exploration and production companies have flocked to the Permian Basin in an effort to diversify their production mixes without assuming excessive risk.

With more than 90 years of production data, the Permian Basin contains relatively few surprises for operators. The region is home to an abundance of exploration and low-risk development opportunities.

Check out these maps of the region put together by independent exploration and production firm Concho Resources (NYSE: CXO), which holds about 98 percent of its net estimated proved reserves in the Permian Basin.

The region comprises three primary sub-basins: the Delaware Basin to the west, the Central Basin Platform in the middle and the Midland Basin to the east.

Source: Concho Resources

Each of these areas is home to a number of oil and NGL-rich plays where producers can tap a number of different formations. These maps are far from exhaustive; the abundance of plays in the region has led to a profusion of different naming conventions. For example, the “Wolfberry” refers to the zone where the Spraberry and Wolfcamp meet.

Source: Concho Resources

Source: Concho Resources

In short, the Permian Basin offers something for everyone: reliable production from vertical wells that offer solid rates of return; emerging plays that offer exposure to multiple oil-bearing formations; and mature oil fields that are ripe for tertiary recovery techniques.

Upstream MLPs and limited liability companies such as Legacy Reserves LP (NSDQ: LGCY), Linn Energy LLC (NSDQ: LINE) have long prized the Permian Basin for its predictable returns. QR Energy LP (NYSE: QRE), which Elliott highlighted shortly after its Dec. 2010 initial public offering, also generates about 42 percent of its production in the Permian Basin. Meanwhile, with more than 1,500 operators in the region, there’s ample opportunity for consolidation and bolt-on acquisitions.

Over the past few years, a number of exploration and production firms have amassed acreage in the region to bulk up their exposure to oil and NGLs or offset riskier offshore and international operations.

Apache Corp (NYSE: APA), for example, launched its acquisition spree in the region by buying assets from ExxonMobil Corp (NYSE: XOM) in 2004 and inking follow-up deals with Hess Corp (NYSE: HES) in 2005, Anadarko Petroleum Corp (NYSE: APC) in 2006, and Marathon Oil Corp (NYSE: MRO) in 2009. The serial acquirer’s most recent deals include the $3.1 billion purchase of 1.7 million net acres in the Permian Basin from BP (LSE: BP, NYSE: BP) and a $2.7 billion merger with Mariner Energy that secured an additional 125,000 net acres in the Spraberry, Wolfcamp and Wolfberry areas.

W&T Offshore (NYSE: WTI) also recently purchased 21,000 net acres in the Permian Basin for $366 million in an effort to diversify its production base.

Advances in drilling techniques and technologies have also given the region a new lease on life. In the play’s mature regions, where decades of primary and secondary production have extracted much of the easily recoverable reserves, operators have sought to stem decline rates and boost end recovery rates by pumping carbon dioxide (CO2) into the field. CO2 flooding artificially increases reservoir pressure, enabling producers to eke 15 percent to 20 percent of additional output from the play.

Conservative Portfolio holding Chevron Corp (NYSE: CVX) pioneered this approach more than four decades ago, resulting in the world’s first commercial-scale CO2 flooding operation. The company remains one of the top operators in the field and in 2010 extracted 115,000 barrels of oil equivalent production per day. Earlier this year, Chevron surpassed more than 5 million barrels of oil equivalent output after 85 years of operations in the Permian Basin.

With its bulletproof balance sheet, reliable yield and ambitious slate of mega projects in coming years, Chevron Corp is a foundational holding for any energy-focused investment portfolio and continues to rate a buy on dips below 105.

Growth Portfolio holding Occidental Petroleum Corp (NYSE: OXY), the leading leaseholder and producer in the Permian Basin, in 2010 extracted the equivalent of 197,000 barrels of oil per day from play. About two-thirds of this output comes from CO2 injections in the Permian Basin’s mature areas. The company annually pumps more than 500 billion cubic feet of CO2 into these reservoirs, making the firm the world’s leading handler of carbon dioxide.

Operators can source relatively inexpensive CO2 via pipeline from the Sheep Mountain storage facility in southern Colorado and the Occidental Petroleum-operated Bravo Dome in northeastern New Mexico. Occidental Petroleum’s Century Plant processes third-party natural gas that contains above-average amounts of CO2, which the company then extracts and uses to support its oil-recovery efforts in the Permian Basin.

Occidental Petroleum’s operations in the Permian Basin generated about 25 percent of the company’s overall oil and gas production in 2010.

More recently, producers have applied techniques and technologies honed in the nation’s shale fields–horizontal drilling and hydraulic fracturing–to extract additional output from mature reservoirs and tap resources formerly isolated in “tight” formations. These innovations have enabled producers to extract more oil from legacy plays in the Central Basin and spurred development in a number of shale and tight oil plays, including the NGL-rich Avalon Shale in the Delaware Basin and the oil-laden Bone Spring and Wolfberry.

Permian Picks

Occidental Petroleum Corp (NYSE: OXY)

Occidental Petroleum Corp is an international oil and gas exploration and production company (72.3 percent of 2010 revenue) that also operates a US chemicals business (20.3 percent) and owns midstream assets (7.4 percent).

The company’s US upstream operations offer plenty of upside. The leading producer of hydrocarbons in Texas, Occidental Petroleum operates primarily in the Permian Basin. Management estimates that the company is responsible for roughly 20 percent of the oil produced in the Permian.

CO2 injections account for about more than two-thirds percent of the company’s Permian output, while water flooding is another production technique in the company’s repertoire. Both technologies facilitate production in mature fields by artificially increasing well pressure. Primary drilling and production account for just 10 percent of output, though management has noted that its acreage contains over 2,000 prospective drilling sites and that the firm continues to sink test wells in the promising Bone Springs area. Management expects production from these plays to ramp up in 2012.

Once Occidental Petroleum’s Century Plant comes online, the company should have sufficient volumes of CO2 to ramp up production in the Permian. The first train came onstream in the fourth quarter of 2010, while the second should be ready in 2012. These operations provide a reliable, low-cost source of oil.

But the firm’s most exciting domestic opportunity is in California, where it has a growing inventory of more than 3,700 drilling locations, the majority of which are prospective for oil and located in areas that are held by production. Few investors would regard California as a huge energy producer–probably because the population boom of the 1940s and huge oil discoveries in the Middle East distracted many producers from developing the area.

Beginning in 1998 with the acquisition of its Elk Hills acreage from the government, Occidental’s geologists have made some unprecedented discoveries in the state, including a massive conventional find in Kern Country that management estimates could contain upward of 175 to 250 million barrels of oil equivalent.

And that says nothing about the approximately 870,000 acres the company holds in prospective shale plays. A long history of seismic activity in the area has essentially pre-fractured the field, substantially lowering costs. The company has identified 520 geologically viable shale drilling locations in California, roughly 250 of which are outside Elk Hills and Kern County. In 2011 management expects to drill 154 shale wells outside Elk Hills proper–47 more wells than the company projected at the beginning of the year.

The average shale well outside Elk Hills yields an initial production rate of between 400 and 400 barrels of oil equivalent per day and costs about $3.5 million. Lower-than-expected costs explain why the company exceeded its initial drilling guidance to such an extent.

Management continues to leverage the firm’s experience in maximizing production from mature fields to win business in the Middle East. The firm inked a 30-year contract with the Abu Dhabi National Oil Company to participate in the development of the Shah natural gas field, one of the region’s largest. The company will have a 40 percent stake in the play, and management expects capital expenditures of roughly $4 billion. But the field won’t enter production until 2014.

In the meantime, Occidental’s operations in Iraq offer the most near-term upside. Along with Conservative Portfolio holding Eni (Milan: E, NYSE: ENI) and Korea Gas, the company is in a consortium to develop Iraq’s Zubair field. Because of the structure of this contract, production levels can fluctuate from quarter to quarter.

Over the long haul, Occidental’s expertise in maximizing production from onshore fields should enable it to grow its business in the Middle East. Meanwhile, the Permian Basin provides a solid production base and plenty of opportunity to expand through bolt-on acquisitions. The company’s dominant acreage position in California also shows promise. With management considering a potential dividend increase in February 2012, Occidental Petroleum Corp ratesa buy up to 100.

Linn Energy LLC (NSDQ: LINE)

Growth Portfolio holding Linn Energy LLC is a limited liability company (LLC), an organizational structure similar to an MLP, that owns oil- and gas-producing properties in six areas: the Permian Basin of west Texas, the Los Angeles basin of southern California, the Bakken Shale of North Dakota, the Midcontinent region in northern Texas and Oklahoma, and the Antrim Shale of Michigan.

Together, the Midcontinent and Permian account for about 80 percent of the firm’s total reserves. Oil and NGLs account for about 50 percent of total reserves; natural gas accounts for the remaining 50 percent.

Linn Energy’s business model is simple: The firm acquires mature oil- and gas-producing assets and hedges the majority of its production for five years into the future to lock in gains.

Linn Energy went public in 2006 and was among the first upstream partnerships to list on the major US exchanges since the 1980s. As a first mover, Linn Energy is now the largest of the upstream partnerships and has superior access to capital, despite its B credit rating. This low cost of capital has allowed Linn Energy to close more than 50 acquisitions since its inception, including acreage in the Bakken Shale, a region where no other upstream MLP operates.

Linn Energy’s size has also been a competitive advantage in the Permian Basin, which the LLC entered in 2009. Competition for smaller deals has intensified considerably, but Linn Energy’s larger market cap and financial flexibility enables it to purse larger deals than its peers.

In the Permian Basin, the company operates primarily in the oil-rich Wolfberry, where vertical wells offer predictable decline rates and relatively low drilling costs. Management estimates that the company has more than 400 low-risk drilling opportunities in this acreage. The company plans to drill about 100 Wolfberry wells in 2012.

The other major distinction is that Linn Energy hedges its production aggressively, locking in prices on the majority of its output. This strategy limits Linn Energy’s to the depressed price of natural gas in North America, a trend that should continue through 2012 because of strong production from unconventional plays.

At the end of the third quarter, the firm had boosted its average daily hydrocarbon output by more than 30 percent from year-ago levels, leading to a 30 percent surge in third-quarter cash flow. These solid operating results enabled Linn Energy to cover its quarterly distribution by a margin of 1.1 to 1. Management expects to cover its full-year distribution 1.18 times.

We expect additional bolt-on acquisitions in the firm’s operating regions to fuel distribution growth in coming years. In early November, management announced the $600 million acquisition of 20,000 net acres in the Granite Wash of Texas and 75,000 net acres outside this play that are prospective for natural gas. Buy Linn Energy LLC under 40.

EOG Resources (NYSE: EOG)

Although EOG Resources’ sizable holdings in the red-hot Bakken Shale and the Eagle Ford Shale tend to generate the most investor interest, the firm has also built a decent position in the Permian Basin’s Wolfcamp, Leonard Shale and Bone Spring plays.

At the end of the third quarter, the company had completed 26 horizontal wells in the Wolfcamp, increasing management’s confidence in the region. Recent well results have generated IP rates of 600 barrels of oil equivalent per day to 1,400 barrels of oil equivalent per day, by far some of the best results in the area. Thus far, oil and NGLs account for about 72 percent of the hydrocarbons produced by the typical Wolfcamp well, while natural gas accounts for the remaining 28 percent. EOG Resources in 2012 will expand its drilling program in this play to four rigs from two rigs.

The company’s acreage in the Leonard Shale and Bone Spring plays are in the early innings of development. Thus far, EOG Resources has completed 19 wells in the region and continues to sink test wells in the Texas portion of its acreage. With much of this territory already held by production, we expect the company to continue to allocate capital to higher priority plays.

An early mover in some of the nation’s hottest liquids-rich shale plays and plenty of potential production growth, EOG Resources rates a buy up to 125.

Concho Resources (NYSE: CXO)

Investors seeking pure-play exposure to the Permian Basin’s emerging plays should consider a stake in Concho Resources. After divesting its acreage in the Bakken Shale for about $200 million in February 2011, the company now generates the vast majority of its production and revenue from the many plays in the Permian Basin. Accordingly, oil accounts for about 63 percent of the company’s annual production, while oil and NGLs account for roughly 85 percent of output–a desirable production mix in the current operating environment.

With 31 rigs operating in the region in 2011, the company achieved record third-quarter production of about 6.3 million barrels of oil equivalent–a 73 percent increase from year-ago levels. Management estimates that the firm earns roughly $53 per barrel when oil prices are at $91 per barrel.

With a solid drilling inventory in the low-risk Wolfberry play and leading positions in emerging unconventional plays that are prospective for the Avalon Shale, Bone Spring and the Wolfcamp, Concho Resources should continue to generate impressive production growth in coming years. We will track Concho Resources as a buy in the Energy Watch List.