Oil and gas production from shale fields and other unconventional plays has revolutionized the US energy market. In 2006 gas production from shale fields contributed just 5 percent of the nation’s total output; five years later, natural gas from these fields accounts for roughly a quarter of domestic production.

Source: Energy Information Administration

This graph tracks historical and projected US natural-gas production. As you can see, the Energy Information Administration (EIA) regards the nation’s shale gas fields as the only source of production growth in coming years.

The agency’s current forecast calls for annual gas production to expand to more than 26 trillion cubic feet (tcf) in 2035 from about 21 tcf in 2011. By 2035, shale gas production is expected to account for about 50 percent of domestic output.

The US is already the world’s leading producer of natural gas, surpassing Russian’s 2010 output by about 4 percent. To put that into context, the US alone (not North America) produces almost as much gas as the entirety of Africa and the Middle East combined. North America as a whole produces 80 percent more natural gas than the entirety of the Middle East. Shale gas is absolutely crucial to US gas supply today and is the major source of growth in coming years.

Developing the nation’s shale fields will also boost US oil output in coming years. Check out this graph of US shale oil and condensate production between 2005 and 2009, the latest year for which the EIA has complete data.

Source: Energy Information Administration

Though slightly out of date, the data in this graph underscores how quickly output from shale plays is growing.

In 2005 US shale oil and condensate production totaled 2.8 million barrels per year–a drop in a bucket in a nation that consumes between 19 and 20 million barrels of oil per day. Four years later, production of these liquids had soared twentyfold to about 56 million barrels per day, with much of that output coming from a single play: the Bakken Shale. Within five years, the Bakken Shale and related Three Forks formation could account for as much as 8 percent of total US oil output.

The Bakken Shale occupies the Williston Basin, a vast area centered in North Dakota and Montana. The play also extends into Canada, though the US portion is generally considered to be more prospective for oil. The map below delimits the play’s boundaries.

Source: Energy Information Administration

Rocks are deposited in layers. The Bakken comprises three layers of shale–an upper, middle and lower Bakken–located at a depth of between 8,000 feet and 11,000 feet in the play’s most productive areas. Drilling activity targets the middle Bakken, a naturally fractured shale rock that contains a high-quality light, sweet crude oil.

Some parts of the play include another productive formation, the Three Forks-Sanish. Operators initially characterized the Three Forks as an area where oil that spilled out of the Bakken had collected. But drilling results have confirmed that the Bakken and Three Forks are actually separate plays; activities in the Three Forks formation don’t sap production from nearby Bakken wells.

The Williston Basin and Bakken Shale aren’t new discoveries; the first wells were drilled back in the 1950s. Drilling technology and techniques were the real discovery.

The simple vertical wells sunk in the 1950s failed to produce oil at high rates. A vertical well travels straight through the Bakken formation, but the only productive part is the 50 feet to 100 feet of the shaft that touches the middle Bakken. In contrast, a horizontal well drilled along the pay-zone exposes thousands of productive feet to the well. In addition, hydraulic fracturing supplements the middle Bakken’s natural fractures, further enhancing productivity

In 2000 E&P firms drilled the first horizontal wells in the field. Since then, several major producers have ramped up activity to the point that the Bakken has emerged as the leading onshore oil play in the continental US. The graph below tells the tale.

Source: Energy Information Administration

This chart tracks production from the two main oil-producing states in the Bakken, Montana and North Dakota. The growth has been tremendous: in the past three years, production has nearly doubled from 257,000 barrels per day (bbl/day) to 488,000 bbl/day. And there’s more growth to come, with output expected to reach between 1.2 and 1.5 million bbl/day by the end of the decade.

When analyzing an exploration and production company’s growth prospects, avoid focusing too much on reserves, which amount to a guess as to how much oil is in place and how much is recoverable. What’s really important isn’t how much oil is in the ground, but how fast the company can produce that oil can be produced.

The US Geological Survey in 2008 pegged the Bakken’s mean amount of technically recoverable oil at 3.65 billion barrels, making the shale play the largest field in US history. However, Bakken operator Continental Resources (NYSE: CLR) estimates that the play’s oil reserves at about 24 billion. The latter estimate would make the Bakken one of the largest oil discoveries of the past three decades.

Continental Resources (NYSE: CLR)

Continental Resources is a large-cap exploration and production company with operations in several Texas, plays the Woodford Shale in Oklahoma and the Marcellus area in Appalachia. But the company has made the Bakken Shale its primary area of focus in recent years. The firm is the second-largest leaseholder in the region and one of the top oil producers. The Bakken Shale accounts for roughly 58 percent of Continental Resources’ total reserves, making the firms one of the most oil-heavy names in my coverage universe.

In the third quarter, the company produced 66,289 barrels of oil equivalent per day, up an impressive 23 percent from the second quarter of 2011. Output in the Bakken surged 27 percent sequentially and 73 percent on a year-over-year basis. Management has also affirmed that the company remains on track to meet its goal of ramping up annual production to 40.8 million barrels of oil equivalent in 2014 from an estimated 22 million barrels of oil equivalent in 2011.

The firm added 22,600 net acres in the Bakken area in the third quarter, bringing its total holdings in the region to more than 900,000 net acres.

In addition, the company has identified another productive region, a deeper formation within Three Forks. In the most recent quarter, Continental Resources drilled its first successful deeper well in the Lower Three Forks formation located under the Bakken Shale. If further test results pan out, Continental Resources would have cause to raise its reserve estimate once again, as this Lower Three Forks formation is widely distributed in its acreage.

The firm’s second major area of operations is the Oklahoma Woodford Shale, a liquids-rich gas play where Continental plans to spend some $355 million in 2012. In the third quarter, production from the region jumped 78 percent sequentially to 7,164 barrels of oil equivalent per day. Continental Resources continues to rate a buy in our Energy Watch List.

Kodiak Oil and Gas (NYSE: KOG)

Kodiak Oil & Gas, which holds about 155,000 net acres in the Bakken, expects to grow its production 10,500 barrels of oil equivalent per day (a 31 percent increase from current levels) by year-end. Thanks in part to recent acquisitions, management expect production to reach 24,000 barrels of oil equivalent per day in 2012 and 30,000 barrels of oil equivalent per day in 2013.

The company continues to aggressively add acreage near its core leasehold, purchasing 13,000 net acres in Williams County for $250 million and another 30,000 net acres for $590 million.

To fund these acquisitions and an expected $585 million in 2012 capital expenditures, the company raised about $375 million by issuing new shares and a further $650 million through a bond issue. Despite carrying a CCC+ rating from Standard & Poor’s, the company was able to issue eight-year bonds at an initial yield of 7.5 percent.

In addition to an expanded drilling inventory, the Kodiak Oil & Gas’ latest acquisitions also increased the company’s scale to a point that it was able to secure a dedicated crew to perform hydraulic fracturing on its wells. The company plans to add a second dedicated fracturing crew in 2012–a big time and cost saver at a time when labor and rig shortages can lead to substantial delays.

With its current drilling plans fully funded and enormous growth potential, Kodiak Oil & Gas rates a buy in the Energy Watch List. With a market capitalization of $2 billion, Kodiak Oil & Gas would be an attractive takeover target for a larger producer seeking entrée to the Bakken Shale.

Oasis Petroleum (NYSE: OAS)

Aggressive Portfolio holding Oasis Petroleum focuses exclusively on the Williston Basin, where has accumulated about 300,000 net acres. Much of this leasehold is prospective for both the Bakken Shale and the Three Forks formation. More than 90 percent of Oasis Petroleum’s production is oil.

The company’s output dropped slightly to 7,893 barrels of oil equivalent per day in the second quarter, primarily because of weather-related disruptions that affected many producers in the area. But production rebounded in the third quarter, when the company flowed 11,583 barrels of oil equivalent per day. Management expects the company’s average daily production to reach as much as 12,500 barrels of oil equivalent per day for the full year. With a 2012 capital budget of up $850 million, Oasis Petroleum should generate solid output growth in the coming year.

Oasis Petroleum is weighing a number of bolt-on transactions, with management indicating that it examined 15 to 20 deals in 2011 alone. A potential takeover target with plenty of room to grow production, Oasis Petroleum rates a buy under 36.

EOG Resources (NYSE: EOG)

Growth Portfolio holding EOG Resources was an early mover in many of the nation’s leading shale oil and gas plays and has amassed enviable positions in the Bakken Shale, the Eagle Ford, the Barnett Shale, the Haynesville Shale and the Marcellus Shale.

The company’s prescient management teams was one of the first to shift its emphasis from dry-gas fields to plays rich in oil and natural gas liquids (NGL). The rapidity with which management implemented this new strategy is staggering. In 2007 natural gas accounted for 77 percent of EOG’s revenue. In 2010 the firm garnered 65 percent of its revenue from liquids output, roughly three quarters of which was from oil. NGL production contributed the remaining quarter of liquids-related revenue.

Management expects the firm’s liquids production to soar 51 percent in 2011 and another 30 percent in 2012.

In North Dakota, the company holds 600,000 net acres and is one of the top oil producers in the Bakken Shale. The firm has seven rigs slated to operate there in 2012 and plans to sink 84 wells. EOG has been testing new well designs and recently announced that using longer laterals in both the Bakken Shale and Three Forks formation should improve recovery rates. EOG Resource rates a buy under 125.

Swimming Midstream

But producing oil only half the battle in the Bakken Shale. The development of midstream infrastructure hasn’t kept pace with the rapid increase in production. Operators continue to face logistical constraints to get their production to the market while the midstream industry works frantically to build additional capacity. EOG Resources, for example, relies on railcars to transport its output to Cushing, Okla., and the Gulf Coast. The firm plans to increase its capacity to ship oil to the Gulf Coast in the coming year because of favorable pricing dynamics in the region.

Union Pacific Corp (NYSE: UNP)

Union Pacific Corp and Berkshire Hathaway’s (NYSE: BRK.A) Burlington Northern SantaFe, which boast extensive rail networks in the western US, stand to benefit the most from the lack of pipeline capacity in the Bakken Shale.

With a network spanning 32,000 miles of track, Union Pacific is the nation’s largest Class I rail operator. The company reported that third-quarter carloads of petroleum products jumped 35 percent from a year ago, largely because of rising demand in the Bakken Shale.

We expect Union Pacific this shortage of takeaway capacity to remain a tailwind, as production shows no sign of slowing and building new pipeline will take some time. Union Pacific Corp rates a buy in My Energy Watch List.

ONEOK Partners LP (NYSE: OKS)

Pipelines aren’t the only energy infrastructure needed in the Bakken Shale. Although the region primarily produces crude oil, the play contains significant quantities of natural gas, about 25 percent to 30 percent of which is currently burned off as a useless by-product. With sufficient pipeline and storage capacity, producers could sell the associated gas.

The natural gas extracted from the Bakken Shale also contains significant quantities of NGLs that must be separated from the raw gas stream. With only little gas-processing capacity in the region, there’s plenty of room for new construction in this market.

ONEOK Partners LP focuses on gas and NGL pipelines, processing plants and storage facilities. The master limited partnership generates about 60 percent of its cash flow from fee-based business lines, which limits exposure to commodity prices. For example, ONEOK Partners requires some customers to pay a mandatory capacity-reservation fee that due regardless of whether the client uses its allotted capacity on the firm’s pipeline.

The MLP’s gathering and processing business, which involves small-diameter pipelines that connect individual wells to processing facilities and the interstate pipeline network, inherently entails some exposure to commodity prices. If a decline in energy prices prompts producers to rein in drilling activity, ONEOK Partners will have fewer new wells to connect to its system and lower volumes of gas and NGLs moving through its system. Unlike takeaway pipeline, gathering and processing assets typically garner fees that vary based on throughput.

Companies can be compensated from performing processing and fractionation services in several different ways. I’ll review three of the most common types of contracts: fee-based contracts, keep-whole contracts and percent-of-proceeds (POP) contracts. 

Under fee-based contracts, a processor receives a fee based on the volumes of gas it processes. This is by far the most defensive and commodity-insensitive contract because there’s no direct exposure to processing profitability.

In a keep-whole arrangement, the producer sends a certain amount of natural gas to the processor, and that gas contains a certain amount of British thermal units (BTU). Some of those BTUs are in the form of natural gas (methane), while others are locked up in NGLs that are part of the gas stream.

The processor accepts the natural gas from the producer but retains title to the NGLs it removes from the gas stream. In exchange, the processor gives the producer the value of natural gas with the same BTU content as the original raw gas. For example, assume a producer sends a processor 2 million BTUs of gas consisting of 1.5 million BTUs of natural gas and 0.5 million BTUs worth of NGLs. Under a keep-whole arrangement, the producer would retain the value of 2 million BTUs of pure natural gas and the processor would own and sell any NGLs removed.

When the price of NGLs is high relative to the price of gas, keep-whole deals generate significant margin for the processor. That’s because the value of the NGLs they keep is worth more than the natural gas they return to the producer.

In POP contracts, raw natural gas is processed and the resulting gas and NGLs sold. The producer and processor agree on how to divvy up total proceeds of NGLs and gas. For example, the producer might accept 80 percent of the total value of the gas and NGLs sold and pay the processor 20 percent for performing its services.

Under POP deals, processors benefit from higher gas and NGL prices; the processor is less interested in the relative values of gas and NGLs–the total value of the products is key.

Currently, the low price of gas and the high price of NGLs make processing a profitable business for ONEOK Partners. Nevertheless, the MLP hedges a portion of this risk with futures contracts.

The largest gas processor in the region, ONEOK Partners owns gathering assets in the heart of the Bakken Shale and four adjacent processing plants. In addition, the Northern Border Pipeline–in which ONEOK Partners holds a 50 percent stake–also services the Bakken Shale.

The MLP also plans to invest $1.1 billion in new gathering and processing capacity. These projects include three processing plants in the Bakken: Garden Creek, Stateline I and Stateline II, each of which is slated to have a nameplate capacity of 100 million cubic feet of gas per day. The POP contracts under which this new capacity is booked feature a minimum fee but also significant exposure to commodity prices.

The company is also constructing the Bakken Pipeline, which will transport liquids from North Dakota to the company’s 50-percent-owned Overland Pass Pipeline that crosses Wyoming, Colorado and Kansas. The pipeline will have an initial capacity of 60,000 barrels of NGLs per day. If demand is sufficient, this capacity could expand to 110,000 barrels of NGLs per day.

The MLP also plans to increase the capacity of its fractionators in Bushton, Kan., to 210,000 barrels per day from 150,000 barrels per day. Fractionators separate a barrel of mixed NGLs into its constituent products. ONEOK Partners has already sold 100 percent of the capacity on these NGL projects, locking in reliable, fee-based cash flows over the long term.

The MLP has a long track record of increasing its distribution and never cut its payout. Since January 2006, the firm has increased its dividend at an annualized rate of 8 percent.

But investments in high-growth Bakken projects are set to accelerate distribution growth significantly over the next few years. The firm paid a $0.595 distribution in early November and plans to increase its payout to $0.605 for this quarter, increasing its payout by 2 cents per quarter throughout 2012. As the bulk of its new Bakken projects come on-stream in 2013-2014 ONEOK is looking to grow its payout by 15 to 20 percent annualized, among the fastest pace of distribution growth of any MLP in my coverage universe.

The MLP generated enough distributable cash flow in to cover its full-year distribution by 1.4 times, providing ample downside protection if commodity prices pull back. Management’s long-term guidance calls for ONEOK Partners to cover its distribution by 1.05 to 1.15 times.

Although ONEOK Partners has some exposure to commodity prices, a favorable location should mitigate these effects. ONEOK Partners LP rates a buy in my Energy Watch List, though the stock price and dividend yield fully reflect the MLP’s near-term growth prospects.

TransCanada Corp’s (TSX: TRP, NYSE: TRP) controversial Keystone Pipeline is another key infrastructure project for the Bakken Shale. The first phase of the project came online in June 2010 and has the capacity to transport 435,000 barrels of oil per day from the Alberta oil sands to Steele City near the border between Kansas and Nebraska. The pipeline also extends east into Illinois. The second phase began operations in Feb. 2011 and connects Steele City to the hub in Cushing, Okla.

The next two phases of TransCanada’s Keystone project have raised the ire of opposition groups, largely on environmental ground. President Barack Obama has delayed making a decision on Keystone until after the 2012 election. We expect the next phases of the Keystone Pipeline to eventually gain approval.

The third phase would transport oil from Cushing, Okla., to the Texas Gulf Coast, alleviating the current glut of supply in Oklahoma. Phase four would be a 1,180-mile extension that would pass through Montana and North Dakota on its route from Alberta to Steele City. Once completed, the project would mitigate the current takeaway crunch in the Bakken Shale.

Yielding almost 3.8 percent shares of TransCanada rate a buy in My Energy Watch List.