Why XTO Energy Is Overvalued

Determining the fair value of an asset is both art and science. While traditional metrics such as Price/Earnings (PE), Price/Book (PB), and dividend discount models offer the appearance of precise mathematical answers, these methods are widely used and do not often provide investors an edge. Over the years, I have often used nontraditional metrics as a way to determine fair value targets and identify trading opportunities.

One example is the method I use to value energy stocks. Most integrated oil companies trade at low P/E multiples with high return on equity (ROE) and sizable dividend yields. With energy prices very volatile, we must assess whether the low P/Es are a function of high energy prices or sustainable business models. Never comfortable applying multiples to peak earnings, I search for alternate approaches.

An alternative metric I have used for energy companies is to examine the reserves each company reports and the current price of energy, and then determine a market value based on the reserve estimate.

With any alternative method, we must ask if the process intuitively makes sense and why it would be a valid measure of fair value. The business of energy companies is to discover, drill, and sell energy. Their reserves offer a view of future production and future earnings. This alone may offer justification to value a company based on reserve value, but I think a private equity perspective helps as well.

The oil future market is deep and liquid. If a company is sitting on reserves, their management should be capable of determining when the oil and gas will come out of the ground and be ready to sell. If you know when the energy can be delivered, you are capable of using the futures market to sell your production at prevailing prices at various dates in the future. The cash received from the futures market could then be used to take a company private. After all, if the stock market values your energy reserves at a discount to the future market's view of energy prices, sell your energy at the higher price, buy back your stock in a leveraged buyout, drill the needed oil to satisfy your delivery obligation, and retain the excess money as profit.

I have been using this metric with conservative assumptions for many years to determine whether energy companies were inexpensive or not. Over the years, this approach has served me well as I have consistently purchased energy company shares at nearly a 20% discount to a conservative fair value estimate. But looking at the market now, something has changed.

XTO Energy (XTO) is an energy company whose oil and gas reserves are located in North America. While I'm attracted to a company with reserves in geopolitically safe areas, I am always looking to buy shares below fair value. Currently, XTO trades above my reserve value estimate. This indicates that XTO is overvalued relative to energy prices on a long-term basis. Over the short term, XTO has a 0.6 correlation to the price of oil. This means that for every $1 that oil declines, XTO should drop $0.60. This relationship has also broken down. Oil has fallen 9% since reaching a recent high on September 16. Over the same period, XTO has fallen 0.5%.

With XTO expensive relative to its reserve value and overbought versus its relationship with oil prices, only a sustained rally in the price of oil can justify XTO not declining. Given the technical damage oil has suffered, a rally is unlikely. As the market realizes this, XTO is sure to decline. Looking to profit from the drop, I recommend a short position in XTO as this week's fundamental trade.

Note: At the time of this article, I am short XTO.

Comments

[prairiedog555:]

Is there a short ETF for Nat Gas?
All NG companies are overvalued. We are in a recession, news flash.
Less industrial usage and people turn down thermostats, and production and storage is up.

Sep 30 06:47 AM

[User 493561:]

XTO is primarily a gas, not an oil play. At least mention gas valuation if you're going to knock the company.

Sep 30 07:36 AM

[peluso:]

Boys this idiot went short clf at 26

imagine

go read about him and wou will know how bad he does

Sep 30 07:53 AM

[Billyspeed:]

"As the market realizes this, XTO is sure to decline." Anyone who says that the market is "SURE" to do anything is a charlatan and not to be listened to!

Sep 30 12:21 PM

[Sean Hannon:]

Today's price movement justifies my thesis. With a 5%+ move in oil (and natural gas higher on the week as well), XTO is slightly lower. I shorted the shares Monday morning at $41.85 so am currently sitting on a small profit. However, I will now be covering. Where XTO had refused to move lower with falling energy prices and was 2% overvalued versus my reserve value, I now see the shares 15% undervalued versus reserves given the large increase in energy prices. Having seen the market change, so will I and am currently covering my short position at market prices.

Sep 30 02:49 PM

[jarco:]

I fail to see the merits of your analysis. As mentioned by another reader, oil and gas don't move in the same price space. Further, XTO is sitting on of the largest reserve positions at a time when NG pricing is at an all time low. Beyond that, speculation about Mexico oil reserves also mentioned in this sector recently, should move substantial energy consumption towards NG.

I too have taken short term profits on XTO as the price gyrates. Longer term, I'm an accumulator

Sep 30 03:50 PM

[Gassy:]

This is probably the best time to buy XTO. You never buy a resource company on the basis of the resource it has already discovered and put on it's annual report. Market is not that foolish to leave easy money on the table. You have to work harder to have a view on how much more can they discover and if that is discounted in the stock price. You have to look at all the acreages they own and the places they are drilling and proving up reserves. I think the current low gas prices give an excellent opportunity to buy at a discount. XTO has a fantastic diversified position of shale gas in the US. These will lead to reserve upgrades for a few years.

Sep 30 05:39 PM

[Billyspeed:]

You better leave the short selling to the pros. You sound like a typical amateur nervous short. Take a big risk for a tiny profit. Stick to a game you know which is obviously NOT selling short.


On Sep 30 02:49 PM Sean Hannon wrote:

> Today's price movement justifies my thesis. With a 5%+ move in oil
> (and natural gas higher on the week as well), XTO is slightly lower.
> I shorted the shares Monday morning at $41.85 so am currently sitting
> on a small profit. However, I will now be covering. Where XTO had
> refused to move lower with falling energy prices and was 2% overvalued
> versus my reserve value, I now see the shares 15% undervalued versus
> reserves given the large increase in energy prices. Having seen the
> market change, so will I and am currently covering my short position
> at market prices.

Sep 30 06:26 PM

[Money Maker:]

You just said to short the stock - and the same day you are covering. This is crappy advise b/c fundamentals truly dont change that quickly in a matter of hours for you to change a recomendation. Do you flop flop trades this quickly in real life - bc if so your trading costs far exceed any profits. Try to recommend a solid strategy that can last months instead of hours.

Oct 01 12:17 AM

[cyfairslam:]

XTO has exhibited one of the best gas price hedging strategies in the business. It is not even mentioned in the article.

Oct 01 07:13 AM