By Simon Lack
Natural gas is a theme we’ve been following for some time. The bullish case for natural gas is well known – it burns cleaner, releasing half as much carbon as coal and 30% less than oil; it’s domestic and therefore is not subject to Middle Eastern geopolitical risk keeping more dollars in the US economy (since the U.S. possesses enough to meet its own needs for decades); and on an energy-equivalent basis it is now much cheaper than crude oil (i.e. an equivalent amount of energy output, measured in BTUs, can be derived using natural gas for around one third the price of crude oil). More recently, the BP oil spill has highlighted that the search for oil is becoming ever more technologically difficult and expensive. It’s likely that a lasting effect of the GOM spill will be a higher required return on capital for those companies engaged in E&P, to cover both increased regulatory oversight and potential liability.
Natural gas prices have been depressed for some time as the technological advances in horizontal drilling and fracturing that have unlocked huge supplies of “shale gas” in the NE U.S. and Texas/Oklahoma. Many drilling leases require minimum levels of drilling in order to retain the lease, resulting in an excess supply of natural gas and returns for many drillers that fail to equal to their cost of capital. BernsteinResearch has calculated that even with natural gas at $5-6/mcf few operators of shale wells are earning sufficient returns. For example, Chesapeake (CHK), Devon (DVN) and Petrohawk (HK) all earn around 4% on invested capital while their estimated cost of capital is 8-10%.
While this is unattractive in the near term, it seems likely that current industry returns are unsustainable and if natural gas prices don’t rise we expect to see production cuts that will reduce supply as companies exit uneconomic activity. As a result, stocks of natural gas E&P companies are in some cases trading at substantial discounts to the value of their net assets. Even CHK, the cheerleader for the sector, has announced it is diversifying by increasing its investments in oil production.
In our opinion this all adds up to a depressed sector with some interesting upside optionality. While timing is never easy, there are a number of issues and any one of which could focus attention on this large domestic resource:
- Middle East instability – the U.S. is increasingly dependent on an unstable and hostile region for oil imports since domestic oil production is insufficient.
- A renewed focus on clean energy - although it is a fossil fuel, natural gas burns cleaner than all the others and no combination of renewable fuels (solar, wind, nuclear) can meet our energy needs in the foreseeable future. President Obama commented specifically on natural gas in a recent speech on the Gulf oil spill, highlighting our reliance on crude oil and the need for alternative energy sources.
- Regulatory constraints on deepwater oil drilling and higher required returns are both likely, causing a shift in investment towards natural gas.
- A pickup in the economy will increase demand for energy, particuraly natural gas, for which industrial uses account for 43% of total demand.
- Investor dissatisfaction with current low returns on natural gas drilling may cause reduced output until natural gas prices rise to properly reflect current costs of production.
Companies poised to benefit the most from a secular bullish view on domestic natural gas have a heavy natural gas focus vs oil, have large amounts of proven and unproven reserves, and have extensive onshore operations in the U.S. Also, because the timing of theme is uncertain, we prefer companies with low levels of debt and low costs of production so that they can still be profitable if gas prices remain low for some time. The table below shows the result of a screen we ran across relevant E&P names. We valued the companies by calculating the NAV of their reserves (both “proven” and “risked”) less estimated production costs and net debt and expressed their share price as a discount to NAV. On this basis Southwestern Energy (SWN) and Petrohawk (HK) were both relatively attractive.
Southwestern Energy is a large U.S. producer of natural gas. SWN has high quality assets with strong growth profile due to recent discoveries in the large shale plays of Fayetteville (900K acres), Haynesville (42,300 net acres) and Marcellus (149,000 net Acres). In addition to 8Tcf of proven reserves, SWN has risked unproven estimated at 47Tcf based on gross unproven reserves of 90Tcf. Furthermore, 70% of unproven reserves are located in the Fayettevilee Shale which is profitable at natural gas prices above $3.25/Mcf. Southwestern’s production is almost 100% natural gas and has only hedged a fraction of 2010 production making it more sensitive to short-term natural gas prices. The company has low leverage with net debt per share of $3.05 and has one of the lowest production costs in the industry with an ROE from shale plays at almost 12% vs its WACC of just over 10% (according to BernsteinResearch). Their estimated NAV, using proved and risked reserves (industry terminology reflecting likelihood of realization) after production costs is around $51 (using the current NYMEX curve), versus a stock price of $38.
PetroHawk is also an attractive way to play natural gas in America. The company currently operates in Texas and Louisiana and has been quick to take large acreage in new shale discoveries. It has premium assets, a good growth profile, management is well regarded, and its shares are cheap to net asset value. Natural gas comprises 98% of its 2.75 Tcfe proved reserves and they have another 47 Tcfe (energy equivalent to about 8 billion barrels of oil) of unrisked resource potential, which works out to about $38 of NAV at today’s NYMEX strip and after subtracting $10 of net debt per share works out to $28, offering almost 60% upside from HK’s current share price of $17.72. Like SWN, HK has less debt than is typical for the industry, and have also hedged less of their production than others. Despite annual revenue growth expectations in excess of 20% over the next 3-5 years, with the company guiding for 30%+ annual growth for 2010 and 2011, HK trades more like a value stock at 38% discount to NAV and under 15x analysts’ forecasts of $1.20 in EPS for 2011.
Apache (APA) didn’t suit because of its lower exposure to natural gas, and although Range Resources (RRC) appeared to fit our criteria, upon further research we felt its enterprise value/EBITDA was too high – too much of their cashflow realization is several years out.
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