It was about a year ago that I became concerned that investors had become a bit too optimistic about natural gas companies leveraged to shale. The thesis was that the supply dynamics were so impressive that the reduction in drilling in conventional formations would be overwhelmed by this new production. Initially, forward gas prices were extremely high relative to spot prices, which was enabling companies to hedge and produce profitably. I have subsequently reviewed the transcripts of many of the significant players on a quarterly basis and shared summaries on my blog. For those interested in prior reviews:
- Natural Gas Outlook Still Smells (5/15/10)
- Profitless Prosperity Ahead (2/13/10)
- Time to Bail on Shale (11/22/09)
- Natural Gas: Extreme Contango (9/5/09)
At this time, the thesis has probably played out fairly fully. As I noted last quarter, many of the companies that were optimistic about gas have changed their focus to oil and gas liquids. Further, as I will describe below, production bottlenecks have started to have a big impact for some companies. While NYMEX forward prices still remain at a premium to near-term prices, the percentage and dollar difference compared to a year ago have declined dramatically. When I described "extreme contango" a year ago, front-month gas was a very depressed 2.75, while the one-year future price was above $5. As of 8/20, near-term gas on teh NYMEX closed just above $4, while the September 2011 future closed at 4.78. Importantly, it is no longer possible to lock in forward gas prices at 5-7 any longer.
While near-term gas prices have certainly recovered over the past year, clearly the declining forward price has had more of an impact on the price of the E&P companies, most of which are near 52-week lows and have underperformed the broad market (click to enlarge):
As an aside, the returns have been pretty much a function of market cap, with the larger companies doing better. Of course, there are many, many other players focused on shale gas, but these are the ones I have identified that are both big players as well as having shale gas be their primary driver.
Let's see what they had to say on the Q2 calls, hitting them in this exact same order...
CHK was a trailblazer in gas shale, but for a couple of quarters now they have been changing their emphasis to gas liquids and oil.
The growth in our liquids production and in our proved reserves and our planned slowdown in natural gas drilling are our most important messages today. I want to make clear, in fact, crystal clear that Chesapeake is pursuing a differentiated growth model for many of our colleagues in the industry. The CHK model is not a commitment to increasing gas productions without regard to natural gas prices. Quite the opposite, in fact. Unless gas prices increase over $6 per MCF, Chesapeake is committed to continuing to reduce its gas drilling CapEx, increase its liquids drilling CapEx. This will be the single largest strategy shift in Chesapeake's history. And once it has been completed during the next few years, it will generate huge benefits to our shareholders. And we believe that unlike with natural gas, Chesapeake's success in finding large new reserves of unconventional oil in the U.S. will not negatively affect oil prices. Obviously, this has not been the case with our large discoveries of unconventional natural gas during the past few years.
This is rational behavior, in my opinion, which is a big change in the historical practices of this company. Chief Gunslinger McClendon maintained that unless gas gets back to $6, they won't be drilling aggressively. One observation: This CEO spends too much time telling investors how the analysts don't understand the company. Where have I heard that one?
Our operations in Fayetteville Shale are on track as evidenced by the 32% growth in company production compared to last year and by a 9% sequential growth. The previously announced sale of a portion of our Haynesville and Middle Bossier properties in East Texas closed for approximately $355 million. And finally, because of our improving results in Fayetteville, our production guidance is unchanged for the third and fourth quarters of 2010, and our capital investment program also remains unchanged at approximately $2.1 billion.
The company continues to report impressive technological improvements that will boost supply and lower costs ultimately, but it pointed to some bottlenecks in the Marcellus:
Then on the fracs themselves and lining up fracs, frac-ing is tough in Pennsylvania. We've got some frac dates set up, that we can get the wells that we have done or we've completed now drilling, but that is a challenge, and you're looking out at something well past 60 days towards, in some cases, 90 days to catch those frac dates, and we're doing everything we can to pull that up, but that's the kind of the way, that direction. The other thing that hasn't bothered us much but could bother us going forward is that they've had a very dry year in northeast, Pennsylvania, and so water has been limited. Fortunately for us, it started raining here before we've had to start to do some of these fracs going forward, but if it stays dry through the fall, you'll see the entire industry be slowed a little bit down just from the fact that there isn't enough water for all the fracs that the industry wants to do.
- Cheasapeake (CHK): -19%
- Southwestern (SWN): -21%
- EQT (EQT): -24%
- Petrohawk (HK): -39%
- Range Resources (RRC): -40%
- Comstock Resources (CRK): -50%
At EQT production, we posted our second consecutive quarter at 31% year-on-year growth in sales of produced natural gas. This growth was again driven by horizontal drilling in our Marcellus and Huron/Berea place.
We now expect to earn a 63% all-in after-tax return on average assuming a flat $6/MMBTU NYMEX. This is double our previous projections. Importantly a $4 NYMEX we can earn a 23% after tax return. Interpolation will give you a reasonable feel for the economics of prices between those two levels. Strategically this is making our current situation even clear than it was. We have an immense resource base.
We have demonstrated that we can economically develop this resource base. However, we do not have nearly enough capital to pursue all of these opportunities and we have no interest in issuing equity at anything like the current prices. So, we focused evermore intently on capital allocation issues. More specifically the most economic steps for us involve developing our Marcellus position and also developing our Huron/Berea position in a manner that keeps Midstream intensity low.
For investors not familiar with EQT, they surprised investors with an equity issuance earlier this year. It's nice to see capital allocation mentioned by an E&P company, as this is an industry that seems to always drill no matter the costs. A big take-away here is that their costs are falling due to better technology.
These guys seem to be getting capital allocation religion too:
Although there is currently a supply-demand imbalance in the natural gas markets, many good companies have chosen to remain on a path of aggressive spending to hold acreage and protect future reserves and potential. And significant growth is an output of these activities.
Petrohawk's early days in the lease capture phase have been aggressive, and we have had to grow our capital budget beyond current cash flow. Petrohawk and its shareholders endured a period of equity raises in 2008 and early 2009 to capitalize the leasing and lease capture phase of the Haynesville Shale development. Those days are behind us.
While painful, this important and needed capital infusion, as well as $1.4 billion in subsequent asset sales have given us substantial liquidity and ability to make more conservative choices today as we face the lower commodity price environment and face service cost inflation.
Before I move on to the next topic, I want to take a few minutes and focus on our progress on the Marcellus play. Let me compare where we were one year ago with where we are today. This time last year, we were producing about 50 million per day net. Today we're producing about 160 million per day net. We have organically grown production by 110 million net over the last 12 months. A year ago during the second quarter call, I stated that our average development well in the southwest part of the play cost $3.5 million to drill and complete, and our average well based on 24 wells at that time with adequate production history was projected to recover 4.4 Bcfe. At $5 flat gas price forever, that generated a 50% rate of return. Today, our cost to drill and complete is $4 million, given we're now drilling laterals that are about 3,050 feet versus 2,500 feet last year. In addition, we're now the completing the wells with 10 stage frac versus eight a year ago.
Today, our average wells reserves are projected to be 5 Bcfe based on 95 horizontal wells. Spending $4 million to recover 5 Bcfe and assuming a $5 flat gas price generates a 79% rate of return versus the 50% rate of return we projected at this time last year. Not only have we driven up net production substantially, we've done it in a much more cost effective way, which results in stronger economics and a much higher rate of return.
I actually follow this company and have a great deal of respect for Jay Allison, the CEO. I note that the company trades near tangible book value. Unlike the larger companies, Comstock is having problems getting services provided due to shortages:
Starting in the second quarter, we’re running behind in completing our Haynesville Shale wells due to the unavailability of pressure pumping services. We currently have 17 Haynesville Shale wells drilled, waiting on completion and the backlog continues to grow.
Given this situation, we’re lowering our production guidance for this year. We expect production in 2010 to approximate 74 Bcfe to 77 Bcfe, which represents a 13% to 18% growth over 2009
Also unlike most of its peers, the company has no hedges after being just 12% hedged in 2009. On uses of capital:
We expect to fund our drilling expenditures and acreage purchases that we budgeted for this year with our cash flow, our cash on hand and the proceeds from asset sales. By the end of the year, we do not expect to have increased our debt balance at any significant way, and certainly we have no plans to sell any equity this year to raise capital.
As I have listened to the calls or reviewed the transcripts, I have found myself much less concerned about the supply issues. The industry seems to be acting rationally with respect to hedging, production, and capital spending. The flatter forward curve seems to be at play. One thing that really stands out is that these companies are reducing costs through scientific approaches to drilling. The longer-term outlook would seem to be one in which these companies may be able to generate profits from their huge reserves, but this supply seems likely to keep a lid on prices as companies will be quick to lock in gas hedges should prices rise to 6-7. With bottlenecks developing and regulatory constraints cropping up, prices may be near a floor at $4. It may be too early to be bullish on these shale plays, but it's probably way too late to be bearish.
Disclosure: No positions