By Eric Chenoweth
For the fourth consecutive quarter, energy stocks failed to move decisively, though there was plenty of volatility as in past quarters. However, we did see some larger directional movement in the oil and natural gas futures markets, with oil reclaiming its dominance over natural gas. So far during the third quarter, the front month contract for crude oil is up just over 1%, while the front month natural gas contract is down more than 13%. As we end the third quarter, natural gas is in the midst of a seasonally weak period for demand (as summer cooling demand dissipates but winter heating demand hasn't yet ramped up), a time when gas prices have been historically at their lowest points within a given year. We'd expect to see significant improvement in natural gas relative to crude oil by the end of the fourth quarter. Not surprisingly, sentiment toward natural gas producers' stocks has also deteriorated, and we think the relative value proposition of gas producers compared to oil producers looks quite attractive.
Still Waiting for a Gas Supply Contraction
We continue to view the supply-side fundamentals supporting low gas prices as unsustainable longer-term. If it weren't for an influx of foreign capital supporting drilling to hold acreage leased during the boom (much of it expiring in 2011 if drilling commitments aren't met), the U.S. gas rig count would be much lower today, in our opinion. At about 980, the U.S. gas rig count is well above the 700 that were active at this time last year. This rising gas rig count flies in the face of what we expect will be lower gas prices in the fourth quarter of 2010 compared to 2009. Very few of the E&P companies we cover have been able to fund their drilling budgets through internally generated cash flow during 2009-2010. More than $40 billion has come in from foreign JVs and those that haven't participated in JVs have mostly sold assets and issued long-term debt. If we assume half of the $40 billion raised in JVs went to immediate balance sheet repair (as many companies that signed JVs were among the most financially distressed), then the remaining $20 billion could help explain how drilling held up so well, despite very low gas prices.
If we assume the average horizontal gas well costs $5 million, and it takes 50 days to drill and complete these wells (which we think is a reasonable average of Haynesville, Eagle Ford, Fayetteville, and Marcellus Shale wells), then each rig running would drive $36.5 million in capital spending annually for an E&P company. So, how much are the extra 280 rigs (980 - 700) requiring E&P companies to spend each year on new wells? That's an extra $10.2 billion per year, or roughly our $20 billion estimate of excess cash raised from the JVs spread over two years. With the new JV money sunk largely in the ground now (or used in debt repayment), and lease expiration pressures set to subside as we push through 2011, we are likely to see a different set of U.S. supply fundamentals taking over. Those fundamentals will be driven largely by companies living within cash flow, which suggests a falling gas rig count. And, higher gas prices will be required to lift cash flows and fund greater drilling activity.
E&P Industry a Victim of its own Fundraising Success
One clear challenge to our thesis could be the past repeating itself, namely the E&P industry has done an incredible job raising capital in the past. They were even able to secure the big financial JVs during the lean years of 2008-2009, which few saw coming in such size. Why won't they raise a lot more money and drill beyond cash flow for the next few years? We view this as the key risk to our thesis. The first threat on this front would be more large financial JVs being created, that is, a continuation of the present financing trend via financial JV. We think this is unlikely, as many foreign firms interested in taking a strategic position in a shale play have likely done so, and many of the E&P companies wishing to enter into large financial JVs have done so. So, even though we anticipate a few more JVs could be in the works (most notably, we believe one or two more from Chesapeake (CHK)--it really initiated the financial JV trend and has been at the forefront of financial innovation within the E&P industry for over a decade given its propensity to outspend cash flow), we expect this avenue to raise large funds will start drying up. We believe asset sales will probably be among the most common method for companies to fund spending beyond cash flow over the next year, but we see this as a much smaller event, and many of the buyers are likely to be other E&P companies (making it a wash of sorts), with some new private equity money possibly entering through these transactions, too. As long as the asset market holds up, we expect light equity issuance.
Finally, we think management teams are starting to realize that missing previously issued growth guidance isn't as damaging to the share price as it used to be. In fact, given the frustration many investors have had over the industry's desire to drill ferociously in the face of low gas prices, we wouldn't be surprised if some companies were rewarded for announcing reduced spending plans in the face of lower natural gas prices. With the gas futures curve lower and flatter, management teams won't be able to lock in higher prices like they have in the past, removing another support beam and justification for greater drilling.
Earnings Power Should Improve from here
E&P companies have found themselves sandwiched between a vise of rising costs and low gas prices. When we wrote our 2010 E&P Outlook in January, we saw a worst-case scenario for E&P earnings power setting up, should gas prices remain low but service costs start to rise off their low levels achieved in 2009. It became clear in second-quarter earnings calls that we're living that scenario today--with operators reporting 20%-50% higher completion costs (compared to late 2009), depending on the play.
With unrelenting drilling to hold leases largely funded by strategically minded JV partners and well-timed hedges made in 2008 "turning the crank" on this vise, one wonders how long this negative environment can persist. Some companies have sought comfort in the arms of oil, where stronger selling prices are thus far making up for rising costs, but most North American E&P companies are gas-focused. Some of the legs supporting the current negative environment seem more stubborn--like the large financial JV partnerships kicking in funds to cash-hungry smaller E&Ps, though we think the pace of these deals will eventually subside. Great hedges are already much harder to find, and as we push into 2011-2012, hedges will likely reset down to $5-$6/mcf. The scramble to hold leases signed in 2008 should also cool down by 2011-2012. Eventually we think the industry will need to see lower activity levels unless the gas price is right, and tough times like we're experiencing now often act to break unhealthy industry behavior. Although the second half of 2010 appears dark for E&P earnings power, we think the present high-cost, low-selling-price environment is unsustainable, and is far worse than what we expect looking out a few years. Should equity prices start to extrapolate the current negative environment, we might see more bargains emerge later this year. We see some pockets of value in the E&P space, with Ultra Petroleum (UPL) and Range Resources (RRC) among our best investment ideas.
Valuations Appear Slightly Cheap
Energy stocks mostly ran in place during the third quarter. Companies have leaned more heavily on debt markets and asset sales relative to equity markets to improve liquidity, conduct deals, and fund budgets. This activity possibly supports our view that energy sector equity appears a bit undervalued presently, though not by much. We'd need to see sustained oil- and gas-price strength or further multiples improvement to justify significant stock price gains from here, in our opinion.
As a group, energy was slightly undervalued at the end of the third quarter, with the market-cap-weighted price/fair value ratio for the energy sector at 0.85. The median price/fair value ratio was 0.95, illustrating a continued disconnect between some of the larger- and smaller-cap names in energy. In general, we see larger-cap energy names slightly undervalued, and many smaller names more fairly valued, in aggregate. Recent valuations contrast sharply with where we stood in early 2009 and late 2008, but are just slightly cheaper than where we've been over the past four quarters.
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