By Simon Lack
I spent some time last week visiting with energy companies in Texas. We continue to believe that natural gas will play a bigger role in supplying America’s energy needs in the future; the U.S. has abundant supplies of natural gas, enough to meet domestic demand of around 23 TCFE (Trillion Cubic Feet Equivalent) for decades. It has only two-thirds the carbon footprint of oil and half that of coal. It’s currently very cheap (roughly one third the price of oil on a BTU-equivalent basis). And it’s all here, in the United States, rather than the politically unstable and at times hostile Middle East.
The development of shale drilling technology has vastly increased the amounts of natural gas that are accessible. In fact the activity has been so successful that it’s greatly expanded available supply and led to persistently low natural gas prices. This has put pressure on many drillers, since typically the lease terms under which they are drilling require certain minimum output (else the E&P company may lose the lease); consequently, many companies operate uneconomic wells so they can hang on to their acquired leases and wait for a pick-up in prices.
While deriving more of our energy from natural gas is clearly in America’s self-interest, identifying a likely catalyst isn’t easy. The focus on clean energy and fears of global warming lost much of their immediacy following President Obama’s election and the recession. Righting the economy and creating jobs understandably demanded attention. Congress also failed to pass an energy bill – the politics are enormously complicated in such a huge country. There will inevitably be winners and losers in any such legislation, both by region and industry. Eastern states might live with a carbon tax that would increase the cost of gasoline, whereas western states where driving distances are greater would be opposed. Coal is extremely dirty, but the coal industry is renowned for its effective lobbying of Congress. And power plants required to switch from coal or oil to natural gas would naturally seek subsidies for the needed investment. Progress will require that the president play an active role – occasionally Obama does discuss energy legislation and natural gas, but it’s too early to say whether this will be an area of focus in 2011.
Since timing is uncertain but we want to maintain exposure to the sector, we have focused on companies that are (i) focused on natural gas, (ii) have strong balance sheets, (iii) have low costs of production, and (iv) have large potential reserves. When we can identify those companies that are trading at a discount to the net asset value of their reserves we tend to invest. Names that we like include Southwestern Energy (SWN), Petrohawk (HK), Range Resources (RRC) and Comstock Resources (CRK). While we think they’re all potentially attractive, we think RRC and CRK are priced most attractively at present.
The meetings we had provided an interesting perspective on the industry. It’s clearer to me now that moving the U.S. towards greater use of natural gas will require effective lobbying by the industry. The natural gas industry is very fragmented, and few companies are big enough to command much attention in Washington. The American Natural Gas Alliance (ANGA) is relatively new and has yet to have much impact on the legislative process. Ultimately it will probably require greater ownership of these assets by the major energy companies before they have an effective advocate – acquisitions are nothing new to the sector, and many names are trading for less than they’d likely fetch if bought. In discussions with company management it’s clearly something they think about a great deal. The oil industry along with the coal industry have long been very effective at getting their voices heard. The fact that both industries are heavily unionized also hasn’t hurt with Democratic control of the White House and Congress over the past two years.
RRC has one of the longest track records drilling in the Marcellus shale in Eastern Pennsylvania. Although the company is headquarted in Forth Worth, TX, many of their executives are from Pennsylvania (including their President and COO, Jeff Ventura). As a result of being the early mover, RRC has some of the most attractive lease terms in the area as well as the lowest costs. They believe they can generate an IRR in the liquids-rich areas of the Marcellus above 50%. Not surprisingly they are directing most of their capex budget to this area and by selling their Barnett Shale holdings will be even more focused on an area that’s expected to grow substantially over the next couple of years. RRC believes that where they are able to extract natural gas in combination with other liquids (such as propane and butane) the returns can compare with those of oil even at below $5 per MCFE. RRC’s proven reserves of 3.1 TCFE are small in comparison with their resource potential of 24-32 TCFE. Much of this is in geology with which they are very familiar, and the company regards the probability of successfully converting this potential into proved as very high, which should drive their growth as well as ultimately make them an attractive acquisition candidate.
CRK is a smaller company, and their stock price has been particularly weak recently. They are in the Haynesville shale and Eagle Ford shale in Texas, and they are among the low cost producers in the industry with total production costs during the first 9 months of 2010 of $1.81 per MCFE (RRC is close at $2.10; SWN is the lowest at $1.37). The Haynesville has some of the deepest wells (11-13,000 feet, compared with the Marcellus at 5-7,000 feet). CRK also has a strong balance sheet with less than 50% debt:equity. However, the company mismanaged its supply of equipment and drilling teams earlier this year with the result that they found themselves struggling to reach their production targets. They have since recovered and adopted more formal, long term contracts with the many providers of specialized equipment and personnel on whom they depend. However, this was an unexpected logistical mistake and their stock price suffered as it became apparent. More recently, the announcement last week of their 2011 capex budget of $522MM (versus $515MM in 2010) was extremely poorly received. The company was surprised by the reaction, and they expect to fund all of it through operating cashflow, assets sales and their revolving line of credit (i.e. no equity). The market evidently was looking for a decrease on this year. As a result, given the expectation of no equity dilution to fund their 2011 capex, we think CRK is attractively priced.
Disclosure: I am long RRC, CRK.