CNX Gas Corporation Q1 2008 Earnings Call Transcript

CNX Gas Corporation (CXG)

Q1 2008 Earnings Call

April 23, 2008 10:00 am ET

Executives

Nicholas J. Deluliis – Chief Executive Officer, President and Director

Dan Zajdel – Vice President, Investor Relations

DeAnn Craig – Vice President, Asset Assessment

Analysts

Ray Deacon - BMO Capital Markets

Brian Corales – Coker & Palmer

Pavel Molchanov – Raymond James

Joseph Bachmann – Howard Weil

Presentation

Operator

Good morning ladies and gentlemen and welcome to the CNX Gas first quarter 2008 results conference call. I’ll now turn the call over to Mr. Dan Zajdal, Vice President of Investor Relations. Please go ahead, Sir.

Dan Zajdel

Thank you, John. Good morning everyone and welcome to the CNX Gas Corporation first quarter 2008 conference call. With me today are Nick Deluliis, President and CEO and the CNX Gas management team.

Before we begin let me remind everyone that various statements we make during this call including the guidance we give and other statements that express a belief, expectation or intention are forward-looking statements under the Private Securities Litigation Reform Act of 1995. Actual results could differ materially from these forward-looking statements. Information regarding the factors that may cause such differences is contained in our annual report on form 10K which has been filed with the Securities Exchange Commission. The SEC permits oil and gas companies in their filings with the SEC to disclose only proof reserves that a company has demonstrated by actual production or conclusive formation tests to be economically and legally producible under existing economic and operating conditions. We use certain terms in this conference call such as “unproved resources or reserves” that the SEC’s guidelines strictly prohibit us from including in filings with the SEC. We also caution you that the SEC views such unproved resource and reserve estimates as inherently unreliable and these estimates may be misleading to investors unless the investor is an expert in the gas industry.

After the remarks by Nick Deluliis we will turn the discussion over to the callers for a question-and-answer session with management.

Now I’d like to introduce Nicholas Deluliis. Nick?

Nicholas Deluliis

Welcome everyone. CNX Gas just completed our best quarter since inception both operationally and financially. That is something that all of our employees can be justifiably proud of and most importantly we executed by continuing to work safely. It has been another quarter in the Company without an employee lost time accident with our streak eclipsing 2.8 million man hours and spanning 14 years.

Better yet, our contractor safety incident rate continues to only be a fraction of the average in the industry.

We posted record total company production of 15.9 bcf and that is a great result but what is more impressive is how we accomplished the record production. It wasn’t the result of strong performance from just one producing play, but instead it was strong performance from all of our producing plays. Individually we had record production from Virginia coal bed methane operations, Mountaineer coal bed methane operations, Nittany coal bed methane operations and our Knox energy joint venture. That is exactly what you want to see from a growth company focused on internal organic opportunity such as we are.

The record production in Virginia was especially meaningful since the CONSOL Energy Buchanan coal mine didn’t resume long well production until mid March which meant basically we experienced a deferral of mine related gas for much of the quarter. This of course bodes well for our potential performance from Virginia operations in the second quarter of this year and the rest of the year.

What gets us the most excited about the past quarter has been the continuing performance in our Mountaineer coal bed methane play. Many of you know this is our all important first step out from Virginia and potentially adds incremental value to our portfolio. The assets, the first quarter of 2008 represents Mountaineer’s best period ever from both a production and income standpoint.

We continue to perfect our horizontal drilling technique and efficiency, continue to see our key well profile metric of mcf for horizontal drill foot climb and we continue to expand and capitalize the all important [mid turn] gathering and processing facilities.

All of that when you take it together adds up to the results that we saw in Mountaineer’s quarter. If we close out the tour of our development plays we see that the Nittany coal bed methane type curves from our drilling program continue to beat the projected curves and cost in Nittany has been extremely well managed both on the capital and operating side.

In our Knox Energy joint venture we have adjusted our strategy to accommodate the success of our first horizontal Chattanooga shale well. We now have a long term methodical strategy for Knox Energy that is going to identify the potential for horizontal shale drilling and depending on what the potential looks like what is the best avenue for maximizing our NAP and returns for the shareholder base in that play.

So production was strong across the asset base for the quarter but as we stated many times in the past production is only going to be a means to an end and the end, of course, that we are after is growth in the forms of things like net income and shareholder return.

Our record production coupled with higher pricing and lower unit costs relative to the fourth quarter translated to record net income of just under $50 million which resulted in earnings of $0.33 per share and the $0.33 includes one-time items with the two key ones being the booking of insurance proceeds from the Buchanan mine fire event last year and the expenses related to the special committee of the Board of Directors that was formed in the first quarter to accept and take an offer from CONSOL Energy.

One-time items when you net them out come out to about $0.02 per share positive impact on earnings and the conclusion is the same with or without the impact. We posted record earnings for the quarter either way.

This net income coupled with our focus and at some times or some might say obsession on efficient and disciplined deployment of capital resulted in our achieving a 20% return on capital deployed on an annualized after tax basis. With our weighted average cost to capital as significantly lower level than these returns you can quickly see that CNX Gas is creating substantial value for our shareholders as we deploy capital into our asset base.

We all know that three parameters ultimately determine net income; the three being of course production, revenue and cost. We already covered production and when you look at our revenue position you see that we are well situated. Our lateral approach to our hedge book has placed us with just under 40B hedged in 2008 at a price above $9. That leaves over 30B at over pricing which looking at the NYMEX curves is currently very strong.

So how do we achieve this enviable position? At the end of the day it was pretty simple. We readily accepted that we, or no one else for that matter, can predict future gas prices and the volatility in pricing was here to stay. We can take advantage of that opportunity using our laddering approach if we focus on cost and maintain a clean balance sheet that doesn’t require taking price exposure off the table.

If you want to be well hedged in this business we feel it is better to be focused on being a low cost producer and not to be focused on trying to predict things like the weather, monetary policy, geopolitics, etc.

On the cost side we provide a detailed break down and discussion in the press release. From a big picture perspective our unit costs were about 9% higher than the first quarter last year, but were lower than the fourth quarter of last year. So the trend of lower unit costs we expect that is going to continue in the second quarter with return, once again, of the deferred [gob] gas production from the Buchanan coal mine.

So summarizing the record earnings and high returns on capital becomes pretty easy. Record production, well hedged revenue book and unit costs trending lower from the prior quarter.

Now let’s talk a little bit about the rest of the year. With the first quarter behind us we are affirming our 2008 production guidance of 72 Bcf which if achieved is going to give us a 24% increase in production over 2007. This percentage increase should be higher than most peer companies in the industry. We remain on track to drill the 500 wells development program. Again that is 300 wells in Virginia, 100 in Mountaineer and 100 in Nittany. To achieve our 72 Bcf target we really don’t need help from our shale exploration program, which I am going to discuss shortly.

Although we don’t need meaningful production contributions from the shale to hit the 72 Bcf target, what we will need is to drill our 500 development wells and execute our exploration program which is $470 million in capital expenditures. But because of our hedge position for the year that we discussed earlier and current NYMEX pricing along with our leading margins we may not need to draw upon our credit facility to fund the capital program this year. I think there is very few companies in this industry that have the luxury of just that, which is remaining unlevered while growing production at this accelerated rate.

So while we are only a few weeks into the second quarter we do know that trends remain favorable. Pricing was strengthened each month through the first quarter and continued to rise in April. We have continued to set daily production records in Virginia and Mountaineer and we should benefit from an entire quarter’s worth of mine related gas.

All in all frankly if we continue to execute we should have a strong second quarter. What do we see beyond 2008? Longer term we remain focused on achieving the 100 Bcf for production by 2010 and doing so is going to make CNX Gas the largest Appalachian gas producer by volume. But you may not realize that when production revenue is the metric CNX Gas is already the largest Appalachian producer. We achieved that distinction based on the strength of our 2007 results and when you look at our hedge book coupled with current NYMEX pricing along with our production targets we should remain the Appalachian leader in revenue. That is an impressive position to be in considering we have only been a stand alone producer with a dedicated management team and active capital markets for around three years. Others have been drilling the basin for decades and when you look at our predecessor operations before spin out we really only began in earnest in the early 1990’s.

So CNX Gas realizes more revenue today and will extract more production tomorrow from its Appalachian gas assets than any other company in what has become the hottest gas basin in the United States.

Okay now let’s talk a little bit about the shales. We have amassed one of the larger positions in the Appalachian shales with nearly 500,000 acres and if you add to that over 300,000 acres of New Albany shale that we control you start to approach one million acres of footprint. Last year we brought in DeAnn Craig in from Chevron to lead our exploration effort and through our technical staff. This year we have our first stand alone exploration budget of $88 million. All of that is going to start to provide clarity on our shale opportunities. If we start a discussion of the shales like the Chattanooga shale in Tennessee right now we have the rig running to drill three additional wells. You’ll recall that our first horizontal Chattanooga shale well came on with an open flow of just under 4 million cubic feet per day which is a company record. Rather than just drill offsets we want to see if we can replicate this result in other sections of the 250,000+ acre joint venture.

So we’ll be drilling three new wells to further define this play this year. Now, as those new wells are completed within the Chattanooga shale, the rig that has drilled those will then move afterwards into eastern Kentucky to proceed with our Huron exploration which is just under 200,000 acres. We will drill three horizontal exploration wells to explore this acreage this year.

At the same time we are also proceeding with our Marsalis testing program. In January we were targeting the Marsalis and hit 1.2 mcf of gas in the tight sand up hole from the shale so we completed the well before reaching the Marsalis. This well was tied in to line in about five days and it continues to produce about 600,000 cf per day. So our first Marsalis well we just sputted Monday of this week and this first of three Marsalis wells we are going to drill this year will be drilled vertical while the next two after that are going to be designed to be taken horizontally.

We continue to lease and add to our Marsalis position but that is mostly or predominantly to round out the legacy position we currently hold which sits mostly in southwest Pennsylvania and northern West Virginia.

Outside of Appalachia we are also testing our 300,000+ acres of oil and gas in the Illinois basin. This acreage will be addressed using a three tier approach which includes evaluating conventional oil and gas potential and better understanding both existing biogenic and thermogenic New Albany shale depletions.

CNX Gas has joined a shale consortium for that basin and we will take into consideration information gleamed from that consortium before drilling wells to exclusively test the New Albany shale.

In the interim we will give a preference to targeting up hole horizons which are thought to contain conventional oil and gas. Most of our oil and gas acreage, remember, in the Illinois basin sat in the hands of coal companies for decades. They weren’t interested in having their properties drilled out but others all around those properties have been producing commercial quantities of hydrocarbons for literally decades.

So we’ll keep you posted on our results across the range of shale opportunities as events unfold in 2008. It should be a busy year on that front. One question with regard to these shales which has been regularly asked is what happens if your shale exploratory program is successful? Can you continue drilling in 2008 or are you going to have to wait until 2009? Related to that a follow-up question is often are you willing to tap into your credit facility in order to fund a continued or expanded 2008 shale exploration program?

The answer to these questions is pretty simple. If we achieve success in our shale exploratory program we are going to do what we can to accelerate drilling in 2008 and tapping into the credit facility is certainly an option. Other than maintaining our sell or safety record we can’t think of really anything else that would please us more than to have to ask our Board of Directors for more capital to fund additional drilling into the shales. But that is only going to happen once we have a reasonable expectation for accretive NAV and returns as the result of shale development. That is the patience and discipline that basically got us to where we are today. It is not a process that is broke and we certainly don’t have any plans to fix it as long as it continues to work.

In the mean time, we don’t need again success from the shales to achieve our 72B of this year or for that matter the 100 Bcf in 2010. So success in the shales again is incremental to these levels. That brings to light the bigger strategic issue regarding our shales; CNX Gas effectively has a free option while others place capital at risk in an attempt to develop and aggressively exploit the shales we can patiently and methodically assess what we control waiting to see the results from the peers. The learning curve at the end of the day for a second mover on shales and at facing where we are already a leading producer is not as long or as steep as you might think especially when you have a large legacy position like we do. In fact at the end of the day it might just be the highest NAV route but time will certainly tell.

So in summary CNX Gas we feel represents the premier holding in the ENP investor space. Coming off our best ever quarter there are a number of reasons we feel that way. The facts speak for themselves. We have the best safety record in all of ENP. We are on pace to post 24% production growth for 2008. We see ourselves getting to 100 Bcf in 2010. We are the lowest cost producer in the eastern U.S. We are the highest margin producer in the U.S. We sit on nearly one half a million acres of Appalachian shale with another 300,000 of New Albany shale. We have a balance sheet that is effectively debt free with cash on hand. We deliver returns on capital that are well above our weighted average cost to capital.

So before I turn it back over to Dan I want to thank the management and operating teams at CNX Gas for remaining focused on execution throughout the quarter. Everyone remained honed in on our performance during the quarter while major external events played out. The team simply did what they always do. They executed in a very efficient and accident free manner. As shareholders I think we owe them our thanks.

With that I will turn it back over to Dan.

Dan Zajdel

Thanks, Rick. We’re ready to take questions from the audience. If you have dialed into this call as a member of the media I’d ask you to withhold your question until after the call when I can speak with you individually.

John, could you please instruct the callers on the procedure for asking questions?

Question-And-Answer Session

Operator

Certainly. Ladies and gentlemen if you would like to ask a question today please press the * then 1 on your touchtone phone. You’ll hear a tone indicating you have been placed in the queue. If your question gets answered and you wish to remove yourself from the queue please press the # key. Once again if you have a question please press * then 1.

Our first questions are from the line of Ray Deacon with BMO Capital Markets. Please go ahead.

Ray Deacon - BMO Capital Markets

Hey Nick it sounds like your balance sheet is in great shape and I’m just wondering if you are successful in the three upcoming Marsalis and the Chattanooga would you be able to ramp up activity this year and also if there is upcoming carbon legislation I guess in what way could you potentially benefit from that?

Nicholas Deluliis

Ray the issue with regard to some of the shale plays we are exploring right now it really does come down to for us is NAV. Let’s say we are lucky enough to get strong results from the Marsalis that look to be accretive and have a good rate of return. What we do then is develop an expanded exploratory program and step out program and that program and timing is set with regard to what can be done in the most efficient manner again from an NAV or rate of return standpoint.

So the good news is with regard to something like balance sheet or access to capital that is not a rate limiting factor in any way shape or form within the foreseeable future and the expansion beyond what we have currently committed to with regard to shales would be set by simply the efficient deployment of capital. So it is a pure NAV type of assessment. We don’t want to move too quick where we start destroying value but we are going to move as quickly as we can and capital constraints because of our balance sheet won’t be a problem.

On the carbon side of the equation the devil is always going to be in the details with regard to the specific plans that basically the Congress or presidential candidates propose, come up with and approve regarding climate change mitigation efforts. It is those details that will ultimately determine timing and availability and eligibility of carbon offsets or carbon credits and we do know that no matter which foreseeable plan comes into play we are in a pretty good position with regard to seeing some value creation for our shareholders on that front. As to how much and when we would start realizing that and what our strategy would be to try and monetize it we would want to wait and see how the specific rules and policies and elections, frankly, pan out.

Ray Deacon - BMO Capital Markets

Got it. Thank you.

Operator

Our next question is from the line of Brian Corales with Coker & Palmer. Please go ahead.

Brian Corales – Coker & Palmer

Hey guys. Good quarter. Just a question on the 30 acre down spacing in Virginia. Do you all have any reserves built on 30 acre spacing or how can we think of that as you start the in fill process?

DeAnn Craig

The only reserve we booked so far in 30 acre spacing are associated with two pilot programs we have to confirm that 30 acre spacing was a good move. There will be additions when we go ahead…at the end of the year when we have drilled these 30 acre in fills.

Brian Corales – Coker & Palmer

The reserve estimate you put out for the first quarter, did that include some down spacing?

DeAnn Craig

No, it did not because we had just gotten the permits and so they would not have been in there.

Nicholas Deluliis

The 30 acre down spacing Brian with regard to the [proved] reserves that we put out I believe in February largely excluded that from the analysis.

Brian Corales – Coker & Palmer

Okay. Just one other question in regard to the down spacing. Can we just take the acres and go by 30 acre spacing? Is this viable in part of the acreage and not in others? How should we look at that?

[Not identified]

You have to remember Brian that we have the two fields side by side and the Oakwood field which is now predominantly on 40 acre spacing and then Oakridge and a small piece of Nora that is on 60’s. That is the part that would be going to 30’s as we continue to submit applications to the Virginia Oil and Gas Board. But I believe that Middle Ridge and a little piece of Nora is in the vicinity of 60,000 acres.

Brian Corales – Coker & Palmer

Okay. Thanks guys and good quarter.

Operator

Just as a quick reminder if you do have a question please press * then 1.

Next we go to the line of Pavel Molchanov with Raymond James. Please go ahead.

Pavel Molchanov – Raymond James

Hey good morning guys. A quick question on drilling costs. As the Appalachia has some of the hottest place in the country, Marsalis and so on, are you starting to see daily to creep up and if so what area specifically?

Nicholas Deluliis

Pavel with regard to drilling costs and really access to the services across the spectrum as well I think we are in a really strong position. A big part of that goes back to what we saw when we first spun out in 2005 when gas prices were very high coming off of Katrina and we wanted to ramp up our efforts and there was a concern not only to costs but just to availability of things like rigs and services. I think what gives us the biggest advantage at the end of the day that allows us to continue managing these spots is that we have got a very significant acreage footprint across these different major plays whether it is on the coal bed methane side or the shale side. Secondly the cost in the economies of scale that we can produce by development drillings of these areas basically establishes us as the low cost producer within those plays and you couple those two things together and if you are a well service provider or a driller you look at that and suddenly the risk associated with committing capital in the form of drill rigs or employees or any other type of associated services…it is much lower than it would be maybe for the peer company right next to you where if you know that capital program those drilling commitment budgets are going to be $5 gas or $10 gas. So I think at the end of the day that is one of the largest advantages we have with regard to be being able to control and manage costs.

I think the second big thing is that with regard to those geographic footprints we have in Appalachia we also have the advantage of service providers of not having to move significant distances to drill out a certain place for us over the course of years. That adds big advantages like safety with regard to their employee rank and file and just overall headaches with regard to logistics and providing us services.

So we feel good about cost with regard to CNX Gas. I think you will see some cost escalation in the basin overall just because of the heightened activity and the accelerated timing with regard to that activity.

Pavel Molchanov – Raymond James

That’s great. And just a related question, are you starting to see any take away capacity restraints or bottlenecks on that front?

Nicholas Deluliis

No, it is something we always focus on and manage whether it is the mid stream and processing that we own and operate or whether it is the interstate network. I think the big difference between today and three years ago when we were spun out is that today there is an awful lot more discussion and projects about capital deployment beginning to take away capacity projects. But with regard to our current operations I think we are in a relatively good position with regard to ensuring we have a ticket on the highway so to speak to get the gas to the market.

Pavel Molchanov – Raymond James

That’s great. Thanks very much.

Operator

Ladies and gentlemen just as another reminder if you do have a question please press * then 1 at this time.

We’ll go to the line of Joseph Bachmann with Howard Weil. Please go ahead.

Joseph Bachmann – Howard Weil

Hi Nick, how you doing this morning? Just a couple of questions. First, do you have any update on your Trenton Black River activity at this point in time?

Nicholas Deluliis

Trenton Black River is something that we know we have a significant position in. I think at last count it is half a million acres coming in on about 600,000 acres. It effectively sits under all of our major Appalachian shale footprints. Our initial activity on the Trenton Black River was similar to what we are doing with also the Bakken shale out in North Dakota where we are partnering with big, well established producers in those plays. With the Bakken in North Dakota it is Marathon. With the folks in upstate New York with regard to our Trenton Black River acreage up there we have left them unnamed because of confidentiality issues. But that has been the approach to date. The results we have seen through those types of ventures on the Bakken and Trenton Black River front has been positive to date. The real issue, though, is moving beyond upstate New York acreage which is a minority or small portion of the 500-600,000 acres we control is what do we do with the rest of this moving forward?

The way I tend to think of it is we tend to think of it in terms of vertical horizons within the company. We have a given acre in northern West Virginia. We have already figured out and established the pipelines and processing facilities we operate on the surface. We usually have some surface ownership to go with that. We’ve got the coal bed methane figured out. So going a little bit deeper through that acre you’ve got the CBM development occurring 500 to 2000 feet below it depending on the play and now we are focusing to the next vertical layer which is the shales below it and some of the shallow gas potential up hole from the shales. That is where we are currently focused today. As we get to year end and into 2009 I think the next big opportunity to start exploring and get a handle on would be the 500-600,000 acres of the deep conventional below all of those.

The nice thing about thinking of it vertically is not only is it sort of a logical progression but you also start to see how the economies of scale might be able to be brought home for someone like CNX Gas versus a peer company that just might own, for example the Trenton Black River, or just might own the pipeline or just might own the coal bed methane. All of those horizons we think our unit costs and rate of returns should appreciate because of it.

So Trenton Black River I think is right behind the shales. I think as we get into year end and early 2009 that is when you’ll start to see a more formalized process like what we have in the shales.

Joseph Bachmann – Howard Weil

Okay. Great. Then last one, in terms of the shale consortium in New Albany, who is a part of that besides you guys?

DeAnn Craig

This is the RPSEA group. I believe it is Southwestern, Quicksilver, Nobel, Aurora and ourselves.

Joseph Bachmann – Howard Weil

Great. I appreciate it. Thanks guys.

Operator

To the presenters no further questions in queue.

Nicholas Deluliis

Okay. Thanks everybody. I’ll be around for the rest of the day and the call will be available for replay for a week. John do you have the replay information?

Operator

I do. That replay starts today at 12:00 p.m. ET and will last until April 30 at midnight. To access the replay please dial [phone]. International parties please dial [phone] and the access code is 918698. Any concluding remarks?

Nicholas Deluliis

That’s it. Thanks very much everybody.

Operator

Ladies and gentlemen that does conclude your conference for today. Thank you for your participation. You may now disconnect.

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