Two independent reports were recently released indicating not only that Marcellus natural gas reserves are bigger than previously estimated, but also cheaper to drill than any other shale reserve in the country. However, the new reports, separately released by Standard & Poor's and ITG Investment Research, aren't exactly news to Marcellus heavyweights like EOG Resources (NYSE: EOG).
If corroborated these reports could be an embarrassment to the Energy Information Administration, which lowered its estimates of total Marcellus reserves by nearly 70%, to 141 tcf, earlier this year. Around the same time, Chesapeake Energy (NYSE: CHK) instituted plans to dramatically reduce its drilling activity on the Marcellus. According to data through December 2011, Chesapeake was the largest Marcellus producer up until the reduction, followed closely by up and coming private E&P Antero Resources.
However, in its desperate bid to raise cash through divestitures ahead of a looming cash crunch and reduce drilling costs, Chesapeake did all it could to hold on to its Marcellus acreage, even while massive blocks of its Utica shale holdings went up for bidding. I think this helps prove the estimates of Standard & Poor's and ITG, since if Chesapeake truly believed that the Energy Information Administration estimates were accurate, its Marcellus acreage would also be held out for sale, and Cabot would not be as publicly bullish about the play's potential.
Evidence Points to Severe Underestimates of Marcellus Potential
A recent statement by Seneca Resources, the E&P arm of National Fuel Gas Company (NYSE: NFG) on the dissolution of its joint venture with EOG also tends to indicate that the Marcellus is being underestimated. Although EOG's decision not to drill for further interests in acreage subject to the joint venture forced Seneca to reduce its production estimates for 2012 by about 10%, Seneca's press release gave more than a few hints that the firm is pleased in the trade off, since it means that the remainder of acreage under the original joint venture reverts to Seneca's 100% royalty free. At higher reserve estimates, this could prove immensely profitable for the firm.
Meanwhile, EOG also reduced dry gas drilling activity on its own acreage, but is bullish on the potential of the Marcellus, recently indicating that its Marcellus holdings are among "core acreage held for future development at higher prices," along with other key acreage in the Haynesville and Barnett shales. If productivity from dry gas wells is lowered as producers continue to pull rigs to focus on revenue driving oil instead of natural gas, the Energy Information Administration estimates that spot natural gas prices at the Henry Hub could break $4 again by mid-2014. This is a big if, however, as latecomers to natural gas continue to break ground and established producers continue to bring up natural gas through extremely productive wells set before the natural gas price collapse, keeping storage levels at historic highs.
Optimistic estimates point to plans in the works by Cheniere Energy (NYSE: LNG) and others to export liquefied natural gas that could push natural gas prices upwards sooner than anticipated in the long term, since exporting at higher prices would tend to push domestic natural gas towards parity. In the short term, arguments for both a mild winter keeping prices stable and a cold winter pushing prices higher abound. Still, in either scenario, EOG is a winner. Not only is it attractively hedged by its shale oil positions, but its long term focus on keeping the price of production at industry leading lows means that its breakeven is probably quite low. ITG estimates that the average break-even on the Marcellus is $3.81 per mcf, and I think it quite likely that EOG's break-even is even lower.
There are several reasons this should be so. Back in 2010, EOG reported that new completion procedures instituted during the year saw substantial increases in production rates on wells turned to sales. Such efficiency gains paired with its low first-mover entry cost and further cost reduction measures such as downspacing and other efforts at improving its margins support EOG's profits even at low market prices.
Another reason for believing EOG's break-even on natural gas to be low is looking at its competitor, Cabot Oil and Gas (NYSE: COG). Cabot's break-even is astonishingly low - "probably below $2," according to Cabot CFO Scott Schroeder. It still makes sense for EOG to continue diversifying into oil since it was among the first to acquire oil shale acreage and now has an excellent advantage in being a first mover, but that does not discount its natural gas potential in the least.
Although the outlook on the Marcellus may look overly optimistic in today's punishing market, a recovery is on the horizon. One need look no further than Kinder Morgan Energy Partners' (NYSE: KMP) and Enterprise Products Partners' (NYSE: EPD) plans to build out infrastructure servicing the Marcellus. Combined with producers' plans for the future, it appears that few are putting stock in federal estimates of the Marcellus' potential, and those investors who do are sure to miss out on the rebound.
EOG is currently trading around $111 per share, with a price to book of 2.2 and a forward price to earnings of 17.5. This is a dip ahead of its third quarter earnings report and a solid buy opportunity. Chesapeake is currently trading around $20 per share, giving it a price to book of 0.9 and a forward price to earnings of 11.5. Cheniere is currently trading around $16 per share, giving it a price to book of 10.6 and a firmly negative forward price to earnings of minus 7.2. National Fuel is trading at similar value ratios to EOG, at around $53 per share, giving it a price to book of 2.2 and a forward price to earnings of 18.3. Finally, Cabot is trading around $43 per share, with a price to book of 4.3 and a forward price to earnings of 50.3, high due to its reliance on natural gas but propped up by bullish investors awaiting a natural gas recovery.