Why I Just Shorted Antero Resources

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About: Antero Resources Corporation (AR), Includes: AM, SWN, UPLC, WLL
by: Ian Bezek
Summary

Don't expect the recent bounce in E&P companies to last long with natural gas in the dumps and oil sliding again on renewed trade war worries.

I've been buying quality energy companies and looking for a hedge for my position.

Antero Resources seems misunderstood and is being priced based on hope rather than economic reality.

I particularly question how much its position in Antero Midstream is worth.

Unless natural gas prices bounce sharply before 2021, Antero Resources is heading for grave problems.

Multiple investors that I have great respect for have made the case for owning Antero Resources (AR) recently. One even suggested that you might want to make Antero your largest equity holding. Unfortunately, I don't see the deep value at AR stock. In fact, I don't see much value at all. It looks like a highly-levered company that serves a fast-eroding call option on natural gas prices that will end up worthless if commodity prices don't improve sharply and soon.

Permian Gas Is Killing The Pure-plays

The fundamental problem with Antero and other gas-focused producers is that the marginal suppliers in the market don't care about price. They don't care at all, in fact.

The frackers in West Texas pay their bills with crude oil production. Anything they get for associated natural gas production is a bonus. And if they get nothing at all, that's fine, they can flare it off. As a result, you have the east coast players producing natural gas and needing to make a profit simply off their gas plus NGLs. Meanwhile, they're competing with a fast-growing supply of natural gas whose marginal cost is zero.

The Permian situation isn't about to get any better. Permian pricing for natural gas has gotten close to zero at times recently, and producers are flaring off a lot of natural gas rather than selling it at all. But new pipelines will be coming online later this year that will allow this wasted flare gas to be sold nationally, adding to a market already groaning under endless supply.

Additionally, overall Permian energy production growth has slowed down sharply in recent months. While there are various reasons for this, one big reason appears to be that producers wanted to wait until more natural gas infrastructure was in place to drill more wells. The result? Once new pipelines come online, expect the Permian drillers to step up their production work to take advantage of the new pipeline capacity. The adage goes that the cure for low prices is low prices. This won't work if producers keep expanding their capacity regardless of demand.

This is part of the bigger problem in North American E&P. Incredibly, there's still too much capital available in the industry. Private equity keeps funding deals, and even a few companies have managed to launch public offerings in recent years.

And the vast majority of bankruptcies so far have been Chapter 11s, which simply get rid of debt and interest burdens, and allow the underlying producers to keep drilling and adding more to the glut of supply. These firms come out of bankruptcy as low-cost producers, putting additional pressure on existing levered firms to pump even more to meet their interest payments as prices fall farther. It's a downward cycle that has pushed nat gas prices - in particular - through the floorboards. Until the grow production to pay interest treadmill stops, it's hard to see a sustained recovery for the industry.

If you own AR stock or another similar levered pure-play nat gas producer, you're hoping that the glut of production will suddenly clear up before your existing debt burden matures. That doesn't seem like a great bet, given the new production from the Permian and elsewhere outstrips likely new nat gas demand.

Exports Won't Save The Day

Since there's not enough demand in the U.S. to use up all the robust (and still growing) supply of natural gas, bulls point to overseas markets for salvation.

And there's some truth to the basic idea. Mexico, for example, with its formidable and growing manufacturing base has use for cheap natural gas. Exports to Mexico are growing, but not even at a rate sufficient to sop up most of the new Permian production.

That leaves us with overseas LNG exports. This was supposed to be the industry's great hope. But that's not likely to pan out either. LNG prices in Asia have plummeted to 10-year lows as oversupply from the U.S. and Australia have outpaced demand. Rig Zone recently noted that:

Natural gas in Asia is heading toward the lowest price in a decade, possibly extending pain for global oil majors suffering from the fuel’s weakness.

The latest bad news for bulls came this week, as China National Offshore Oil Corp. bought a liquefied natural gas cargo for early September delivery to China at about $3.90 per million British thermal units, according to traders with knowledge of the transaction. The region’s benchmark price, the LNG Japan/Korea Marker, briefly touched $4 per million Btu in April 2016, but hasn’t dropped below that since 2009. The LNG market has been flooded by the startup of projects in Australia and the U.S., while mild weather across North Asia cuts consumption.

Looking to Europe as a market for your glut of natural gas? Think again - it's seeing a big plunge just like Asia:

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YCharts

That's a cool 60% drop from recent highs, also, as it turns out, to 10 years low. Even if Europe and Asian prices recover despite the glut of LNG imports from abroad, there's another problem: most of the U.S.' LNG export capacity is already built or will be completed over the next year.

What to do with all the new natural gas production capacity slated to come online from 2021 and beyond? Eventually more export capacity could be built if demand was there, but we're unlikely to get much of anything else in that regard before 2024 or 2025. Antero needs sharply higher natural gas demand well before then.

Don't Get Confused By Earnings

Just taking a cursory look at the P/E ratio, beaten up E&P plays like Antero might look cheap. In fact, Antero is trading at under 3x trailing earnings, and somewhere between 10-20x forward earnings, depending on what data source you look at. The fact that earnings are set to decline sharply should tip you off to realizing that EPS isn't a great metric here.

And here's an example that should frighten you. Ultra Petroleum (UPL) just announced what looked like decent earnings in May:

Yes, they missed earnings, but they still brought in 14 cents of EPS and 21 cents per share if you prefer GAAP. Revenues were also up 21% year-over-year. Sounds good right? And yet...

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YCharts

Unfortunately, UPL stock is trading at 18 cents now and the market is pricing it for bankruptcy sooner or later, despite little in the way of near-term debt maturities. It's easy to show net income if you have a substantial hedge book in place, but the question becomes: What happens after your hedges roll off? If natural gas prices don't go higher in a year or two, then what?

Sure, Antero doesn't have debt due until 2021 and they are heavily hedged in the meantime. The company's hedging book is shown in detail on page 27 of their most recent 10-Q. We see robust hedging for the remainder of 2019 at $3.45 on a weighted average basis, and similar hedging volume at a $2.87 average for 2020. Unfortunately, the company's hedges for 2021 and beyond are less than half the volume they have in place for 2020, and are also locked at or below $3.

(Update, August 14, 2019, 11:15 a.m.: Comments on the company's collar and floor pricing have been corrected after a commenter brought inaccuracies to the author's attention.)

Notably, the company has no NGL hedges at all past this quarter, which is another point of weakness as liquids make up nearly a third of the company's production. Pricing in these, in particular ethylene and thus Antero's ethane, has been difficult in 2019.

Turning back to natural gas, excluding brief winter spikes, it hasn't maintained a meaningfully higher price since 2014. A year or two is not a long time for things to turn around when we're in year five of this phase of the slump and things are actively getting worse both for gas and NGL pricing.

For another example, look at Southwestern Energy (SWN). This one is slightly less levered than Antero and has no significant debt maturities until 2025. It has long been billed as a "survivor". Yet the stock has slumped to less than $2 per share. It's down to a 1x trailing P/E ratio. Yes, 1. And yet the stock keeps going lower because earnings aren't the relevant metric here:

To those saying AR or SWN or whatnot stock is too cheap to short, I'd note the following. In late 2018 at $5, SWN stock was down 90% from its 2014 highs. It has since proceeded to drop another 60% already.

I Don't Buy Sum-Of-The-Parts Valuations Involving Antero Midstream

Read through bullish commentary on AR stock over the past year, and you'll see people repeatedly bring up the idea that Antero Resources is cheap because so much of the market cap is backed up by its ownership position in Antero Midstream (AM).

And you can make that case. But what is Antero Midstream stock worth without Antero Resources? It's been argued that AM's contract is not reflective of market rates, and that Antero Resources would look to get rid of it in a potential bankruptcy filing.

Since Antero Midstream hasn't significantly diversified away from Antero Resources, what's it worth if the parent goes bust? It's hard to say, but the potential valuation is quite low, especially since there are questions about related-party issues and past fair dealing. I'd suggest that one reason why Antero Resources' bonds are still trading up near par (an element of the bull case for AR stock) is that Antero Resources should be able to recast the contract with Antero Midstream in bankruptcy, making the creditors' position much stronger, though it'd be too late for the common stock at that point.

I'd also note that Antero Midstream has a huge bullish fan-base, seemingly primarily of income yield seekers who may be overlooking fundamental problems in search of a fat dividend. I'd also point out, incredibly enough, that the last 11 articles on Seeking Alpha on AM stock have all been bullish; meanwhile, the stock has collapsed. The idea that Antero Midstream stock is undervalued may be right eventually, but so far, it's been a dud for a long time despite many people thinking otherwise.

In any case, it seems the market is now pricing AM stock as though it has significant risk from Antero Resources going bust - which is a valid concern - and thus invalidates the idea that AR stock-owners can count on AM value to bail them out. It's circular thinking to try to value one off the other when both are in freefall:

Chart Data by

YCharts

The Windstream/Uniti (UNIT) situation is a good recent example (in which, sadly, your author lost some money) of how carve-out yield assets aren't necessarily safe shelter if the parent company bites the dust.

Why Short Antero Resources Now?

Some are going to say it's way too late to short AR stock at this point. After all, it's down 51% year-to-date and 90% since 2014. Surely what goes down that far must go back up eventually, right? Not necessarily.

In fact, many short sellers tend to only take positions after a stock has fallen sharply. The sayings about the trend being your friend and not fighting momentum apply. A stock that is going up has positive momentum, a story, and interested buyers behind it. Even if it is materially overvalued, there's no guarantee that it won't get a lot more overvalued before it cracks.

Once a stock falls sharply, however, it gets a lot easier to keep dropping. And, of course, the maximum gain on a short position is 100%, regardless of where you short from. There's no prize for getting to a short position early. On the other hand, if there's a good shot of bankruptcy ahead, it's rarely too late to get in once things are heading decisively south.

But why short right now? For that, I'd mention Seeking Alpha author Raw Energy's August 1st comment summarizing recent market action.

Damage is and will likely to continue to be widespread in the E&P sector. The sharp move up prior to earnings and the Fed mtg. appears to simply have been a short covering rally or simply a seller boycott for a few days. Earnings from companies like CXO and WLL are hitting most of the oil producers (also due to lower oil prices), and now natural gas producers that have reported and were up appear to be rolling over as well.

In an upwardly trending market, holding through earnings often pays off, but in a weak market the market pauses (at best) before renewing the trend. Be careful out there!

We just had a big short covering rally in the sector, and in specific stocks such as Antero. But now the sellers are back with a variety of good reasons and the dominant trend should reassert itself, pushing Antero and peer stocks to new lows. Whiting's (WLL) horrific earnings report certainly hit sentiment:

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YCharts

Whiting had a nice short squeeze from $16 to $18 going there, only to lose 38% of its value the next day. Given how awful industry fundamentals are, it should scare the day traders trying to ride short-term bounces when this sort of carnage happens.

The new Trump tariff threat is certainly a catalyst to the downside as well. Oil prices dropped as much as 7% on Thursday following Trump's latest tweets:

Chart Data by

YCharts

And let's think about Antero more specifically for a minute. It relies heavily on NGL sales for revenue. China is typically a huge buyer of U.S. exports in this category, as it still has big markets for things such as propane that have waned in the U.S. However, China cut back its imports sharply as the trade war kicked off, and things are unlikely to improve on that front with Trump escalating the stand-off again. As a reminder, Antero is far less hedged for its NGL production than it is for natural gas.

More broadly, China's weakness is a major hurdle for the overall natural gas market globally. Bulls had been hoping China could bail out what was already shaping up to be a pretty underwhelming 2020. See the commentary from RBC as quoted in this Oilprice.com article:

"We see the market as clearly oversupplied in 2019 and more moderately oversupplied in 2020, with really only China able to re-balance the market through continued demand growth."

Thus, the market will be oversupplied with gas next year. The article continued, noting that:

"Hub pricing in Europe and Asia has fallen well below our expectations, and with European gas storage filling at levels ahead of historical norms, it paints a pretty ugly picture for gas markets," RBC said, adding that the culprits behind the current oversupply were a mild winter in key markets and an increase in global LNG supply. Going forward, the RBC analysts warned that European demand for gas will stagnate thanks to the increased adoption of renewables [...]

The bank’s analysts noted the absence of any bullish factors for gas prices at the moment, saying these are only likely to be seasonal depending on the weather. They also said the first signs of these factors would not make themselves visible until early winter.

Got all that? A glut of natural gas is building globally, not just in the U.S. Already, there are threats to long-term demand overseas, such as renewables. There are no bullish catalysts for gas prices through to winter - which is still quite a ways off given the rate nat gas stocks have been slumping lately. And the one thing that could potentially work off the supply overhang - China - is in the penalty box.

In fact, the China dispute is apparently blocking the creation of new LNG export facilities, casting a shadow over the future of the industry that will linger long past when the current dispute ends. The article notes that:

According to a senior IEA official, China will become the world’s top LNG importer within the next five years, just as the U.S. becomes the largest exporter by 2024, with annual exports of over 100 billion cubic meters in that year. That, however, would only work out with stronger LNG prices and an end to the trade war that has stumped some LNG ambitions because of the lack of long-term import commitments, notably from Chinese importers.

Antero Resources: Time Is Running Out

It's tempting to think of AR stock as a long-dated call option on natural gas prices recovering. I'd take issue with this, however. Sure, the stock price is only $4.50 per share, which may sound cheap. But the market cap is still $1.4 billion. The market is assigning a whole lot of value to a firm whose equity will have little to no value within a few years if natural gas prices don't move smartly back up before the debt comes due. And the nearly $3 billion debt pile starts maturing in 2021.

And at some point, people will conclude the business model/management strategy just isn't working. This tweet puts it nicely:

And yet even now, Antero is still spending to grow production more. Arguably, that's because management isn't necessarily aligned with AR's interests since it also gets big dividend paychecks from its sizable ownership position in AM stock. According to Gurufocus data, insiders own 16.4% of AM stock compared to 7.2% of AR stock. Key insiders such as Glen Warren own more AM (16.2 million shares) than AR stock (10.2 million shares). AM gets its growth - and thus bigger dividends - from forcing AR to produce more, whether or not it is economic. If these companies were more independent, there's a decent chance that Antero Resources would change its production and CAPEX strategy.

It's worth considering that former large owner Warburg Pincus dumped its entire AR stock stake over the past year and other corporate directors sold shares as well.

You see bulls arguing that the company is cheap based on the company's PV-10 value or other such metrics. But PV-10 in particular was calculated on significantly higher natural gas prices. Sure, if natural gas spikes, AR and other such stocks will go with it. But why would natural gas spike now? There's way too much supply versus demand in the U.S. and you have more potential supply literally being burnt off in Texas. And with LNG exports, we've managed to spread our natural gas glut to Asia and Europe crashing their prices as well. And if prices do go up despite the huge oversupply, the struggling producers will simply produce and hedge more, slamming the price back down.

A lot of people seem to be in denial about the state of the natural gas market. A rebound is inevitable - this is a cycle that is already long in the tooth, they say. But a ton has changed structurally. As long as producers are incentivized to keep drilling and there's not nearly enough demand to use all the supply, the secular bear market for natural gas will remain. And to those who say prices have to go up soon, just ask Canadian producers about that theory. The price of Canadian gas has been under C$2 for years.

Do the math on what happens to Antero and other U.S. gas plays if that happens here. Levered U.S. gas producers are in for a world of hurt if natural prices even stay at today's levels, let alone reach the depths that they've plumbed in Canada.

As I see it, you need a sharp rally in natural gas back to at least 2018 levels for Antero and other such stocks to have a decent shot of holding their remaining value let alone recovering substantially. For example, consider the recent Macquerie underperform rating and $5.50 price target (It was still trading at $7 then) for AR stock that nonetheless assumed significantly higher gas prices than we have today.

But if natural prices stay here - or heaven forbid go down even more - it will be lights out for these firms once their debt maturities arrive. And as the Ultra Petroleum example showed above, the equity can get to effectively zero well before the bonds are due. Southwestern, which has a better fiscal position than Antero, hasn't been spared from the relentless selling either.

Due to the complicated Antero Resources/Midstream situation and the fixed contracts that force Antero to produce more and more, incredibly, the company has to keep growing production even as the price of what it produces is collapsing.

Take a step back from this specific stock for a second: if you got a chance to invest in a business that was contractually obligated to increase production while the price of its goods was collapsing and it faced heavy debt maturing soon, you'd run far away, right?

That's what you should be doing with AR stock as well. The only reason to get involved with AR stock is to short it if you want to hedge your better energy positions, in which case AR stock is a great pick. If you own natural gas royalty funds like San Juan (SJT), integrated majors, or commodity futures/funds directly, a short position in a levered producer like Antero can work as a nice hedge. With a ton of borrow available at a minimal rebate and no dividend to worry about, it's easy to maintain a short position as AR stock continues its relentless descent toward zero.

Disclosure: I am/we are short AR. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I am long UNIT and SJT.