Investing in the Marcellus Shale

by: Harry Chernoff

The hottest natural gas play in North America is the Marcellus Shale. The core area runs from southwestern New York through much of western Pennsylvania and parts of West Virginia and Ohio. Industry activity in the Marcellus has been growing rapidly in the past few years but only gained popular attention when a technical paper from Penn State and SUNY-Fredonia, estimating original gas in place at 168-516 Tcf and recoverable reserves of as much as 50 Tcf, got picked up by USA Today.

Of course, Penn State’s announcement was not the first word on the subject. Several of the major independents, including Range Resources (NYSE:RRC) and Chesapeake Energy (NYSE:CHK), have large acreage positions and drilling programs. Among the smaller independents, the most relatively outsized acreage positions include those of Atlas Energy Resources (ATN), Cabot Oil & Gas (NYSE:COG), Linn Energy (LINE), Exco Resources (NYSE:XCO), and Rex Energy (NASDAQ:REXX). Essentially all the participants are reporting good-to-excellent results from increasingly aggressive capex programs, including horizontal drilling.

In very broad terms, recent drilling shows recoverable reserves of about 1 Bcf per vertical well on 40-acre spacing with F&D costs of about $1.00/mcf. Horizontal wells are estimated at about 2.5 Bcf on 80-acre spacing at costs less $1.00/mcf. The shales are easily accessible, susceptible to new techniques in fracing and completing, and cover an area several times the size of the Barnett shale. Meanwhile, the combination of F&D costs well below the North American average and gas realizations well above NYMEX levels (because of proximity to pipelines in the Midwest and Northeast) is making full-cycle economics almost irresistible.

There are three obvious approaches to playing the Marcellus in the stock market. The first approach is to go for size and demonstrated technical capabilities. Range Resources (RRC) began the modern exploration and development of the play in 2004. RRC has 650,000 net acres in the play out of 1.1M acres in the Marcellus trend and estimates its net unrisked reserve potential at 10-15 Tcf. Range is planning 60 wells this year, about 40 being horizontal. The last eight horizontals IP’d at 3.2 to 4.7 mmcf/d.

On the other hand, Range is a large, diversified independent, with an EV exceeding $10B and an estimated 2008 EV / EBITDA multiple exceeding 10x, making the Marcellus a modest percentage of a large company that is highly valued for reasons other than the Marcellus.

Chesapeake Energy (CHK) has 1.0M acres in the play but a much more conservative assessment of the potential: 5.7 Tcfe unrisked and 1.4 Tcfe risked, assuming 1,400 risked, net undrilled locations on 160 acre spacing, and 1.25 Bcfe per $1.6M vertical well.

While Chesapeake has the most Marcellus acreage among the independents, its $36B EV means the Marcellus is a very small percentage of the company.

An entirely different market approach is to look for concentrated and aggressive development off a small-to-moderate base. Atlas Energy Resources (ATN), with an EV of $2.75B and 230,000 net acres, and Linn Energy (LINE), with an EV of $3.8B and 182,000 net acres, are the primary candidates in this group. Forward EV/EBITDA multiples for both companies are about 8x. ATN estimates its Marcellus potential at 4-6 Tcf.

The obvious concern with companies like ATN and LINE is their MLP-like structure. This type of structure is based on high current yields and high payout ratios (typically from exploitation of PDP reserves). It is impossible to simultaneously maintain an MLP-like payout ratio and internally fund the development capex needed to convert resources into PDP reserves.

A third approach is based on the small-cap and mid-cap independents for whom a mid-range combination of cost, performance, internal funding, and valuation combines with an outsized exposure to the Marcellus. Of the numerous companies in this group, Cabot Oil & Gas (COG) and Exco Resources (XCO) are particularly noteworthy.

In February, Cabot called the Marcellus the most exciting new play in the U.S. and a large part of the biggest program the company has ever planned. Exactly how exposed COG is to the Marcellus is impossible to say. In some reports COG says it has “well over” 100,000 net acres in the play but also says the Marcellus is productive under at least 200,000 of its 1M acres in West Virginia. Meanwhile, its 20-well development program for 2008 is in Pennsylvania. Cabot’s most recent vertical wells, in West Virginia, IP’d at 1.2 to 1.8 mmcf/d, with horizontal drilling on tap across the play, starting in Pennsylvania. COG has also stressed that much of its Marcellus acreage underlies existing production and facilities in other zones so the incremental cost of deepening into the Marcellus and connecting to pipelines is very low (see conference call transcript).

All of these factors have helped put a Marcellus-related bid into the price of COG. It gained more than 15% in the two weeks after highlighting its Marcellus potential. With a valuation of 8x 2008 EBITDA, however, it trades well above the industry average. EV is $5.1B. In February, Exco reported over 191,000 net acres in the overpressured, thicker Marcellus fairway and more than 350,000 acres in the broader play. XCO also announced plans for a modest Marcellus capex program, including at least 10 vertical wells and 4 horizontal wells, out of a then-announced $625M capex budget. XCO also said it was evaluating the potential for a $50-100M Marcellus capex expansion this year (see conference call transcript).

March 13, XCO increased its capex program by $175M, including $150M for the Marcellus, all of it internally-funded. Exco now estimates an unbooked reserve potential of 6 Tcfe on its more than 368,000 net acres in the Marcellus, including more than 198,000 acres in the overpressured fairway. This reserve potential compares to current reserves of 2.1 Tcfe (1P) and 4.5 Tcfe (3P). Exco’s announcement expands its Marcellus program by about a factor of ten compared to the level in the earlier budget. It easily vaults XCO to the front of the overall E&P sector in terms of Marcellus capex relative to the size of the company ($3.8B EV). It also positions XCO for a big increase 1P/2P/3P reserves should the drill bit activities match those of its peers in the play. Strictly from a Marcellus perspective, XCO looks to be the play on several metrics, both long-term and short-term. The knock on XCO has been its poor profitability until very recently.

That, however, is changing as A&D activities over the past few years are finally converted into solid drilling results, production, cost control, and EBITDA. Most valuation metrics are about average but include nothing for the Marcellus. 2008 EV/EBITDA is estimated at about 6x. Overall, XCO offers the most aggressive Marcellus program off a reasonably valued base. The prices of stocks like COG and ATN significantly outperformed their peer averages immediately following similarly aggressive comments on their Marcellus potential and capex. The same thing is likely to happen to XCO in the immediate future. Notes:All EV/EBITDA multiples are 2008 estimates based on First Call EBITDA estimates, excluding non-E&P segments, as reported by SunTrust Robinson Humphrey, March 7, 2008.

Disclosure: Author holds a long position in XCO