Michael Hall: Natural Gas - A Victim of Its Own Success
The Energy Report: Whatís your view on the oil and gas price near term and intermediate term? Something that really got our attention recently was T. Boone Pickens saying that he thought weíd see $60 or $80 oil before weíd see $40 again. We were darn close to $40 at the time.
Michael Hall: Near term, itís extremely hard to say whether weíll see $75, which is what I think T. Boone threw out there, or $40 first. The volatility in the market today is unprecedented for a number of asset classes, and commodities are no exception. I think weíre setting up for a big spike, a big run up in price. Iím not sure it happens overnight, though.
Our view is to continue to try and stay somewhat cautious throughout 2009. On the supply side, U.S. producers are laying off rigs by the dozen every week. The supply side of things is going to fix itself. Unfortunately, I think weíre going to really have to wait to see a turnaround in demand until we see a good sustained snap back in price. Then the big question for us becomes when, obviously, and thatís a tough one. I donít think itís overnight.
TER: Michael, you say Ďthe supply side is going to fix itself,í which sounds to me like we currently have too much inventory. Weíre shutting down rigs and production, and eventually weíre going to hit that crossover in demand. Do you have any projection on when that supply is going to finally meet demand?
MH: Yes. Itís a good question. I spend most of my time with the natural gas markets, and weíve done a lot of work trying to assess when all these rig count reductions will make their way into the market. Some of the work weíve done suggests that weíre probably already starting to seeóthough we donít get real-time dataósome production decline as a result of rigs being laid down.
To give you a little background info, the rig count, which is provided on a weekly basis by a firm called Baker Hughes Inc. (NYSE:BHI), peaked out in September 2008 with the gas rig count at 1,606 rigs. As of the end of last week, it had fallen 640 rigs, give or take, so youíve seen a pretty massive decline, 40% decline, from the peak. We think thatís already starting to have an impact on supply.
As far as demand, Iíve got some indications on some leading indicators that itís starting to at least slow the rate of decline, which is encouraging, but not quite a turnaround yet. When it all crosses is a really difficult thing to determine, but I certainly donít think itís this first half of '09. We tend to think maybe weíll see the snap back in the fourth quarter of 2009 for the gas market, keeping in mind all summer, every summer, weíre always injecting gas into storage and all winter weíre always pulling gas out of storage. Itís really once we hit the winter this year, this next winter, I think thatís when you could a sustained rally.
TER: So it's hard to tell. If we have a big mild winter, then we could still be in an oversupply situation.
MH: Next year? Yes, itís certainly possible. The way we see inventories shaking out by the end of the summer, call it November 2009, is right around 3.7 trillion cubic feet of gas in storage at that time, which would be well above five-year average and pushing up against full. (Full is thought to be around 4 trillion cubic feet of gas.) If we come into the winter with that sort of storage environment and itís a warm winter, yes, you might not get the big run up. That said, our math suggests supply will be on a steep decline by that point, which could help to aggravate any weather impacts.
TER: But if weíre pretty much at almost full, to me itís sort of like the water levels in California. You have to have a fair amount of consumption to get it down to what would be a point where the massive run up of natural gas would occur.
MH: Yes, agreed. I think whatís important to keep in mind, though, is if underlying that storage is a supply and demand environment where supply is shrinking rapidly, which is what we think could be happening by, call it November 2009óand by rapidly, I mean declining around 9% year on year, which is a pretty steep declineóand if, all of a sudden, your supply and demand balance is that far out of balance, even if itís somewhat warm, youíre going to draw down from storage very quickly. It may not happen in November, in terms of the price run up, but I think itís still probably likely at some point during winter of 2010, assuming demand is coming back, from a macro standpoint, by that point.
TER: How quickly can these rigs come back on line?
MH: Thatís a good question and hard to assess precisely, but there are some issues in the system in terms of logistically getting rigs back up and running. So itís not overnight. I tend to think you can probably drop rigs faster than you can bring them back on. So, historically, if you look at rig counts, they tend to fall off really hard when things get oversupplied, and then they take a lot longer to add back to the recount. So itís more of a slow, gradual build up. The reason being youíve got to go hire all the crews that were laid off; youíve got to find the people; youíve got to mobilize the rigs to where you want them.
Then what I think could be an issue this cycle is capital. All these companies have pretty much gone into hunker-down mode, where theyíre spending within their cash flow and acting very conservatively, as they should be. But, if all of a sudden you get a snap back in price and letís say they want to go spend 150% of cash flow to answer that snap back, we may be still in an environment where capital is still quite risk averse, and that could just be another kink in the system in terms of getting rigs back up and running quickly.
TER: What non-geopolitical situation could possibly cause oil to go up in price? Obviously, if we have a geopolitical situation, that could have a big impact on the price of oil.
MH: Two things really. Itís supply and demand, right? And on the supply side, itís continued cuts from OPEC and/or greater adherence by OPEC to their existing cuts. There was a bit of a consensus in the market that weíd see more cuts out of OPEC in March. We were not convinced that that would happen, and indeed it didnít. But if you see another cut out of OPEC this year, you could get a bit of a snap back or a rally. But the sustainability of that rally, I think, is underpinned by demand. Until we see an improved demand environmentóand by that, just global GDP resuming its upward trendóuntil you get that, I really think itís going to be pretty difficult to have a sustained increase in price. It needs to be both supply and demand.
ER: So then, youíre saying the recession needs to be resolved and bottomed, and then it will start to build.
MH: I believe so, yes. At the end of the day, Iíve always kind of thought that for crude markets, and really most commodity markets, marginal demand is what sets the price. As long as demand is falling, in theory, marginal demand is a lower price than the current price. Until we get the snap back in demandóand I donít think it has to be dramatic to firm things or at least get things moving up on a sustainable basisóbut until you get that return of demand, I think itís going to be pretty tough to maintain an upward slope in crude prices.
I think we could still have a decline in demand worldwide in 2009; but by 2010, I think itíll be back. Long term, I certainly see a very robust environment for crude demand growth.
A stat I like to throw out: if you look at the average consumption per capita in China and India and average those two countries, it currently runs around 8% of the average per-capita consumption in South Korea and Japan. If you increase that to just 30% of the South Korean and Japanese average by 2020, that increase alone from China and India is enough to provide 2% annual growth in global demand through 2020 in the crude markets, holding everyone else flat. Thereís just an immense amount of potential in those markets. But if everyone else is failing from a GDP standpoint, I donít think emerging markets have much hope. I think the myth of uncorrelated global growth was kind of busted in the last yearóafter we had busted it in the pastóso we learned our lesson again. Itís there and the BRIC countries (Brazil, Russia, India, and China) are huge. Theyíre very important, but I donít think theyíre going to be able to do it if weíre still struggling in the U.S.
TER: When I think of low gasoline prices, thatís like a tax give-back to consumers, which theyíre enjoying. How do you measure the offset of that to a higher oil price and how many benefits do you get for that vs. the lower one where individuals have a little more money to spend? Is there a correlation there?
MH: There has been work done on that. You can almost think of it as a stimulus package of its own into the economy. Some teams in our Research Department have done the math on that. Itís an extremely significant stimulus on the economy.
And there are actually signs that people are driving again. If you look at vehicle miles traveled in the U.S., they had been on decline starting last year on a year-on-year basisóthe first decline weíd seen since I believe the Ď80s, but perhaps the early Ď90s. Those are starting to turn back over, and the trend is starting to look a little more friendly on that stat. So thereís evidence that people are taking note of cheap gasoline right now.
TER: Sure, especially those who do it for a living and do the cost comparison.
MH: Thatís a good pitch for natural gas. High oil prices, assuming they come back, will result, I think, eventually in higher gasoline prices. But thereís a big call, a big lobby anyhow, trying to push for additional use of natural gas as a vehicle fuel. Long term, I think itís an interesting market from a demand standpoint for natural gas. I donít think it fixes or snaps anything in the near term, but itís something to watch.
TER: What are some companies that youíre currently giving a buy rating to that would obviously benefit from that?
MH: Well, theyíd all probably benefit ultimately. One thatís been active in pushing and lobbying for natural gas being used as a vehicle fuelófor domestic security and clean air reasons and just energy diversityóis Chesapeake Energy (NYSE:CHK). Iíve got a buy rating on that and thatís one that, like many in the oil and gas patch, has seen a dramatic decline from its highs of last summer. Itís currently trading just under $20 a share after peaking out over $60 a share last June-July timeframe.
Theyíve got the largest inventory of leasehold in the country and I think provide more optionality to gas, probably, than any other stock out thereóparticularly on a large cap front. At this point, youíre getting a lot of that optionality for free. I think the marketís trying to test what you would call a Ďproved value,í so just what their proved reserves are worth in the ground. And, you know, you could end up lingering here until we get that snap back in price. But if you can have any sort of long view, I think you have dramatic potential upside with Chesapeake shares at this point.
TER: Whatís your price target?
MH: Our targets are based on a number of different price scenarios and just to give the base case of what we assume is $7 gas and $70 oil by 2012 and beyond. Between now and then, we start with $4.60 in 2009 and then ramp it up to $7.50. We also run a number of different cases. But our current target on it is $27, which provides meaningful upside and, like I said, is well below the 52-week high of well over $60.
TER: Can you give our readers some of the ideas and ways you think they can position themselves in your sector with stocks that you like?
MH: Sure. Chesapeakeís one Iíve always liked a lot. Unfortunately, Iíve ridden it all the way up and down, but I do see a lot of potential, particularly long-term, with Chesapeake. Another on the large-cap side is XTO Energy Inc. (NYSE:XTO). XTO is what we call the highest quality of all the large cap gas names that we look at. Theyíve done a tremendous job of hedging over the last year. They ended up monetizing over $2 billion in hedge gains over the last couple of months, paying down debt, and fixing up a balance sheet that had some leveraging on it after roughly $11 billion in acquisitions during 2008. The push back is, letís say, people say they bought at the top. My rebuttal and theirs would be, well, they hedged very well and they locked in their returns when they did those acquisitions. What it really did was just recharge the inventory position at the company. They think they have a good solid five-year inventory to continue growing the company at a peer-busting clip. I think probably over 15% a year in terms of production growth on their current inventory. So in theory you could have significant appreciated growth over the next five years. Our target on XTO is $39. Both of these companies are extremely well hedged looking out this year and next.
TER: What about a smaller cap company?
MH: One down the cap structure that I have been highlighting a lot is Petrohawk Energy Corp. (NYSE:HK). This is more of a mid-cap producer thatís had extreme volatility in last 12 months and the big reason being is that they, along with Chesapeake, really, helped expose whatís now thought of as one of the industryís leading shale plays, which is the Haynesville Shale. The Haynesville Shale is in Northern Louisiana and East Texas, although the Northern Louisiana part is kind of leading the economics at this point. Petrohawkís put up, frankly, the best wells, as their legacy acreage happened to be right smack in the heart of this Haynesville Shale in their Elm Grove field. So theyíve put up wells that have initial production rates in excess of 20 million cubic feet a day.
These wells come off hard, come off fast, 80% in the first year or more, so youíre setting up a steep treadmill as soon as you stop drilling because itís going to be hard to get back on for all these companies, and for the industry as a whole, with all these shale plays. But I think Petrohawk, for a mid cap, has one of the brightest outlooks out there. They did just do a follow-on stock offering to help shore up the balance sheet for some acquisition opportunities they see in the core of the Haynesville Shale, and then they also did a significant amount of high yield back earlier this year in the January timeframe. So theyíre well capitalized at this point and theyíre actually still planning to grow their production 40% in 2009 despite the current environment. My most recent target is $25 per share.
The 52-week high on it is well over $40, so youíre well within that range and still have meaningful upside potential from here. Frankly, long term, and while I have no knowledge of any M&A activity, I believe it could be a take out. I think eventually itíll get acquired just given the quality of the asset they have in the Haynesville. Itíll probably end up in the hands of a larger company with greater capitalization.
A small cap favorite Iíve been pushing is Bill Barrett Corp. (NYSE:BBG). Bill Barrettís predecessor company, Barrett Resources, was the Rockies gas explorer that was sold to Williams several years ago and Bill Barrett Corp. is the follow-on company. Fred Barrett is the CEO, the son of Bill Barrett. Bill Barrettís still on the board. The company remains an active explorer and developer in the Rockies region. Historically, the Rockies have kind of been thought of as a long supply/short demand environment, so you end up with export constraints and issues getting the gas to market. So, youíve had big price discounts on Rockies gas for the last few years. You had a big pipeline come around in 2008, the Rockies Express pipeline, which opened up a lot of opportunities for Rockies producers. Again, in 2008, weíve already almost filled it up. But here we are, as everyone is laying off rigs, the Rockies has laid off rigs at a faster clip.
There are indications that Rockies production as a whole, industry-wide, is actually starting to decline. I think that could help the pricing issue, particularly from a relative standpoint. The company currently trades at almost $24 a share. Iíve got a $36 target on it. It trades at significant discounts to everyone I cover. Itís at 2.9 times cash flow, 3.7 times EV/EBITDA. Youíre paying just $1.48 for proved reserves in the ground. My peer averages on all those are 4.9 times cash flow, 6.1 times EV/EBITDA, and $2.14 for proved reserved.
Itís a small company; itís somewhat under-loved, under-appreciated in my opinion. I think as prices eventually recover, the Rockies could well lead that recovery because of this additional capacity that was brought on line in 2008 that weíll have to fill back up again. Theyíve done a good job of delivering with the drill bit on the exploration front. In 2008, they discovered a play called the Gothic Shale. Itís in the Paradox Basin in Colorado and itís a shale gas play like any of the others. Itís just in the Rockies and it looks like theyíve got a significant multi-year development project on their hands that theyíll be continuing to prove up in 2009.
TER: Are they going to need funding? How do they get their capital?
MH: They are currently drilling and spending within cash flow, which is the mantra of the industry at this point. Historically, theyíve been conservative with the balance sheet, and they tend to keep things that way. Theyíve done a really good job of hedging as well, so theyíve locked in their significant cash flows for this year and next. I donít show them in an immediate need of any funds. And, if things get back off to the races, then if they want to try to accelerate development in this Gothic Shale or some other play, itís an option out there.
TER: What about in the limited partnerships?
MH: The one I would probably choose to highlight would be Atlas Energy Resources (NYSE:ATN). A big part of what they do is offer what are called Ďdrilling program partnershipsí to the public. So you can be a general partner in their drilling program and theyíll flow through tax write offs, basically, so you can shelter a lot of income.
The new budget being proposed by the Obama administration is proposing a repeal of what are called Ďintangible drilling costsí and the expensing of intangible drilling costs (IDCs). That could affect that part of their business. I donít know if it would eliminate it. From my talks with the company and after thinking things through, I think there are some opportunities to restructure how the partnerships would be offered. There still would be some deductions it seems like from the IDC standpoint. It just wouldnít be overnight; you wouldnít get to expense it all up front. But, that said, even if that part of the business goes, there still is a stream of cash flow that would basically deplete over time like a well that is still flowing to Atlas. If I just take what Iíd call a normalized cash flow assumption for 2009 and back off the part thatís at risk because of the proposals in the new budget, I still get a $2.68 per unit normalized cash flow. If I slap a five times multiple on that, which is a pretty normalized mid-cycle multiple for an E&P company, you still get about $13.40 per unit.
Iíve got a $34 target out there on the company. I think thereís a significant opportunity here, frankly. Youíve got around a 20% yield. But even taking the much more conservative approach as just a walk-through with that somewhat normalized cash flow, you still get over $13 per unit in potential here. I think itís a very interesting entry point, as I think the marketís somewhat overreacted to some proposed legislation. Thereís still headline risk out there, maybe you wait to see what actually ends up happening with the budget. But I believe for those that can take a bit of a longer view, it could be a big opportunity.
TER: You say if they lose this part of the business, they still have almost a royalty, in a sense, operation. What would be the value? Letís say that business totally goes away, now weíre left with what we have. Is your $52 target still intact?
MH: Thatís where the other interesting part of the story liesótheyíre sitting on over 240,000 net acres in the heart of whatís called the Marcellus Shale. The Marcellus Shale is in Pennsylvania, all throughout, really, New York, West Virginia, thought to be potentially the largest gas find in the world at this point. Theyíve got a big core position right in the heart of whatís going on in southwest Pennsylvania.
At this point, I donít think youíre paying anything for that in the stock and thatís where the majority of whatís called the Ďupsideí in my target price comes from; over time, I think theyíre going to prove this asset up. Theyíve already drilled several wells, proven it up. Theyíre one of the leading producers out of the Marcellus Shale and theyíre kicking off a horizontal drilling campaign in 2009 thatís going to, I think, prove this asset to be worth multiple billion dollars to unit holders. So itís almost, I call it, a special situation because I think you probably end up having a restructuring of the company. Itís currently an LLC; they pay out a significant distribution, currently 61 cents a quarter. I see that distribution as safe so long as they continue to have the structure they're in. But, again, if you think about the asset theyíre holding in the Marcellus, itís basically a growth asset, or it should be; so I believe you ought to be plowing 100%-plus of the cash flow that that asset generates back into the asset to continue growing it.
If youíre paying out significant distributions, you canít grow that asset as quickly as you should, in theory. So from my talks with them and from my own personal view, I think a restructuring of the company is possible and some sort of carve-out or another sale of the asset. Itíll be complicated if it happens, but I think ultimately a lot of value will be unlocked here and I think itís an extremely compelling opportunity.
TER: Is this an industry wherein the price of gas falls victim to what the storage is at any given point? Now weíre taking rigs off, so the storage is eventually going to go down. Gas will go up; but once it goes up, you fill up the storage. So is it always this never-ending fluctuation?
MH: Itís a hyper-cyclical business and itís extremely volatile. Itís very seasonal on top of very cyclical. Natural gas, stepping way back from a macro perspective, itís really a heating fuel in the winter, and itís a power-generating or cooling (air conditioning) fuel in the summer. You add not only cyclical pressures from industrial demand, but then also seasonality to it. Yes, itís very, very volatile; itís very, very seasonal and those who are faint of heart should be wary.
Itís a risky sector; itís very, very volatile, but thereís more to it than just storage. There are some long-term secular themes that are important. The industry is kind of a victim of its own success. When storage runs out, itíll do its best to fill it back upóbut it kills its own cycle every time. Thatís whatís happened over the last five to seven years. The industry had been thought of by consumer, and maybe by regulatory, groups as an industry that couldnít grow. Whatís really been proven over the last few years is that it can grow if it gets the right pricing to do it. The resource is out there.
From a long-term perspective, from a consumer standpoint, you donít want to rely on an industry that canít grow, right? But if it can grow, then itís a much more viable fuel for power generation, and possibly transportation, and it becomes that much more interesting from a regulatory, as well as a consumer standpoint. Itís a changing industry; itís an interesting industry in that sense, but I think itís highly investable still because of whatís being exposed this year.
TER: How long are these business cycles? You say itís hyper-cyclical. You mentioned weíve been building up for seven years and this is a seven to ten-year cycle. Can it really change within two years?
MH: Thatís a good question. By the cyclical side of things, I mean the broad economy. Industrial demand is 18 billion cubic feet a day of demand on 64 billion cubic feet a day. So itís nearly a third of total demand. So if industry is shrinking, youíre going to have demand headwinds, and thatís more what I mean on the cyclical side of things. So thatís more dependent on how long itís going to take the U.S. and world economies to start back up again. In terms of a six, seven, or ten-year cycleĖitís hard to say. I think itís different every cycle.
From a macro perspective, youíve got a lot of ultimately inflationary actions coming out of the government, and it could take some time for the multiplier to kick back into effect and dollars start changing hands again. But, when they do, I think a lot of these commodities plays will have real businesses, will throw off real cash flows and are worth a lot more than what theyíre trading for today. If you can take a longer view on things, itís a sector thatís worthy of looking at, I think, but it's also high risk. I would emphasize that.
TER: Michael, thanks so much for your time.
Michael A. Hall, CFA, joined the Stifel Nicolaus Research Team in August 2007. He has been covering the energy sector for roughly six years. Most recently, Michael worked as a Senior Associate covering domestic Exploration & Production at Wachovia Capital Markets. Prior to that, Mr. Hall was a lead associate on the same team at Jefferies & Company and initially at First Albany Capital. He previously worked at Stifel Nicolaus from 2003Ė2004 and started his coverage of the Energy sector following the Oilfield Services industry. Mr. Hall's return to Stifel Nicolaus marks his initial effort as a lead publishing analyst and he intends to continue to focus his coverage on the domestic Oil & Gas Exploration & Production industry.
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Disclosure: Additional disclosures are available upon request. View here. Additional disclosures include our risks to target prices, which are:
Chesapeake Energy (CHK): In our view, there are a number of risks to our target price on CHK shares. Those risks include, but are not limited to, the failure of management to adhere to its financial plan, the inability to bring F&D costs more in line with industry peers, the failure of emerging resource plays to materialize or at least the potential of those plays to emerge as much less economic than the company's current set of projects, the inability to lock up leases through production, and a sustained downturn in commodity prices in general.
XTO Energy (XTO): In our view, there are a number of risks to our target price on XTO shares. Those risks include, but are not limited to, the failure of management to integrate recent acquisitions, the inability to execute on substantial growth plans, the failure of emerging resource plays to materialize or at least the potential of those plays to emerge as much less economic than the company's current set of projects, and a sustained downturn in commodity prices in general.
Petrohawk Energy (HK): In our view, there are a number of risks to our target price on shares of Petrohawk Energy. Those risks include, but are not limited to, an overly aggressive assessment of resource potential in the company's various plays - particularly the Haynesville Shale, a blowout of the basis differential at the Henry/Perryville/Carthage Hub, a dramatic tightening in the supply of rigs, completion services, and pipeline capacity, as well as a sustained downturn in commodity prices in general.
Bill Barrett Corp. (BBG): In our view, there are a number of risks to our target price on shares of Bill Barrett Corp. Those risks include, but are not limited to: a sustained downturn in commodity prices in general, expansion of the discount of Rockies gas prices to NYMEX due to a tightening of pipeline takeaway capacity (specifically as it pertains to capacity on the Rockies Express pipeline), a negative record of decision from the BLM on the West Tavaputs EIS, as well as a failure of the market to recognize the company's vast resource potential and to price shares as such.
Atlas Energy Resources (ATN):
In our view, there are a number of risks to our target price and
distribution estimates for Atlas Energy Resources. Those risks include,
but are not limited to, a rising corporate decline curve, the
suitability of the prospective Marcellus Shale for the MLP structure,
and a tightening of the service market in the Appalachian Basin. In
addition, given the importance of the tax treatment on MLPs to their
consideration as an investment opportunity, any negative changes in tax
treatment could likely result in significant underperformance in ATN
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