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Michael Hall: Natural Gas - A Victim of Its Own Success

Source: The Energy Report 03/26/2009
March 29th, 2009

Where's the price of oil and gas going? The volatility in the today's market is unprecedented for commodities, which Michael Hall, lead publishing analyst at Stifel Nicolaus Research Team, believes will elicit a big spike in price. In this exclusive interview with the Energy Report, Michael sifts through theories and trends in the hyper-cyclical oil and gas business and discusses future implications of declining rig counts and what that means to domestic energy.

The Energy Report: What’s 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 we’d see $60 or $80 oil before we’d see $40 again. We were darn close to $40 at the time.

Michael Hall: Near term, it’s extremely hard to say whether we’ll 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 we’re setting up for a big spike, a big run up in price. I’m 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 we’re 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 that’s a tough one. I don’t think it’s overnight.

TER: Michael, you say ‘the supply side is going to fix itself,’ which sounds to me like we currently have too much inventory. We’re shutting down rigs and production, and eventually we’re going to hit that crossover in demand. Do you have any projection on when that supply is going to finally meet demand?

MH: Yes. It’s a good question. I spend most of my time with the natural gas markets, and we’ve 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 we’ve done suggests that we’re probably already starting to see—though we don’t get real-time data—some 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 you’ve seen a pretty massive decline, 40% decline, from the peak. We think that’s already starting to have an impact on supply.

As far as demand, I’ve got some indications on some leading indicators that it’s 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 don’t think it’s this first half of '09. We tend to think maybe we’ll see the snap back in the fourth quarter of 2009 for the gas market, keeping in mind all summer, every summer, we’re always injecting gas into storage and all winter we’re always pulling gas out of storage. It’s really once we hit the winter this year, this next winter, I think that’s 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, it’s 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 it’s 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 we’re pretty much at almost full, to me it’s 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 what’s 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 2009—and by rapidly, I mean declining around 9% year on year, which is a pretty steep decline—and if, all of a sudden, your supply and demand balance is that far out of balance, even if it’s somewhat warm, you’re going to draw down from storage very quickly. It may not happen in November, in terms of the price run up, but I think it’s 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: That’s 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 it’s 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 it’s more of a slow, gradual build up. The reason being you’ve got to go hire all the crews that were laid off; you’ve got to find the people; you’ve 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 they’re 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 let’s 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. It’s supply and demand, right? And on the supply side, it’s 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 we’d see more cuts out of OPEC in March. We were not convinced that that would happen, and indeed it didn’t. 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 environment—and by that, just global GDP resuming its upward trend—until you get that, I really think it’s going to be pretty difficult to have a sustained increase in price. It needs to be both supply and demand.

ER: So then, you’re 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, I’ve 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 demand—and I don’t think it has to be dramatic to firm things or at least get things moving up on a sustainable basis—but until you get that return of demand, I think it’s 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 it’ll 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. There’s just an immense amount of potential in those markets. But if everyone else is failing from a GDP standpoint, I don’t think emerging markets have much hope. I think the myth of uncorrelated global growth was kind of busted in the last year—after we had busted it in the past—so we learned our lesson again. It’s there and the BRIC countries (Brazil, Russia, India, and China) are huge. They’re very important, but I don’t think they’re going to be able to do it if we’re still struggling in the U.S.

TER: When I think of low gasoline prices, that’s like a tax give-back to consumers, which they’re 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. It’s 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 basis—the first decline we’d seen since I believe the ‘80s, but perhaps the early ‘90s. Those are starting to turn back over, and the trend is starting to look a little more friendly on that stat. So there’s 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: That’s a good pitch for natural gas. High oil prices, assuming they come back, will result, I think, eventually in higher gasoline prices. But there’s a big call, a big lobby anyhow, trying to push for additional use of natural gas as a vehicle fuel. Long term, I think it’s an interesting market from a demand standpoint for natural gas. I don’t think it fixes or snaps anything in the near term, but it’s something to watch.

TER: What are some companies that you’re currently giving a buy rating to that would obviously benefit from that?

MH: Well, they’d all probably benefit ultimately. One that’s been active in pushing and lobbying for natural gas being used as a vehicle fuel—for domestic security and clean air reasons and just energy diversity—is Chesapeake Energy (NYSE:CHK). I’ve got a buy rating on that and that’s one that, like many in the oil and gas patch, has seen a dramatic decline from its highs of last summer. It’s currently trading just under $20 a share after peaking out over $60 a share last June-July timeframe.

They’ve got the largest inventory of leasehold in the country and I think provide more optionality to gas, probably, than any other stock out there—particularly on a large cap front. At this point, you’re getting a lot of that optionality for free. I think the market’s trying to test what you would call a ‘proved value,’ 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: What’s 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. Chesapeake’s one I’ve always liked a lot. Unfortunately, I’ve 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. They’ve 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, let’s 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 that’s had extreme volatility in last 12 months and the big reason being is that they, along with Chesapeake, really, helped expose what’s now thought of as one of the industry’s 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. Petrohawk’s 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 they’ve 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 you’re setting up a steep treadmill as soon as you stop drilling because it’s 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 they’re well capitalized at this point and they’re 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 you’re 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 it’ll get acquired just given the quality of the asset they have in the Haynesville. It’ll probably end up in the hands of a larger company with greater capitalization.

A small cap favorite I’ve been pushing is Bill Barrett Corp. (NYSE:BBG). Bill Barrett’s 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 Barrett’s 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, you’ve 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, we’ve 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. I’ve got a $36 target on it. It trades at significant discounts to everyone I cover. It’s at 2.9 times cash flow, 3.7 times EV/EBITDA. You’re 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.

It’s a small company; it’s 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 we’ll have to fill back up again. They’ve done a good job of delivering with the drill bit on the exploration front. In 2008, they discovered a play called the Gothic Shale. It’s in the Paradox Basin in Colorado and it’s a shale gas play like any of the others. It’s just in the Rockies and it looks like they’ve got a significant multi-year development project on their hands that they’ll 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, they’ve been conservative with the balance sheet, and they tend to keep things that way. They’ve done a really good job of hedging as well, so they’ve locked in their significant cash flows for this year and next. I don’t 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, it’s 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 ‘drilling program partnerships’ to the public. So you can be a general partner in their drilling program and they’ll 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 ‘intangible drilling costs’ and the expensing of intangible drilling costs (IDCs). That could affect that part of their business. I don’t 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 wouldn’t be overnight; you wouldn’t 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 I’d call a normalized cash flow assumption for 2009 and back off the part that’s 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.

I’ve got a $34 target out there on the company. I think there’s a significant opportunity here, frankly. You’ve 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 it’s a very interesting entry point, as I think the market’s somewhat overreacted to some proposed legislation. There’s 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? Let’s say that business totally goes away, now we’re left with what we have. Is your $52 target still intact?

MH: That’s where the other interesting part of the story lies—they’re sitting on over 240,000 net acres in the heart of what’s 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. They’ve got a big core position right in the heart of what’s going on in southwest Pennsylvania.

At this point, I don’t think you’re paying anything for that in the stock and that’s where the majority of what’s called the ‘upside’ in my target price comes from; over time, I think they’re going to prove this asset up. They’ve already drilled several wells, proven it up. They’re one of the leading producers out of the Marcellus Shale and they’re kicking off a horizontal drilling campaign in 2009 that’s going to, I think, prove this asset to be worth multiple billion dollars to unit holders. So it’s almost, I call it, a special situation because I think you probably end up having a restructuring of the company. It’s 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 they’re holding in the Marcellus, it’s 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 you’re paying out significant distributions, you can’t 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. It’ll be complicated if it happens, but I think ultimately a lot of value will be unlocked here and I think it’s 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 we’re 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: It’s a hyper-cyclical business and it’s extremely volatile. It’s very seasonal on top of very cyclical. Natural gas, stepping way back from a macro perspective, it’s really a heating fuel in the winter, and it’s 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, it’s very, very volatile; it’s very, very seasonal and those who are faint of heart should be wary.

It’s a risky sector; it’s very, very volatile, but there’s 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, it’ll do its best to fill it back up—but it kills its own cycle every time. That’s what’s 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 couldn’t grow. What’s 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 don’t want to rely on an industry that can’t grow, right? But if it can grow, then it’s 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. It’s a changing industry; it’s an interesting industry in that sense, but I think it’s highly investable still because of what’s being exposed this year.

TER: How long are these business cycles? You say it’s hyper-cyclical. You mentioned we’ve been building up for seven years and this is a seven to ten-year cycle. Can it really change within two years?

MH: That’s 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 it’s nearly a third of total demand. So if industry is shrinking, you’re going to have demand headwinds, and that’s more what I mean on the cyclical side of things. So that’s more dependent on how long it’s going to take the U.S. and world economies to start back up again. In terms of a six, seven, or ten-year cycle–it’s hard to say. I think it’s different every cycle.

From a macro perspective, you’ve 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 they’re trading for today. If you can take a longer view on things, it’s a sector that’s 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 2003–2004 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 units.

Source: The Energy Report 03/26/2009

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