SIR #11: Three Explosive Opportunities in Natural Gas
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• New drilling techniques created a supply glut, pressuring natural gas prices.
• Natural gas producers have materially increased production, but profit margins have been pressured due to low prices.
• Wider distribution networks and growing demand create an attractive rebound opportunity for natural gas producers.
• Three natural gas producers offer compelling trading opportunities as the industry begins to rebound:
- Bill Barrett Corp. (BBG)
- PetroHawk Energy Corp. (HK)
- Southwestern Energy (SWN)
Natural gas has been a major disappointment over the last two years…
When the Obama administration took office, many believed that new energy policies would significantly increase demand for the “clean burning fossil fuel.” Visions of natural gas cars, new gas fired electricity plants, and increased use of gas for personal heating and cooking fueled a sharp rise in the price per Mcfe (thousand cubic feet equivalent).
But the global economic crisis has put many energy initiatives on the back burner for both political and economic reasons. So the expected increase in demand for natural gas has been pushed back into future quarters. Most analysts still believe we will eventually see a significant ramp in use – but that only covers half of the equation…
While lack of follow-through in demand for natural gas is partly to blame for lower prices, the supply side has been the primary driving force. A new production process called Hydraulic fracturing – or “fracking” has allowed producers to tap into huge gas reserves that were previously unavailable.
The result has been a supply glut of natural gas which has sent prices spiraling. Ironically, the very technology which allowed drillers to sharply increase their production level, has also caused profit margins to plummet.
An economic crisis didn’t help matters any as industrial demand for natural gas failed to materialize. Essentially, a “perfect storm” of supply shock and stagnant demand growth has created a two-year bear market for natural gas producers. But there are signs that this supply overhang may be lifting – and with it, the prospects for some of the top E&P trading vehicles.
Efficient Transmission, Eventual Demand
Although natural gas futures contracts are traded on the NYMEX, much of the market for buying and selling the fuel has historically occurred locally. Limited ability to transmit and store the gas has created disparities between different markets, and caused pricing in some areas to remain robust, while regions close to ample supply have seen much lower prices.
But as master limited partnerships have actively increased the amount of pipeline available to natural gas buyers and sellers, prices have become more predictable from market to market. Offering producers a number of different potential markets increases price efficiency and allows for better visibility when budgeting for new drilling projects.
Natural gas as a commodity has also seen much more stability over the last several months and appears to be in the process of forming a broad base. A price range between $3.50 and $5.00 per Mcfe allows most natural gas producers to operate profitably, and with any increase in economic demand, we could once again see a bull trend in natural gas prices.
At this point, investors have largely priced in the most negative assumptions due to the extended bearish action. This means that the stock prices of many producers trade at a discount to potential long-term earnings.
As Mercenary Traders, we’re not too worried about theoretical price targets and analyst 5-year cash flow models.But from a trading perspective, these names are beginning to once again attract the attention of institutional buyers.
With the sector being largely neglected by portfolio managers, new buying interest could send stock prices significantly higher. A sharp increase in demand for these stocks sets up a great trading opportunity for us.
Below are three attractive natural gas producers that are at the top of our watch list:
Bill Barrett Corp. (BBG)
• Strong production growth while still increasing proven reserves annually.
• Finding and development costs continue to decline, bolstering profit margins.
• Hedging programs have protected the company from falling prices – realized selling prices remain strong.
• Strong balance sheet with liquidity for future development.
Bill Barrett Corp. is based in the Rocky Mountains, a region which represents roughly a quarter of the US natural gas supply. The company is an aggressive growth enterprise, with a history of consistently increasing production. This year, BBG will approach 100 Bcfe (billion cubic feet equivalent) compared to just 52.1 in 2006.
What makes BBG particularly attractive is the company’s ability to grow its proven reserve base even while aggressively increasing its production schedule.
A mix of internal exploration along with outside acquisitions has allowed the company to grow its reserve base to the point where several years worth of production are represented in underground assets.
Ramping up production along with reserves is only beneficial if costs are in line. Bill Barrett has seen its Finding and Development costs decrease over the last three years from $2.48 per Mcfe to an estimated $1.74 for 2010. Total cash costs are estimated at $1.97 per Mcfe which means the company can produce natural gas at a robust profit even with the current spot price at historical lows.
The executive management team has an average of 25 years experience in the industry – which is paying off in a number of different areas. In addition to strong efficiencies in production growth and reserve replacement, the company has an excellent track record on the sales side.
BBG has made an attractive agreement with Enterprise Products Partners L.P. (this company is featured in our MLP report) with a portion of production comprised of natural gas liquids (NGL). This agreement along with hedging contracts has resulted in realized prices of $7.14 per Mcfe – roughly 60% above the current spot price for natural gas.
Bill Barrett continues to allocate capital to its exploration and drilling programs which in turn drive future growth opportunities. This year the company will spend between $475 and 485 million on its diversified portfolio of properties. But with ample cash flow, a debt to equity ratio of just 28%, and nearly $700 million available through a credit facility, the company has plenty of liquidity.
As investors warm up to the idea of owning natural gas companies again, BBG shares are starting to rise. The stock was rangebound between $29 and about $37 for nearly a full year and has begun to ramp higher.
If natural gas prices remain stable, BBG’s reserves (minus cash production costs) should represent more than $50 per share – an increase of 25%. But if pricing for natural gas has truly put in a floor and is ready to rebound, the value of these reserves could increase exponentially – and don’t forget the company’s track record of replacing reserves at twice the rate they can pull gas out of the ground!
PetroHawk Energy Corp. (HK)
• Diversified portfolio of natural gas resources in Louisiana, Texas and Arkansas.
• Robust production growth with 35% increase expected in 2011.
• Annual proved reserve growth of 61% for last three years.
• Recent divestitures and restructuring creates a stable financial position.
PetroHawk operates in the resource-rich southern US and has specific drilling rights for properties concentrated in the Haynesville Shale, Lower Bossier Shale, Fayetteville Shale and Eagle Ford Shale natural gas deposits.
While the company faced some financial challenges in quarters past, management has addressed liquidity and debt issues allowing the company to aggressively pursue production growth. In fact, PetroHawk expects to increase the amount of gas produced by roughly 35% from 2010 to 2011.
Even with an aggressive production schedule, Petrohawk continues to increase its proved reserves as the Haynesville Shale projects have been particularly rich. The strong reserves help to increase investor confidence – an important issue given the company’s recent financial struggles.
As natural gas prices fell in 2008 and 2009, the company’s aggressive drilling programs caused a bit of a cash-flow pinch.
Lower selling prices for natural gas, along with ballooning drilling costs put the balance sheet in a precarious position. Pending principal payments on senior notes loomed with HK unlikely to have the liquidity to meet its obligations.
But so far in 2010, PetroHawk has raised a full $1.5 billion through asset sales and used the proceeds to pay down revolving lines of credit. Management was also able to restructure its debt and move a significant portion of liability payments out several years.
The resulting company now has ample liquidity, strong natural gas assets, and an attractive stock price given the expected long-term growth. Moody’s has upgraded the long-term corporate outlook to “stable” from “negative,” and the stock price has rebounded nearly 40% from the low set in August.
Analysts expect the company to generate EPS of $0.51 this year – quite a feat considering the financial challenges and historically low natural gas prices. Next year, earnings are expected to grow by 80% and most Wall Street firms have a conservative long-term view on natural gas prices.
During the third quarter, PetroHawk sold its natural gas for an average realized price of $5.19 per Mcfe. This price included a realized gain of $0.99 per Mcfe from hedging activities which means the actual third party average price was $4.20. Future profits should have a high degree of correlation with the actual spot price for natural gas – which makes this stock an excellent trading vehicle as natural gas once again catches a bid.
Now that the company has dealt with its debt issues it has become attractive to long-term investors. The chart pattern is also attractive with the stock making a series of higher highs, and higher lows – something momentum traders typically look for.
At this point, the reward to risk ratio appears favorable, and I will be looking for key inflection points and opportunities to pick up exposure.
Southwestern Energy (SWN)
• Committed to organic growth – allocating capital to internal drilling projects.
• For every Mcfe the company produces, another 5 Mcfe added to reserves.
• Cash operating costs of $1.31 per Mcfe – among the lowest in the industry.
• Recent base in stock chart offers significant buying opportunity.
While many companies increase their size through acquiring smaller competitors, Southwestern Energy has decided to pursue growth organically – and has been very successful. The company is experiencing a “hockey-stick” ramp in production, the compounding effect of a long-term drilling plan.
But even more astonishing is the fact that as production grows, additions to proven reserves are still outpacing production by a multiple of 5. This means that for every Mcfe of natural gas pulled out of the ground, five additional underground units are added through exploration efforts.
Estimated reserves of 3,657 Bcfe ensures that the company can continue to increase production for years to come. And with an exceptionally low cash operating cost of $1.31 per Mcfe, Southwestern has kept profits at peak levels even when spot prices for natural gas plummeted.
Below is a quick snapshot of some of the key metrics driving SWN’s success:
Management continues to allocate a significant amount of resources to expansion projects. In 2010, the company should spend roughly $2.1 billion with 75% of capex allocated directly to drilling.
But even though management is spending billions to reach new gas reserves, SWN remains fiscally sound with a debt to capital ratio of just 31% and roughly $380 million available to be drawn from the company’s credit facility. I should note that the average interest rate is currently at 0.9% – giving the company an exceptional return on borrowed capital.
From a trading perspective, SWN is setting up beautifully after hitting a low near $30 in September. The stock has since rallied as natural gas dynamics appear to be improving, and a recent consolidation between $36 and $39 offers a key inflection point.
With any strength in the natural gas market, I would expect the stock to exceed its previous high near $50, and potentially trade much higher. Even if spot prices for natural gas remain rangebound, SWN should continue to flourish with low production costs, enviable resources, and an experienced management team focused on growing reserves.