Monthly Archives: May 2012

Keeping Perspective with Commodity Prices

I originally planned to write the second part of my “Stock Price Appreciation by Play” series today, but I got to writing about natural gas prices and couldn’t put the pen down.  I’ll finish the stock price series tomorrow, but in the meantime, hopefully you find this topic useful, particularly when evaluating the historical performance of oil and gas stocks.

Any investor who is thinking about buying stock in an oil and gas company has to be concerned about commodity prices, because they drive the value of the assets of all companies in the industry.  U.S. companies with natural gas weighted assets have been hammered over the past few years due to low natural gas prices at U.S. hubs.  As investors, we shouldn’t be concerned with where commodity prices have been, but where they are going.  If I could model oil or natural gas prices I would have a bright future as a consultant, but that doesn’t mean that I can’t study the past behavior of commodities which have been very volatile (see graph below).  Knowing this, I might buy a Cabot (NYSE: COG) or an Ultra (NYSE: UPL) today, even though gas prices might not turn around until 2013 or even 2015.  (Note: COG closed yesterday at 32.82,  down from its 52-week high of $45.00; UPL closed yesterday at 18.64,  down from its 52-week high of $48.91.).  The bottom line is, by buying today I probably get in near the bottom of the market.  Now I might not see returns until 2015, but if my stocks double that year, we’re still talking about a pretty decent three-year return on investment.

Source: EIA

While oil has enjoyed a relatively steady climb from a low of $10.82/Bbl on December 10, 1998 to $99.86 at market close on May 22, 2012, natural gas prices have been much more volatile.  Over the 15-year time period studied, there has been three separate instances where natural gas has gained and lost 50% or more of its value during a two-year time period (see three volatility bands on graph).

Energy Equivalency: On an energy equivalent basis, 1barrel of oil generates the same amount of energy as approximately 6 million British thermal units (MMBTUs) / 6 thousand cubic feet (Mcf) of natural gas.  Therefore, all else equal, we expect oil to trade at a 6x premium to natural gas.  Because supply and demand forces enter the equation, we know that this is not always true; however it’s worth noting that on May 22, 2012 WTI crude closed at $91.44/Bbl versus $2.55/MMBTU for natural gas, a 35.9x premium (versus the expected 6.0x).  As recent as June 9, 2011, oil traded at a 20.7 premium to natural gas and only 10.8x premium on July 2, 2008.  Is oil overpriced? Has increased natural gas supply due to shale gas production led to a justifiable slide in natural gas prices?  Either way, one can bet demand for natural gas will grow quickly over the next few years.

When you look at the performance of the companies in the stock price graphs I’ve been talking about, keep in mind that these are historical performances and guarantee nothing of the future.  As shown by the graph above, commodity prices are volatile, so don’t expect gas to stay low indefinitely.

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Stock Price Appreciation by Play (Part 1)

Today I looked at three companies who are either pure-plays in a particular basin, meaning all of their production comes from basin x, or whose production is primarily from a particular basin.  What I predictably discovered was that investors are favoring oily companies in oily plays, such as Kodiak (NYSE: KOG) in the Bakken Shale, versus a gassy company in a gassy play, such as Cabot (NYSE: COG) in the Marcellus Shale which I will discuss tomorrow.

The purpose of this post is to inform readers about different companies and different plays and how investors are valuing each company and each play.  This summer I plan to do a more in-depth analysis on each play that will be accompanied by economics based on commodity price decks.  For now, here’s some historical data that will tell you how companies have been fairing in three different plays across North America.

1.  Kodiak in the Williston Basin: KOG is a mid-cap company who is a pure-play in the Bakken Shale.  Its stock price has nearly doubled over the past twelve-months, driven by an increase in daily production of over 300%.  More importantly, 91% of the company’s production was oil in Q1’12, and this stat won’t change as the company continues to drill away at its impressive leasehold in North America’s premier shale play.  If you’re bullish on oil, you’re bullish on KOG.

2.  Approach in the Permian Basin: AREX is a small-cap company who is making big waves in the Permian Basin.  The Permian weighted company’s stock price is up 63% over the past 12-months, but notice it hasn’t been driven by production increases.  Instead the company has increased its oil cut in production to 62% from 41% as it has ramped-up development of the Wolfcamp zone (see map below) in the Midland Basin (Eastern Permian Basin, Texas side).

Permian Basin Stratigraphic Map

Source: AREX 2012 Corporate Presentation

3.  DeeThree Exploration in the Alberta Bakken Shale: DTX is a micro-cap company whose primary asset base is in the Alberta Bakken, which is located in Southern Alberta and Northern Montana.  The Alberta Bakken is an emerging oil and gas play and DTX’s recent well results in the play have provided a boost to its stock price.  DTX has approximately 200,000 acres in the Alberta Bakken, most recently acquiring 9,400 net acres in the play for a modest $167 per acre.  If the company can continue to deliver quality well results, it could be in position to have a big 2012, benefiting from what could be a very economic play for the company.

U.S. Oil Sands to Develop Utah’s Oil Sands

U.S. Oil Sands (TSXV: USO), a Calgary based exploration and production (E&P) company whose assets are located in Utah’s oil sands in the Uinta Basin, will begin development of the previously undeveloped sands this summer and expects to produce 2 MBOPD by 2013.  The micro-cap company trades on the Toronto Venture Stock Exchange (TSXV) and has a market capitalization of $43 million based on a share price of $0.17 Canadian dollars (CD) as of market close on May 25, 2012.  USO currently has CD$2.8 million in cash on hand and is all equity financed (no debt).

According to the Oil Shale & Tar Sands Programmatic Environmental Impact Statement, a document prepared by the U.S. Bureau of Land Management (BLM), Utah’s oil sands contain approximately 15.5 billion barrels of oil (BBbls) in place (largest oil sands resource in the U.S.).  For comparison, North Dakota’s Bakken Shale is estimated to contain 8 BBls (expected USGS 2013 estimate) of recoverable oil.  Because no company has developed oil sands in the U.S. to date, it’s difficult to estimate the amount of oil that is recoverable from the Utah sands; however, Canada’s Athabasca oil sands are estimated to contain 174 BBls of recoverable oil from approximately 1.7 trillion barrels of oil in place (10% recovery factor) which would imply Utah’s sands contain 1.59 BBls of recoverable oil.

The Assets: U.S. Oil Sands currently has a 100% working interest in approximately 32,000 acres in the Uinta Basin (see map below).  Because the company has not begun to produce its acreage, it has no proved reserves.  Note: Under SEC guidelines, companies must demonstrate the ability to economically extract resources from a formation before it is allowed to book proved reserves.  An independent consulting firm, such as Netherland Sewell, will perform the reserve analysis for a given company.  Booking of reserves is important for several reasons, including for comparison purposes with other companies and as collateral for debt.  On USO’s 2012 reserve report prepared by Sproule, a Calgary based oil and gas consulting firm, the company is estimated to have 190 MMBbls (not adjusted for royalties) in place or 19 MMBbls of recoverable oil using a 10% recovery factor.

Note: Financial statements for companies who trade on Canadian stock exchanges can be found here.  If you want to find reserve information for a Canadian company, you will be looking for the “Oil and Gas Annual Disclosure Filing” or Form 51-101.

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Valuation: While USO has no proved reserves, production or cash flow from operations from which to base a valuation on, we could look at its 2013 production estimates to see where the company would be trading based on the estimates and compare them to other similar sized pure-play oil sands companies.  USO’s enterprise value (EV) was $43 million as of market close on May 25, 2012.  On an EV/Flowing Barrels (or EV/Daily Production), the company would be trading at $21,500 per BOEPD (gross of royalties) based on its 2013 daily production estimate.  Because  bitumen (see “about oil sands” section below) is a lower grade of oil than light crude, expect oil sands companies to trade at lower multiples and lower valuations than non-oil sands companies.  This also means that oil sands companies need a higher price of oil than non-oil sands companies for their assets to be economic.  In USO’s 2012 corporate presentation, the company factors in $20 per barrel discount to WTI (West Texas Intermediate).

About Oil Sands: Oil sand extraction can occur on the surface by strip mining or, if the resource is lower, using in situ techniques.  The target resource is bitumen (see picture below), a heavy type of oil which must be refined in an “upgrader” where it is converted to a synthetic form of crude oil and sold at market.  If the bitumen is shallow, companies use trucks to shovel it into dump trucks, before it is taken to a refining facility.  If it’s deeper, companies will drill wells into the ground and inject steam to melt the bitumen and force it to the surface.  When the bitumen comes out of the ground, it’s attached to sand from which it is separated (using hot water) before it’s sent to the upgrader.  As you can imagine, the trucks used in the production process burn a lot of fuel and, combined with the C02 emitted by the upgraders, leads a carbon footprint for the oil sands industry that is between 20% and 40% higher than that of conventional oil extraction, however considerably less than oil shale production (see chart below).

Oil Sands

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Carbon Footprint of Oil and Gas Production

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Source: http://www.huffingtonpost.com/bill-chameides/the-carbon-footprint-of-o_b_1381020.html?ref=green

How Concerned Should Investors be about Fracking?

I would assume most astute investors in the oil and gas industry have been paying attention to the fracking issue for years, trying to determine when/how/if it will impact their investments.  For those unaware of the fracking process, check out this video on Cabot’s (NYSE: COG) website.  Evidence that companies are using known carcinogens,  including naphthalene and benzene, in their frac-fluid cocktails is leading to growing concern around the globe that drinking water is at risk.  Fracfocus.org has provided a list of common frac chemicals here.  The following is a list of states/countries who have either a moratorium or ban on the controversial hydrocarbon recovery technique known as hydraulic fracturing or “fracking/fraccing” (let me know if there’s others, as this list may be incomplete):

United States: Vermont recently became the first state to ban fracking, New York has a fracking moratorium in place while it studies the practice, New Jersey has a one-year moratorium on fracking; Canada: Nova Scotia issued a fracking moratorium until mid-2014 while it studies the technique, Quebec has suspended fracking indefinitely while it conducts its own study; Europe: France is the first country to ban fracking; North Rhine Westphalia (a German state) imposed a moratorium last year.

What conclusions do I draw from this?  People around the world are becoming concerned with the recovery method, and local governments have addressed those concerns in certain cases.  As far as companies operating in the U.S are concerned, there hasn’t been much action.  Vermont and New Jersey aren’t exactly hydrocarbon hot-beds and while New York’s proposed regulations would outlaw fracking near major population areas and on state owned land, it would allow the practice on private land.

Most, if not all, state regulations require oil and gas companies to line wellboars with cement casing to a specified depth below the water table.  If the cement settles properly and doesn’t crack, the water table is protected from hydrocarbons and frac fluid which will come up out of the ground.   The University of Texas recently released a report last year after studying the Barnett Shale (N.Texas), the Marcellus Shale (Pennsylvania, New York, Appalachia) and the Haynesville Shale (E.Texas/W,Louisiana) which concluded that water contamination was probably coming from poor casing jobs, not fracking.  So there, no you know what to blame.

While the University of Texas study may have given fracking a break, does it really matter for investors?  The bottom line is, frack fluids are finding a way into people’s drinking water and the oil and gas industry is responsible.  What everyone needs to realize (investors included) is that a certain amount of contamination is expected with regards to oil and gas drilling.  Now America needs to evaluate the progress oil and gas companies are making, and determine whether it’s willing to maintain the status quo.  Bloomberg recently ran a story where state regulators reported environmental violations occurred at 27% of wells drilled during the first eight months of 2011, this number is down from 54% during all of 2008.  New York is studying the mistakes that oil and gas companies made in Pennsylvania and finding that 62% were administrative and preventative in nature.

I believe the decision New York’s government makes will be a big one for the industry, and one that investors should pay close attention to as the USGS recently estimated that the Marcellus Shale contains approximately 84 Tcf (equivalent to 14 billion barrels of oil) of recoverable natural gas reserves.  If New York, a predominantly liberal state with significant natural gas reserves, allows fracking to proceed, it will be a bellweather for other states who are considering banning the practice.

A potential alternative to current frac methods: An undisclosed company operating in the Utica Shale in Ohio has solicited GasFrac Energy Services (TSX: GFS) to frack wells using LPGs (liquified petroleum gas), a predominately propane mixture.  It will be interesting to see how economic GFS’ services, which could turn out to be a boon for the LPG/NGL (natural gas liquids) market.  It’s probably of no coincidence that the Utica shale produces a substantial amount of NGLs or wet gas.  Although flammable, use of LPGs would cut down on frac water demand.

Either way, any current or potential investor in the oil and gas industry needs to be paying attention to these issues, because legal issues relating to fracking, government regulations and drilling moratoriums are all issues that could effect any oil and gas company in your (potential) portfolio.  Keep in mind that fracking isn’t the only issue we need to be paying attention to, as water shortages in Texas (attention investors who own companies with Eagle Ford Shale assets) and earthquakes from injection wells are also serious issues.

Concho Resources Buys Three Rivers Operating Company for $1.0 Billion

Concho Resources (NYSE: CXO) announced in a press release on May 13, 2012, that it entered an agreement to buy all of Three Rivers Operating Company’s oil and gas assets (all of Three Rivers’ assets are located in the Permian Basin) for $1 billion in an all cash deal effective April 1, 2012.  Concho Resources, a pure-play Permian Basin operator with one of the largest acreage positions in the Basin, just strengthened its position by purchasing 200k net acres, proved reserves of 58 MMBOE (50% oil) and average production of 7.0 MBOEPD.  This brings the company’s pro-forma acreage and proved reserve totals in the Permian Basin to approximately 750k and 445 MMBOE, respectively.

The Permian Basin: When someone refers to the Permian (see maps below), they may be referring to one or all of three distinct basins within the Permian Basin: the Delaware (West Texas/East New Mexico), Central (West Texas) and the Midland (West Texas) Basins.  When looking for comparable transactions which I discuss below, it’s best to find a transaction that’s located in the Basin from which your target deal is located in and even better yet, in the same county(s).  Note via the Three Rivers map below that the acquisition spanned the entire Permian Basin, so any Permian comparable transaction will be helpful.

Source: Concho’s May, 2012 investor presentation, Three Rivers’ Corporate Website

Valuation: CXO purchased Three Rivers’ assets for $5,000 per acre / $17.24 per proved BOE / $142,857 per flowing BOEPD (production).

Did CXO overpay/underpay for the assets? This is important if we are an investor in CXO, because it can tell us how responsible the company is investing shareholder dollars.  To determine this, we need to find some comparable transactions in the Permian Basin which are preferably recent.  The best place to find this data is to subscribe to a database such as Derrick Petroleum Services’ E&P Transactions database.  Because these subscriptions can be quite costly for the average investor, your best bet is to use Google, Derrick Petroleum’s free database and/or monitor press releases from other Permian players.

February 10, 2012: Energen (NYSE: EGN) purchased Permian assets in the Midland Basin for $65.8 million from an undisclosed seller.  The assets acquired included 3,200 net acres and proved plus probable (2P) reserves totaling 8.5 MMBOE (80% proved undeveloped).  LPI purchased the assets for $20,563 per acre and $7.74 per 2P BOE reserves (no production figures were given).  Generally speaking, the odds of recovering proved reserves are 90% and the odds of recovering probable reserves are 50%, thus a company would obviously pay less for probable reserves (the press release did note that the reserves were primarily proved).

Analysis: EGN paid over 4x as much per acre as CXO paid, but it appears it paid less for proved reserves; however it’s difficult to be sure considering EGN’s package included at least some probable reserves.  These reserves are located in the Wolfberry trend (Midland Basin) where companies like Approach Resources (NASDAQ: AREX) had terrific success during 2011.

July 6, 2011: Laredo Petroleum (NYSE: LPI) acquired Broad Oak Energy (private) for $1 billion.  Broad Oak was a pure-play Permian company with assets primarily in Reagan and Glasscock Counties of the Midland Basin.  The assets acquired included 338k net acres, proved reserves of 140 MMBOE (35% oil) and average production of 21.7 MBOEPD.  LPI purchased the assets for $2,959 per acre, $7.14 per proved BOE and $46,154 per flowing BOEPD.

Analysis: While LPI paid significantly less than CXO with respect to all metrics, keep in mind that Broad Oak’s reserves are gassier than Three Rivers’ (35% versus 50%, respectively).  We also know from CXO’s press release on the acquisition that the acquired assets are 55% proved developed, essentially meaning wells have been drilled on 55% of the proved reserves.  All things equal, a company would pay more for developed acreage, however it’s difficult to draw a conclusion because we don’t know how developed Broad Oak’s acreage was.

Putting it all together: While CXO paid a premium for reserves and production, the acreage value seems very reasonable.  I would also question whether they even paid a premium for reserves and production, being as their reserves were oily.  If we compare the value CXO paid for reserves ($17.24 per proved BOE) and production ($142,857 per flowing BOEPD) to what the market values CXO’s reserves on an EV/Proved Reserves basis ($29.96 per BOE) and EV/Production ($161,256), we find that CXO added assets which complement their asset base (see maps above) for significantly less than the market is valuing its own assets pre-acquisition.

Valuation Metrics: EV/Reserves; EV/Production

Enterprise value-to-reserves/production are two common multiples used in the valuation of oil and gas companies.  Enterprise value (EV) can be thought of as the entire value of the company or the company’s debt + equity.  Where you could use these multiples is if you wanted to create an index or peer group of companies that you wanted to track to see how the market is valuing the company’s reserves or production.  If you were to see that the market is undervaluing a certain company with respect to the peer group, you might consider buying stock in that company.

EV can be calculated a number of different ways, and I will calculate Bill Barrett’s (NYSE: BBG) EV in an example using the quickest and easiest method below:

First calculate BBG’s current market cap which will tell us the value the stock market is assigning to BBG’s shares: closing stock price on May 14, 2012 was $23.40 * 47.810 million shares outstanding as of March 31, 2012 = $1.1 billion.  Next we net the value of BBG’s debt which is also $1.1 billion from its cash which is $95.7 million to get approximately $1.0 billion.  If BBG had any preferred stock or minority interest, we would then add this to its debt total before adding the entire total to its market cap, which gives us an enterprise value of $2.1 billion.

To calculate BBG’s reserves we will look to its most recent reserve report which can be found in its current 10-K.  You will scroll down to the company’s reserve reconciliation (see definition below) towards the bottom of the document on page F-44 (the best way to find a company’s reserve reconciliation in a 10-K which is often a big document is to become familiar with the different lines of the reconciliation such as “revisions of previous estimates” which are common among U.S. companies and do a control + find for that keyword in the document).

BBG’s most recent reserve balance on December 31, 2011 was 1,364,691 MMcfe.  Now if we wanted to put this in MBOE to compare BBG’s reserve total to a company who reported in BOE (refer to the energy equivalency primer I wrote on May 09, 2012), we would divide the reserve total by 6 and get 227,449 MBOE.  (for those like me who didn’t know their roman numerals beyond X = 10 before becoming an oil and gas analyst, M=1,000 and MM=1,000,000).  And if we wanted to convert 227,449 MBOE to simply BOE we would multiply it by 1,000 or move the decimal three places to the right to get 227,449,000 BOE.

Calculating EV/Reserves: Take BBG’s enterprise value of $2.1 billion or $2,100 million and compare it to its reserve total of 1,365 Bcfe (1,364,691 divided by 1,000) to get $1.54/Mcfe.  When we divide million (EV) by billions (reserves), million cancels out million and leaves us with $ per thousand cubic feet equivalent. This metric is interpreted best in per Mcfe because natural gas is priced per million british thermal units (MMBTU) which is roughly equivalent to thousand cubic feet or Mcf.

Calculating EV/Production: For this metric, we will typically calculate a trailing twelve months (TTM) production and compare that to EV.  To find BBG’s current TTM production, look at the company’s latest quarterly report or earnings press release where the company reported net production (see definition below) of 28,210 MMcfe during Q1’12 and 22,568 MMcfe during Q1’11.  For 2011, the company reported net production of 106,945 MMcfe.  If we take 28,210 + 106,945 – 22,568 we get a TTM production of 112,587 MMcfe or 308 MMcfe/d (million cubic feet equivalent per day).  If we want to value BBG’s production on a per day basis, we will take its enterprise value of $2,100 and divide it by .308 Bcfe/d to get $6,818 per flowing Mcfe/d.

A few extra notes regarding these multiples: EV/Reserves becomes a less accurate multiple as the year progresses and we continue to use a 2011 reserves number, because reserve totals will change as companies produce and acquire/divest them.  For this reason EV/Production is a more accurate multiple to use later in the year, however you could alternatively calculate a pro-forma reserve total which would more accurately reflect the value the market is placing on a given company’s reserves.

Chesapeake a Value Buy?

By now many of us have seen the plethora of bad press Chesapeake Energy (NYSE: CHK) has been receiving over the past several weeks: SEC Starts Probe of Chesapeake CEO’s Well Stakes, Chesapeake Bonds Drop After Cash-Flow Estimates Are Cut, Chesapeake Takes Oil Sale Off Table to Keep Cash.  The company, who has seen its stock price tumble 79% to $14.81 as of market close on May 11, 2012 from a high of $69.40 on July 02, 2008 (see graph below), can’t seem to catch a break in the midst of low natural gas prices and a 2012 capital expenditure program that could exceed cash flow by over $9.2 billion if natural gas prices don’t improve.

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The number two natural gas producer in the United States doesn’t lose 79% of its stock price value for no reasons, it loses it for some reasons, those chiefly being lack of funding for its 2012 capital expenditure budget and a highly levered balance sheet in the face of rock bottom natural gas prices.

Funding Gap

CHK has a $10.25 billion 2012 capital expenditure budget (mid-point of current company guidance) yet it only generated $274 million in cash flow from operations during the first quarter of 2012 which is 62% less than the $718 million the company generated during the same period in 2011.  If natural gas prices don’t improve and the company only maintains current production levels, which is likely a worst case scenario, it will generate $1.1 billion in cash flow from operations during 2012, leaving it with a $9.2 billion funding gap.  With only $438 million in cash-on-hand, the company will be forced to sell assets and use its revolver to plug this funding gap.  Below is a pie-chart describing how management expects to fund its operations in 2012:

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Financial Position

Just how over-levered is CHK?  The company has $13.1 billion in debt and a debt-to-total cap of 29%.  The problem is, 82% of its proved reserves (thus most of its assets) are natural gas, a commodity which isn’t economic to drill in most plays at current prices.  Large-cap E&P operators, EOG Resources (NYSE: EOG) and Noble Energy (NYSE: NBL) have debt-to-total cap ratios of 20% and 24% respectively.  While CHK doesn’t appear too over-levered based on that comparison, the market is looking at the entire picture when valuing the company: they are currently saddled with debt, natural gas prices are low which is not only effecting CHK’s ability to fund its capital program but it could also hamper its ability to pay down its debt maturities which begin to come due next year as well as the possibility that CHK will need to sell more equity (a dilutive option at current stock price) or use its $5.1 billion credit facility (currently $2.9 billion drawn) to raise more capital .

CHK has its first major principle repayment due in 2015, when it will owe $1.7 billion in senior notes, in addition to the balance of its revolver (currently $2.9 billion drawn).  After that the company will owe between $1.0 billion and $2.3 billion in senior notes in each year between 2017 and 2021.  This means the company has some time get its finances in order, but it better use that time wisely.

Any Value?

CHK has a P/TTM CFPS of $1.80 as of market close on May 11.  This means CHK investors would currently be paying $1.80 for each $1.00 of cash flow the company is generating.  By contrast, EOG investors are currently paying $5.99 for each $1.00 of cash flow the company is generating.  I wouldn’t argue to buy CHK’s stock just because it’s cheap, you have to believe in the company’s ability to monetize the assets currently on its plate and efficiently increase its oil and liquids production cut (84% and 92% of CHK’s 2012 and 2013 CapEx, respectively, is devoted to oil and liquids plays).  What I would keep in mind is that CHK’s stock is currently getting abused, but it has an experienced management team equipped with an impressive portfolio of oil and liquids rich assets in the Eagle Ford, Mississippian Lime and the Utica Shale.  If you believe the cash-strapped company can get these prospects drilled which will help solve its potential cash-flow problems down the road, this might be the time to buy CHK on the cheap.