Natural Gas Vehicle Primer

At market close on June 19, 2012 oil sold at the Cushing, Texas hub (WTI) fetched a price of $83.99 per barrel, whereas natural gas sold at $2.59 per Mcf at Henry Hub in Erath, Louisiana.  On an energy equivalent basis, Six Mcf produces approximately the same amount of energy as one barrel of oil; therefore, all things equal (particularly with respect to supply in demand) we should expect $2.59 * 6 or $15.54 to equal the price of one barrel of oil.  Instead, we find that one barrel of oil prices at a 5.4x premium to six mcf of natural gas.  The premium paid for oil is caused by increased demand for the hydrocarbon from the developing world (China, India, etc) and its diminishing supply.  Consequentially, natural gas has become an attractive energy source, not only for its pricing advantage to oil but also because it burns cleaner:

Average Emission Rates in the United States

Natural Gas Emissions

Carbon Dioxide_: 1,135 lbs/MWh

Sulfur Dioxide: 0.1 lbs/MWh

Nitrogen Oxide: 1.7 lbs/MWh

Oil Emissions

Carbon Dioxide_: 1,672 lbs/MWh

Sulfur Dioxide: 12.0 lbs/MWh

Nitrogen Oxide: 4.0 lbs/MWh

Source: www.epa.gov

Note regarding natural gas vehicle emissions: According to the DOE, transit buses with natural gas engines produced 49% lower nitrogen oxide emissions and 84% lower particulate matter emissions.

Are we taking advantage of cheap natural gas prices? Aside from coal-to-natural gas switching by U.S. utilities, companies have been building natural gas fueling stations for cars and trucks and converting gasoline engines to natural gas engines.  Chesapeak Energy sponsored Clean Energy Fuels (NASDAQ: CLNE), a company who has T. Boone Pickens on its board, is currently working on a “natural gas highway” across the United States (see below).  The company sells compressed natural gas (CNG) to passenger vehicles and fleets and liquefied natural gas (LNG) to the trucking industry.  Per gallon prices (diesel gallon equivalent) for CNG and LNG at CLNE fueling stations averaged $2.28 and $2.88, respectively, during the week of June 18, 2012.

CLNE’s LNG Highway

Source: http://www.cleanenergyfuels.com

For information regarding CNG fueling stations in the U.S., click here.

Companies like CLNE, Westport Innovations (NASDAQ: WPRT / TSX: WPT) and World CNG (private) are currently focused on building infrastructure for natural gas vehicles (NGVs) and either converting cars/trucks to CNG/LNG or building new NGVs.  Their clients are primarily trucking companies and or vehicle fleets such as airport shuttles, delivery trucks, garbage trucks and taxis.  Given the relatively limited number of natural gas fueling stations, this makes sense because its easier for trucks and shuttles who have defined routes to operate on fueling schedules, versus passenger cars whose destinations change sporadically.  I would expect that as the infrastructure for fueling stations continues to be built out, it will make more sense for greater numbers of passenger vehicles to convert to natural gas.

CLNE has built more than 150 fueling stations and has capacity to fuel more than 25,000 vehicles per day.  Westport Innovations  and UPS have partnered to build more than 1,100 natural gas trucks for the UPS (NYSE: UPS) fleet.  WPRT is also working on development plans with General Motors (NYSE: GM / TSX: GMM) to develop new natural gas engine technologies and Caterpillar (NYSE: CAT) to co-develop engines for off-road equipment.  World CNG plans to have well over 200 natural gas taxis in Chicago by the second quarter of 2012.

The United States has a lot of natural gas, it’s cleaner than oil and it will help our country get off of foreign oil.  Even Obama is on the NGV train, proposing a tax-credit to encourage car owners to convert their vehicles from gasoline to natural gas (WPRT, World One and CLNE’s BAF Technologies all do after-market natural gas engine conversions).  Visit the DOE for information on converting your vehicle to natural gas or any other alternative fuel.

Natural Gas Liquids Primer

So you own a company whose production is weighted towards natural gas.  Because gas prices are low, the company has been talking about shifting  its production cut to “wet” gas or natural gas liquids (NGLs).  The natural questions you should be asking yourself are:

1) What is “wet” gas?

2) What is it used in?

3) How is it priced relative to natural gas/methane?

Answers:

1) When companies refer to natural gas liquids or NGLs, they are speaking of some sort of a mix of the following gases: ethane, propane, butane, iosbutane, and natural gasoline (note that natural gasoline is a different compound from natural gas).  The gases are called “wet” because in high pressure environments (ie: underground) they are in a liquid state.  The blend of gases extracted will vary from reservoir to reservoir, rock formation to rock formation, etc.  For instance, the production cut from a company such as Range Resources (NYSE: RRC) operating in the Marcellus Shale in Southwestern Pennsylvania may or may not contain more ethane than a company operating in the Granite Wash such as Panhandle Oil and Gas (NYSE: PHX).

When NGLs are extracted from the ground, they are in a gaseous form, most likely containing a component of methane as well.  At this point, the gas can be sold to market as a gas and the company will receive a price equivalent to its MMBtu content.  If the liquids component of the gas is high enough, or the frac spread is positive, it will be profitable for the different gas components to be separated or “fractionated” from each other and sold separately at market.  Frac spread (aka NGL margin) may be a term you’ve heard before and it’s equivalent to the price a marketer can receive for its liquids after the fractionation  process less the price received if the gas is sold as one component (prior to fractionation).

2) Ethane is used to create ethylene which is used in the production of plastics and as a petro-chemcial feedstock which basically means its a component of various petroleum based substances; propane we know as a fuel source for stoves, engines and other products; butane is used in gas lighters and as a component of synthetic tires; iso-butane is a refrigerant used in air conditioners; natural gasoline is used in the production of ethanol.

3) NGLs in the United States are processed, stored and sold at one of two main hubs: Mont Belvieu which is a hub in Texas, East of Houston and at the Conway hub in Kansas.  NGLs are typically priced in $/gallon, so if we want to find out how their price compares to that of a barrel of oil we simply multiply by 42 (there are approximately 42 gallons in a barrel of oil).

The graph below shows propane spot prices at Mt. Belvieu during the past year

Source: www.eia.gov

According to the Oil Price Information Service (OPIS), the average futures price for ethane, propane, isobutane, normal butane and natural gasoline for the month of July are $0.36,  $0.80, $1.46, $1.38, $1.80, respectively.  Before we get too ahead of ourselves thinking that natural gasoline is the most important component of NGLs due to its higher average futures price, consider that these components all come out of the ground in different quantities and the theory of supply and demand tells us that, all things equal, if there’s less supply of a product it probably costs more.  Like I noted in paragraph one, gas blends will vary from reservoir to reservoir; however I’ll use an average blend the sell-side energy investment bank Tudor, Pickering, Holt & Co used in a midstream primer it issued in November, 2008.

Typical NGL mix (midpoint of range)

Ethane: 42.5%

Propane: 27.5%

Isobutane: 10%

Normal Butane: 7.5%

Natural Gasoline: 12.5%

This NGL component mix shows us that ethane and propane are (on average) responsible for 70% of the value of NGLs, thus making them the most important component for pricing in the NGL mix.  Based on the Mt. Belvieu spot prices above, the following is an estimate of the expected price received for a barrel of natural gas liquids during the month of July versus the natural gas equivalent.

Commodity prices in July, 2012: NGLs versus Natural Gas

The analysis above shows us why natural gas weighted companies are shifting production towards liquids rich formations.  However, note that while NGLs currently price at a significant premium to natural gas, this premium has shrunk over the past year as propane (see how propane prices have slid in graph above) and ethane prices have decreased over the past year.  This should be expected because as production of NGLs increases, supply increases, and without a corresponding increase in demand, prices will decrease.  So while NGLs can certainly be a boon for “dry” gas weighted companies, they might not be a long-term solution.

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.

Valuation Metrics: P/E versus P/CFPS

Today I’m going to discuss why the price-to-earnings (P/E) multiple is not the best multiple to look at when evaluating oil and gas stocks.  While the P/E multiple is widely-used and straightforward, earnings tend to be variable and are subject to manipulation through the recognition of large one-time losses/gains, etc.  Because of the variability of earnings, the price-to-operating cash flow per share (P/CFPS) multiple is preferred to the P/E multiple when evaluating oil and gas stocks.  To show you why this is so, let’s take a look at an example:

In the table below, I’ll compare the P/E and P/CFPS multiples of Quicksilver Resources (NYSE: KWK), a small-cap gas-weighted operator whose assets stretch from the Barnett Shale in Texas to the Horn River Basin in Northern British Columbia, to GeoResources (NASDAQ: GEOI), a small-cap oil-weighted operator with assets primarily in the Eagle Ford Shale of South Texas and the Bakken Shale of Western North Dakota.

KWK’s stock looks less expensive than GEOI’s when looking at its P/E multiple in 2010.  In 2011, KWK’s P/E multiple increased 125% versus only 26% for GEOI, making KWK’s stock appear less attractive than it was in 2010.  If you were to only look at the P/E multiple, you might conclude that KWK is now more expensive than it was in 2010, however this may not be true.  KWK’s stock looks cheaper than GEOI’s when comparing P/CFPS multiples in 2010 and like even more of a value buy in 2011.  The mixed signals KWK’s P/E and P/CFPS multiples are sending can (in part) be explained by impairment expense (see definition below).

Earnings tend to have high variability in the oil and gas industry due to impairment expense, a one-time non-cash expense that can have a significant impact on earnings.  When oil and gas assets are acquired they are capitalized at cost and expensed thereafter.  If the assets are deemed impaired due to a decline in commodity prices or a revision of proved reserves, an impairment expense is incurred.

In 2011, KWK incurred an impairment expense (due in part to low natural gas prices) of $107 million versus $48 million in 2010.  By contrast, (keep in mind KWK and GEOI are similar sized companies) GEOI incurred an impairment expense of only $3 million and $6 million in 2010 and 2011, respectively.  KWK’s impairment expense contributed to the company’s earnings per share total in 2011 which decreased 80% from 2010, leading to a 125% increase in its P/E multiple.  Over this same time period, KWK’s cash flow per share decreased by 37% and its P/CFPS multiple actually decreased due to the stock price decline KWK incurred during 2011.  KWK’s relatively lower cash flow decline versus earnings kept the P/CFPS multiple more stable than the P/E earnings, providing a more accurate view of the company’s performance during 2011.

Keep in mind that the purpose of this post isn’t to determine to what extent KWK is undervalued with respect to GEOI, it’s to show the impact that impairment expense can have on the P/E ratio, thus rendering the ratio less valuable when evaluating oil and gas stocks.  Remember, cash is king in the finance world, and while high impairment expense can signal trouble for a company down the road, it doesn’t impact the cash flow statement.

Glossary of Terms

Gas-Weighted/Oil-Weighted: Proved reserves predominantly consist of gas/oil.

Proved Reserves: Proved oil and gas reserves are those quantities of oil and gas, which, by analysis of geoscience and engineering data, can be estimated with reasonable certainty to be economically producible from a given date forward, from known reservoirs, and under existing economic conditions, operating methods, and government regulations (Source: SEC).  Proved reserves are often referred to as 1p or P90 which indicates a 90% probability of extraction of estimated reserve total.

Impairment Expense: A non-cash expense incurred when it is determined that the carrying value of a company’s oil and gas assets is greater than the actual value of the assets.  Impairment can occur due to a reserves revision, a decrease in oil and gas prices, etc.

A Few Notes on Interpreting Oil and Gas Press Releases

My first several posts to this blog will be introductory in nature.  In creating the blog, I want to make sure that anyone visiting it can find all of the information they need to understand my future posts within the archives of the blog.  This particular post will cover some basics on interpreting press releases.  Also note that I’m writing this blog to both inform and educate readers (in addition to my own selfish reasons of wanting to stay current with the industry), so don’t hesitate to ask me any questions, no matter how basic they may seem.

I plan to define terms (see below) I use in each post to ensure readers can easily understand the terminology used in each post.

Glossary of Terms

Working Interest: The percent of interest a company owns in a well.  If a well costs $1 million and a company owns 10% of that well, the company will pay $100k (10% of cost) to drill the well and receive 10% of the proceeds from the well’s production.  Note that companies will usually have to pay out a percentage of its gross proceeds from a well in the form of royalties to the landowners.

Operator/Non-operator: The operator of a well is the company who drills and maintains the well.  Operators typically own a majority (+50% interest) in the well.  Because an operator will rarely want to take the financial risk assumed with owning a 100% interest in a well, minority owners or non-operators will own a minority interest in a well.

Barrel of Oil Equivalent (BOE)/Thousand cubic feet of gas equivalent (Mcfe): The amount of energy required to produce the same amount of energy as one barrel of oil or one-thousand cubic feet of natural gas.  Companies usually report BOE on a 6:1 basis, meaning it takes 6 Mcf to produce the same amount of energy as 1 barrel of oil (BO).

Interpreting Press Releases

As we speak I’m reading Northern Oil and Gas’s (NYSE AMEX: NOG) first quarter 2012 (Q1’12) earnings press release which you can find here.  NOG is a small-cap non-operator whose assets are located in the oily Bakken formation located in Western North Dakota.  If you look in the section titled “Drilling and Completions Update”, you will notice that NOG participated in 112 gross or 12.4 net wells during Q1.  As a non-operator, NOG holds a minority stake in all of the wells it drills and if we divide 12.4 (net wells) by 112 (gross wells), we see that the company has an average working interest of 11% in the 112 gross wells it participated in during Q1.  This tells us the amount of risk NOG is taking per well and the proceeds we can expect the company to generate per well (if we know how many barrels a given well is producing per day).   Also, it’s important to distinguish gross from net wells because sometimes companies will only report the gross wells they participated in during a period, making it seem as though they’ve drilled more than they actually have.

Another topic readers should be comfortable with when reading press releases from oil and gas companies is energy equivalency.  Companies will often report production in barrels of oil equivalent (BOE) if most of their production is oil or in thousand cubic feet of gas equivalent (Mcfe) if most of their production is natural gas.  If readers want to compare the production volumes of an oil weighted company to those of a gas weighted company, they will need to be able to convert oil production to gas equivalency and vice versa.  Refer again to NOG’s Q1’12 earnings press release and look at the section titled “First Quarter 2012.”  In Q1’12, NOG produced 717,518 barrels of oil (BO), 345,427 thousand cubic feet of natural gas (Mcf) totaling 775,089 barrels of oil equivalent (BOE).  How did the company get to that BOE total?  Well obviously 717,518 barrels of oil equates to 717,518 barrels of oil.  For the natural gas total, refer to the glossary above.  Note that it takes 6 Mcf of natural gas to produce the same amount of energy as one barrel of oil.  Using this logic, we take the 345,427 Mcf of natural gas and divide it by 6 to determine the number of barrels of oil equivalent the gas total equates to –> 57,571.  If we add this total to the 717,518 BO that NOG produced during Q1 we get the 775,089 barrels of oil equivalent the company produced during Q1’12.

Also note that we can take the 775,089 BOE that NOG produced during Q1 and divide it by 91 (the number of days in Q1) to receive the company’s average daily production volume which was 8,517 BOE.

By no means is this all you need to know about interpreting oil and gas press releases and more topics will be covered in future posts.

–Braden