Duane Grubert: Gas Wants a Wicked Cold Winter
Source: The Energy Report (10/29/09)
CRT Capital Group Senior VP Duane Grubert likes oil better than gas. Why? As he tells The Energy Report in this exclusive interview, the oil-and-gas price link is weaker than it's been in over a decade and natural gas is too dependent on a fierce winter to fuel demand and drive pricing up.
The Energy Report: Basically, Duane, we'd appreciate a top-down overview of where you see natural gas and oil going in the short run and then long term, and where you see the markets both domestically and internationally.
Duane Grubert: I'm primarily focused on North American markets, and the link between oil and gas has been falling apart over the last year or so, which is one of the very investable themes out there right now. Let's start with the natural gas side. We've really had this revolution; in the last five or seven years producers have discovered that they could produce gas out of really terrible rock—the gas shales. In the last year, with really high prices in 2008 as an incentive, the sector has been very creative in increasing the productivity of these wells in effectively bad rock to the point where there really is a sea change.
Gas is now abundant; very credible producers are saying they have tremendous volumes of project backlogs. So we're in a situation where gas prices are really going back to gas-on-gas competition and the clearing price of gas being set by the sector's cost structure.
TER: And the oil side?
DG: It's a lot different on the oil side. Time and time again, we've seen politics, macro factors, infrastructure constraints, etc. It's much less researchable to talk about where oil prices are going relative to gas prices (again, for North America), because effectively you have this island market for natural gas and dominantly a domestic supply.
We certainly pay attention to cost structure on the oil side and we certainly pay attention to things like social budgets of some of the Middle East nations. But in terms of a number, which ultimately everybody wants, we start with the first question: What will investors be willing to assume as a long-run normalized price? I'm very comfortable thinking that gas markets will reflect a clearing price of something like $6 per MMBTU, which is miserable relative to where oil is trading currently.
Right now the stock and bond markets are reflecting something like $60 oil, even though the current prices are a lot closer to $80. So in terms of an outlook for price, I am comfortable telling people to think about a normalized $6 gas price for the medium and long term, but I am a lot less certain on the oil side. Because of cost structures and so forth, we're kind of a $60-plus shop in terms of an outlook. We recently bumped up our view of what securities will reflect to $65 oil in our target setting, but left gas alone at $6.
TER: So the opportunity appears to be in natural gas because you're looking at a 50% upside from the current price?
DG: The situation has really changed quickly. We had a period in the shoulder season when people didn't use either air conditioners or heaters, between summer and winter, where the spot price of gas dipped below $3, but we very quickly recovered from that. In mid-October, November gas was priced at over $5, with the strip for next year very close to that clearing price I've been talking about—around $6.
So it was correct early in the year to say gas prices must go up. They did go up, and they've gone up toward this clearing price. If you're a bull on gas, you're really making a weather call from this point forward into 2010, and there are some moving parts. We have had far less drilling, we may have some economic recovery, but at the end of the day, the weather call is very dominant as a driver of whether gas prices will improve much from here.
TER: What is it typically costing to produce gas out of some of the shale plays you mentioned?
DG: People often confuse the notion of an ongoing cash cost versus an all-in invested cost. In terms of cash cost, most producers now are able to get gas out of the ground from existing wells for about a dollar per MCF. On the capital side, very credible producers—for example, Chesapeake Energy Corp. (NYSE:CHK)—are showing numbers that indicate they can have, say, a 10% pre-tax return with on the order of $4 for the gas in the most competitive shales, such as the Haynesville and the Marcellus.
It quickly erodes when we look at a broader universe of types and qualities of wells. The best projects that can tolerate a fully loaded $4 are very material, but very many producers are doing a lot of work on what they perceive to be best-in-class type projects within their own portfolios. They need more like $5–$5.50 fully loaded.
TER: As you said, you need a higher price before it makes sense to get the gas out of the ground.
DG: Yes, and so we've seen a very rational response by the sector laying down drilling rigs. While they're producing and making positive returns on a cash basis, on a project basis prices simply haven't been high enough to justify activity. We've dropped down from about 1,600 rigs drilling for gas mid-to-late last year to about 700 rigs now.
TER: Haven't we seen some uptick since the bottom?
DG: Very small. The last few weeks we've seen a little bit here and there, partly driven by the ability of producers with those perceived best projects to hedge. In the last couple of months, we've had very low spot and near-month NYMEX prices, but very big spreads moving into next year such that producers could have sold forward at $6 or even $7 per MCF for 2010. So we're beginning to see a little bit of an uptick in activity related to hedging and also to some of the producers needing to drill to retain their acreage.
TER: What are some of the natural gas stocks you're telling your clients they should be buying?
DG: We're actually running out of upside to our targets. The names we like best are the better-capitalized names—Chesapeake and EOG Resources, Inc. (NYSE:EOG), for example. Generally, we're sticking with the better-capitalized names because they would be able to endure, as they had to do earlier with this year's weaker markets.
For the next quarter or two, where gas prices will be and how stocks will behave is very much a call on weather, but we do still see some upside in a few names independent of weather. That would be going toward valuations reflecting the long-term $6. If we have a wicked cold winter season, though, we will see bigger upsides and don't want to miss out on those.
We stay generally away from some of the smaller go-go names, and right now names that are very cheap are pretty scarce. An exception is Forest Oil Corporation (NYSE:FST). It's been in the doghouse with investors for a while, having used up liquidity for some acquisitions last year and having taken a slow growth year in 2009. But with Forest Oil, you've got a deep value opportunity and not too much risk on natural gas relative to where the stock is trading.
TER: Any other names of interesting gas plays you'd like to share with us?
DG: Energy XXI (NASDAQ:EXXI) is one of the more interesting names in the space, inasmuch as there is so much uncertainty about gas prices. We're always on the lookout for names that have material volume upsides through exploring, and Energy XXI is effectively a company that acquired properties from firms such as Pogo Producing Company, which was bought out a couple of years ago. The Energy XXI business model is to improve properties that they acquire, and they've proven quite capable of doing that.
But their second line of business is they're partnered with McMoRan Exploration Co. (NYSE:MMR), which is another name we like. McMoRan is involved with some ultra-deep drilling near shore. Effectively their idea is that certain sands will still be of good quality at great depth and the associated great pressures at great depth will make them producible at high rates. McMoRan has had some good luck with that in some shallower projects, but a couple of very large projects—one known as Blackbeard and one known as Davy Jones—may be very material to the industry and certainly to both McMoRan and Energy XXI.
So our view on Energy XXI is that its core business of keeping production relatively flat and therefore cash flow flat has been good, and we've been very positive on the bonds for Energy XXI. But for the equity call, the progress being made on McMoRan and the extent of Energy XXI's participation in those programs is the material driver. In fact, we find this relatively small and really still fairly unknown name one of the more exciting stories in the sector.
TER: Switching to oil, it's currently trading around $80, but as you said, the stocks are performing as if it's at $60. What do you like in that sector?
DG: When you look at the United States, the only mature projects that are oily rather than gassy are pretty much in California, Alaska and the Permian Basin (western Texas and southeastern New Mexico). More recently the Bakken Projects in North Dakota have been very encouraging, as well. So, while not all that many companies are leveraged to oil in the domestic landscape, those are the companies we like to do a lot of work on.
We're focused on mid-sized companies and are quite constructive on companies having exposure to the stronger oil markets in a period where most of the investment community has spent a lot more time trying to find gas upsides rather than oil. That includes companies such as Berry Petroleum Company (NYSE:BRY), Plains Exploration and Production Company (NYSE:PXP) and Whiting Petroleum Corporation (NYSE: WLL).
TER: Could you talk a little bit about what you see as the opportunities in some of those companies, maybe starting with Berry?
DG: Berry has an incumbent position in California producing heavy oil. It was originally a family-operated company, and eventually became public and stuck to its knitting of doing heavy oil on the same acreage that the Berry family had been developing since the early part of the 20th century.
So, here's Berry with very low geologic risk in California, captive acreage that has deeper potential, with a lot of visibility with reserve upsides, and with technology that has progressed over the last 20 years to a point where very low finding and development costs are a normal part of what Berry does.
A year or so ago, with the higher commodity prices, Berry decided to try to diversify into some of the sexier shale projects, and ended up using a lot of liquidity in pursuit of a land grab in East Texas. That turned out to be very poorly timed, considering the collapse of the commodity market in 2008. They've gotten away from the idea that this is the right time to be expanding into natural gas.
So with Berry, we have a story basically of deleverage of the balance sheet afforded by these higher oil prices and going back to their core business of oil production. So that's a name we continue to like.
TER: You also mentioned Plains Exploration and Production Company.
DG: Plains is another very interesting producer. Its CEO has been famous as a serial dealmaker over the years, and our view is that Plains is finally to a point where its portfolio really doesn't need any tinkering. It also has a very large California position, which gives Plains a base load of oil production and makes it an oily producer, again a scarce thing within the sector.
In addition, the company has a 20% position in Chesapeake's Haynesville program. That is a huge project with a multi-year, even multi-decade development ahead of it, so it was quite a big step and a growth engine for Plains. Beyond that, Plains also participates in the McMoRan exploration program offshore, and has some oil exploration in the Gulf of Mexico with partners like (Royal Dutch Shell plc [NYSE:RDS.A]). So it's a very diverse upside portfolio and a very stable ongoing production system. And the market has really under-rewarded Plains for the scale of upsides it has.
TER: And how about Whiting?
DG: It's a very interesting name in terms of its position in the Bakken, where Whiting has put together acreage that is partly shared with EOG Resources in North Dakota and has been putting on very high initial rate wells in the Bakken both with EOG and in their own independent project.
So basically Whiting has become increasingly oil-leveraged. The Bakken is fairly new for Whiting, but it also has water-flood and CO2-flood projects in Texas and Oklahoma that represent about 50% of their reserves. While the market was out there looking for the next big gas shale play, a name like Whiting sort of stayed under the radar screen, and recently the stock has done quite well. Some competitors that are also active in the Bakken—such as Continental Resources, Inc. (NYSE:CLR)—have been perhaps over-rewarded for the upside there, so we continue to be very positive on Whiting, which is cheap relative to Continental.
TER: How would you tell investors to divide oil and gas in their portfolios over the next 12 months?
DG: At this point, we're much more constructive on oil names than the gas names. That doesn't mean staying away from gas as much as it means sticking with the gas players who are diversifying. A good example of a quality gas name is XTO Energy Inc. (XTO), which has a very strong balance sheet and is building out its business oil-wise, both in the Bakken and the Permian Basin. However, we think the market is rewarding XTO shares now to a point that prompted a recent downgrade by us from a "BUY" to a "Fair Value" rating on valuation. We see Chesapeake and EOG Resources as cheaper high-quality exposure to gas, with an eye on more diversification over time.
We would definitely be very positive on getting exposure to both the under-rewarded oil leverage—Berry, Plains and Whiting—and taking an element of exploration exposure. Here I think of Plains Exploration and also the McMoRan program, directly but also especially through the leveraged exposure investors get by owning Energy XXI. That's a smaller name that we think will be around for a long time, or one that may reward investors in a merger scenario.
In summary, we like oil better than gas; we like the gassy players that are getting oilier, and we like an element of exploration with some track record attached to it.
DISCLOSURE: Duane Grubert
I personally and/or my family own the following companies mentioned in this interview: None
I personally and/or my family am paid by the following companies mentioned in this interview: None
Covering the energy industry, Duane Grubert is Senior Vice President and Principal of CRT Capital Group LLC, a Wall Street broker-dealer with research that covers the entire capital structure, based in Stamford, CT. He joined the firm in 2007 after working at Sanford C. Bernstein, Fulcrum Global Partners and Execution LLC. In his first two years as a publishing analyst, he was voted Institutional Investor Magazine's "Up and Comer" for both exploration and production and for natural gas; he ranked in the top 10 for both categories thereafter.
Prior to turning to Wall Street, Duane spent 17 years with Unocal (now part of Chevron Corporation [NYSE:CVX]), as a petroleum engineer, in international business development and finally as general manager of corporate strategy and business intelligence. He served stints in Thailand, Alaska and California, executing on $100 million worth of drilling projects, obtaining a technical patent, driving large-scale contract negotiations and working with executive management in the U.S., Latin America and Asia. Duane has a BS in Petroleum Engineering from Stanford University and an MBA from California State University.
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