The Energy Report: Josh, political tension in the Middle East always prompts speculation over potentially rising oil process. What has the price action been since violence in Egypt intensified?
Josh Young: Prior to the turmoil in Egypt, oil was in the $90–95 per barrel ($90–95/bbl) range; it is now trading over $106/bbl. Prices will continue to rise if political instability spreads into the oil-producing neighbors of Egypt, or disrupts shipping on the Suez Canal.
TER: Do you see a potential for turmoil in Saudi Arabia?
JY: The possibility of protests turning violent is real across the Arab world. In the eastern part of Saudi Arabia, resistance by Shia has a taken on a violent undertone—nothing like the dramatic upswing in violence in Egypt, but it has the potential to fester and spread. Remember, the Arab Spring first got hot in Tunisia, and then spread like wildfire to Morocco and Libya. One of the big political factors that has destabilized the region of late has been a combination of a concentration of wealth generated by oil production along with inflation, particularly of food prices, which has made life a lot worse for the poor people in those countries.
TER: Turning to North America, are we looking at weaker earnings and higher interest rates for next year, as many economic pundits suggest? If so, will this trend affect oil and gas prices?
JY: There is a lot of price support for oil and natural gas. The marginal cost of production for oil continues to rise. Marginal oil is being produced in secondary areas in the Bakken and other peripheral shale plays where oil is economic above $100/bbl. Producers are drilling in the Arctic and in deepwater and ultra-deepwater, where offshore rigs and related facilities can cost billions of dollars. The trend is progressively higher production costs, and that requires higher oil prices. Worldwide rising marginal production costs indicate the price direction going forward.
TER: For investors who want to take advantage of a potentially large spike in oil and gas prices, can you explain what is meant by "contango" and "backwardation"?
JY: These terms describe the shape of the forward price curve of futures contracts for resource commodities. "Contango" is when the current price for oil is cheaper than the futures price for oil delivered in a year or two. "Backwardation" is the opposite: The current price for oil is higher than the price to buy oil later.
For example, if a trader wants to buy West Texas Intermediate (WTI) oil five years out, it costs roughly $85/bbl versus the current price of ~$106.50/bbl. I know commodity traders who profit from trading futures contracts based on analyzing the changing shape of these curves over time. But I prefer to invest in value-priced equities as there is a more clearly defined intrinsic value.
TER: What are the relative benefits of investing in oil and gas ETFs and master limited partnerships (MLPs) versus buying more stock in the majors or looking for solid juniors?
JY: Things don't look great for Exxon (XOM:NYSE), Conoco (COP:NYSE) and other majors who are being hit hard by cost escalation, particularly in offshore exploration and development. These firms are aggressively buying and drilling around the globe, yet production is not increasing much—and in some cases it is declining—despite their unprecedented capital expenditures on drilling and production.
And with the ETFs, which are subject to contango and backwardation, the challenge is simply that you have no crystal ball. Most retail ETF investors are not able to understand the shape of the futures curve better than the commodity trading specialists who do this for a living. I look to the smaller, value-priced oil companies as the foundation of my investment strategy.
TER: You are a proponent of redeveloping mature basins. Why?
JY: There is less risk in redeveloping existing fields than in exploring for new fields, conventional or unconventional. Many exploratory wells, even shale wells, lose money. But there is good money—and less risk—in redeveloping fields in, say, Oklahoma.
TER: Which junior explorers and producers interest you in the mature basins?
JY: I like Gastar Exploration Ltd. (GST:NYSE). During the past year, the company has seriously reshaped itself. And it has cleaned up its balance sheet. It has signed onto accretive deals. Gastar is redeveloping the Hunton play in the Sooner Trend in Oklahoma and is drilling horizontal wells for $5 million ($5M). It had an excellent well come on-line with production at 200 barrels per day (200 b/d) and incline to more than 1,000 b/d for nearly 60 days before it started to decline, which is really exciting. The economics of that type of flow is unparalleled among the onshore resource plays.
TER: What is the rate of return on that particular well?
JY: Perhaps as high as 200%. And that means getting $10M back in the first year and maybe $3–4M in the second year. The net present value on that well is somewhere between $25M and $50M. The exact value depends on how rapidly the well declines and, obviously, the forward price for oil. But it is a phenomenal well by any measure.
TER: What makes the Hunton special?
JY: Consider this scenario: The stock of Goodrich Petroleum Corp. (GDP:NYSE) is shooting up because it is in a resource play that people are very excited about called the Tuscaloosa Marine Shale (TMS). The big difference between the Hunton and the TMS is that multiple well-known public companies are active in the TMS. The most prominent one is Goodrich, but Sanchez Energy Corp. (SN:NYSE) recently bought into the play. Devon Energy Corp. (DVN:NYSE) had a big position and recently sold out. EOG Resources Inc. (EOG:NYSE) has drilled a number of wells in the TMS.
At this point, investors are focused on the TMS and are generally unaware of what is really happening with Gastar's redevelopment play in the Hunton. In the Hunton, about 50 horizontal wells with results have been drilled in the last three years. In the TMS, there have been about 20 results during the same time frame. In the Hunton, about 45 out of the 50 wells indicate a roughly 60% rate of return. But in the TMS, there are only about four wells that might be economic so far. The well announced by Goodrich is producing 1,500 b/d and cost about $14M. The Hunton wells are costing about $5M and some are producing more than 1,000 b/d. Gastar estimates that it will be able to get the cost per well down to $4.5M, which will drive returns even higher.
The Hunton is somewhat proven from an industry perspective. There is way more well data, way more outperformance, and the play shows a fundamentally lower risk profile than the TMS. Gastar has a good idea of where to drill, in other words. One would think that because the Hunton is working out so nicely, Gastar should be trading at a high multiple. But Gastar is trading at less than six times its 2013 enterprise value to EBITDA. Goodrich, on the other hand, trades at about 12 times its 2013 enterprise value to EBITDA. As people wake up to what is happening in the Hunton, there is the potential for Gastar's stock to radically re-rate. I bought some Gastar stock today, and yesterday, and the day before—and I may just keep buying it!
TER: Gastar is also operating in the Marcellus.
JY: It is important to understand that Gastar has developed its main field in the Marcellus. Even if Gastar did not have the Hunton, its six times EBITDA is very cheap relative to the other Marcellus-focused companies with similar rates of return. Those companies include Rex Energy Corp. (REXX:NASDAQ), Cabot Oil & Gas Corp. (COG:NYSE), Range Resources Corp. (RRC:NYSE) and EQT Corp. (EQT:NYSE)—and they are trading at approximately 12 times enterprise value to 2013 EBITDA. Gastar's CEO recently estimated that its Marcellus asset alone could be worth $7 per share, which highlights how cheap he thinks the stock could be at around $3 per share.
TER: What is the story with Range, Rex Energy, EQT and Cabot?
JY: They have all shown increasingly good results in the Marcellus and are trading at multiples. Their rates of return are reasonably high despite low natural gas prices. Range and EQT have massive inventory. Cabot has exceptionally high production from its dry gas well. Rex has some exposure to the Utica. Each of them is trading at a reasonably fair price. Each is run by good managers. They have beat expectations quarter after quarter. They are at or near being free cash flow positive, which is attracting generalist investors, because it is easier for a generalist to evaluate a company that is generating free cash flow, as opposed to a company, like Gastar, which is outspending its cash flow on capex for now. That should change by the end of 2014, which could further re-rate Gastar stock.
TER: What is the situation with Lucas Energy Inc. (LEI:NYSE.MKT)?
JY: I was on the board of directors of Lucas Energy for about six months, which restricts what I can say to a certain extent, but I can talk about the facts. Lucas recently secured new financing at about 11%, which is a higher interest rate than a typical bank loan, but lower than a typical mezzanine financing. Lucas has announced that it will use the loan to partially pay off short-term debt. That will improve its working capital situation. And it will deploy the cash to re-drill wells in known producing oil zones in its main fields. Generally, expenditures on workovers produce high rates of return by completing existing wells and opening wells into new zones.
TER: How does that work?
JY: Let us say that a company is producing oil from a well at a depth of 15,000 feet. It spends a relatively small amount of money to open up the nearer well. And if it produces even 10 or 20 b/d and the operator only spent $50,000 to open it, the rate of return can be well over 100%.
TER: Do you have an update on GeoMet Inc. (GMET:NASDAQ)?
JY: Geomet recently sold an asset, paid down debt and got back into compliance with its lending facility. Surprisingly, despite higher natural gas prices and a fully compliant debt facility, the equity and the preferred stock have not traded up since then. In particular, the preferred stock seems appealing with a 12.5% current payment in kind (PIK) yield and trading at a 25% discount to "par." This could be an interesting way to get exposure to high yields with upside to natural gas prices, which could potentially recover over time.
TER: I noticed that EQT has joined other large and small oil and gas firms in the Center for Sustainable Shale Development (CSSD). And Range Resources has been releasing information about the chemical composition of its fracking liquid. Are there problems with water pollution in hydraulic fracturing that will bite investors sooner or later?
JY: Range has disclosed the contents of its frack fluid as 99.5% water and sand. It adds four chemicals to the fluid, which are all found in household cleaning supplies. Range's view is that its fluid contains nothing in it to contaminate water. To my knowledge, there are no cases of fracking leading to water contamination. The cases that have been cited are related to water wells that were drilled into coal bed methane reservoirs. In the film Gasland, people were able to light their tap water on fire because there was natural gas mixed in with it. That water well was drilled 80 feet down into a coal seam, and as the water was used up, the pressure on the coal eased and allowed the release of natural gas.
There are cases where chemicals found in drinking water were related to truck crashes. Unfortunately, in parts of the Marcellus it is hilly. Occasionally, trucks transporting chemicals crash and those chemicals spill into the water. That is not different from any other industrial activity. Our ability to live modern lifestyles is contingent on certain levels of manufacturing activity and industrial activity that leads to some level of pollution of the environment.
TER: Thanks for sharing your perspective, Josh.
Josh Young is the founder and portfolio manager of Young Capital Management, LLC. He is also a board member of Lucas Energy Inc. He previously served as an analyst at a multi billion-dollar single-family office in Los Angeles. Prior to that, he was an investment analyst at Triton Pacific Capital Partners. He was also a corporate strategy consultant at Mercer Management Consulting and DiamondCluster. He holds a Bachelor of Arts in economics from the University of Chicago.
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1) Peter Byrne conducted this interview for The Energy Report and provides services to The Energy Report as an independent contractor. He or his family own shares of the following companies mentioned in this interview: None.
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