Andrew Coleman: Overall, the space was helped by stronger domestic gas prices as we came out of the cold winter. The Q1/14 numbers have not been fully reported yet, but gas prices were up to $5 per thousand cubic feet ($5/Mcf) at bid week. As a result of this increase, a number of gas-weighted exploration and production (E&P) companies outperformed the market.
TER: What changes do you see on the table for Q2/14?
AC: From the macro standpoint, we at Raymond James have been asking ourselves, "How and when will gas storage begin to replenish?" The answer to that question will dictate how the gas market reacts during the next three to six months. Clearly, the strength of the winter weather sales and the reduction in storage levels make us much more positive on 2014 gas prices than on 2015 gas prices. We think there will be enough coal switching to keep gas prices from getting too frothy. We also believe the E&P industry's ability to bring new supply to the system will help close the storage gap. So, while we recently increased our 2014 gas price deck, we left 2015 unchanged.
TER: Are we looking at a global glut for oil and gas?
AC: That's certainly been the sentiment at Raymond James for the last 24 months. Supply coming from the North American shale plays has overshadowed demand growth. The market remained tight last year due to supply curtailments made by the Organization of Petroleum Exporting Countries (OPEC) in the Middle East. And in the months to come, I think we'll continue to see growth in North American production volumes and a trend toward oversupply, with the first pricing disruption coming from a widening Brent/LLS spread.
TER: What role are the Saudis and Chinese playing in the current oil and gas environment?
AC: Prior to the shale oil development boom, there was one marginal producer of oil—Saudi Arabia—and one marginal buyer of oil—China. However, the discovery of U.S. shale oil deposits introduced the country as a second marginal supplier. It is our view that Saudi Arabia will cut oil production to keep the market balanced, but there's a question as to how much the Saudis will cut. The recent Saudi cut of 1 million barrels of oil per day was more than we expected in the short term. Will it cut more? A part of the answer depends upon the health of China's growth trajectory, as the country's slowed progress has given way to concern for the robustness of its oil demand.
TER: Will the North American shale fields keep producing for the long term?
AC: Raymond James recently published an article that attempts to answer that question, analyzing the Bakken Shale. We used our type-curve models to forecast what it will take on a rig count basis to get Bakken production to slow its growth rate. The report shows that the rig count would have to be cut by more than 50% in order for production to show a noteworthy decline. Growth is being driven by a combination of pad drilling (e.g. faster cycle times) and downspacing (e.g. higher-density drilling).
It used to take 60 days to bring a new well online in the Bakken, but now, the average time is half that. And even if the productivity of the rock in the basin is declining, producers don't have to deal with infrastructure bottlenecks, such as transportation issues. Roads and other infrastructure were built throughout the Bakken during the first few years of the boom and those efficiencies are helping to offset any potential risks to reservoir productivity at this point. That scenario is likely to continue through the end of this decade.
TER: In your previous Energy Report interview, you discussed a number of exciting North American E&P companies. What are some of the names you're following today?
AC: EOG Resources Inc. (EOG:NYSE) is the best run and most respected E&P company out there. It's been my Top Pick for some time because it has a great balance sheet and the fastest growing large-cap E&P profile in the sector and the stock certainly reflects these strengths. It's a dominant player in the Eagle Ford play, where it has experienced huge growth. It's also one of the pioneers in the Bakken and is testing acreage in the Permian Basin. Given that Raymond James' commodity outlook for the next two years models West Texas Intermediate (WTI) oil moving toward $75/barrel ($75/bbl), I see EOG as a great defensive name. It offers good production growth on a debt-adjusted basis.
TER: Do you think the stock is an attractive buy at the present time?
AC: Absolutely. It's hard to argue with the company's level of execution. Considering our overall risk aversion at Raymond James, EOG is a best-of-breed at almost any size market cap.
TER: What's the main way that Raymond James factors risk into commodities analyses?
AC: The risk is that we are pricing WTI in the mid-$70/bbl range next year. The Bakken and midcontinent supply puts pressure on the Brent and WTI spread.
TER: Is that what makes Raymond James risk averse?
AC: Yes, that supply environment makes us cautious on E&Ps. We aren't as cautious as we were two years ago, when we thought the WTI would drop to $65/bbl, but we're still cautious, and we are not seeing enough growth on the demand side to offset that risk.
TER: How about another E&P name investors should keep an eye on?
AC: QEP Resources Inc. (QEP:NYSE) has a number of catalysts on the near-term horizon. In Q2/14, we expect it to finish the bid process for assets that it has targeted for divestiture. Last December, the company purchased properties in the Permian Basin for $950 million ($950M). Utilizing like-kind exchange rules, QEP is seeking to divest its Midcontinent properties to take advantage of the tax benefits it can gain by high-grading its portfolio. It also has saleable assets in the Cana and Granite Wash Basins, and we expect the proceeds from these two asset sales to potentially top the $950M that management spent in the Permian. These deals could be announced in 2–6 weeks and will help QEP deleverage and plow some money back into operations in order to generate production growth.
Interestingly, QEP is also on the cusp of finalizing its midstream business separation plan. We expect to see a filing with the Securities and Exchange Commission (SEC) soon, which will detail how it plans to go about that process. You may recall that JANA Partners LLC acquired shares of QEP stock late last year. QEP subsequently agreed to take on additional board members. Now, it seems everyone on the board agrees with Management's plan to spin off the midstream business and to fully separate it from the rest of QEP.
The proceeds from the midstream separation—and the proceeds from its asset divestitures—could drive the company to trade at a much more attractive E&P multiple since it will be poised to generate more production growth. We could potentially see a $10/share increase.
TER: Are there any other companies that pique your interest?
"Energy XXI's acquisition of Energy Partners Ltd. is part of a plan to create the largest pure-play Gulf of Mexico shelf producer."
AC: Last month, Energy XXI (EXXI:NASDAQ) announced that it will acquire Energy Partners Ltd. (EPL:NYSE). This is part of a plan to create the largest pure-play Gulf of Mexico shelf producer. In my view, this will allow Energy XXI to boost its low-risk inventory, effectively resetting the clock on its development plans. It is similar to what happened after the firm's acquisition of properties from Exxon Mobil Corp. (XOM:NYSE) in 2010: the increased inventory allowed it to have a deeper backlog and to be more selective with its development plans. This deal with Energy Partners allows Energy XXI to do the same thing. In the short term, it will find low-hanging fruit to monetize, generating more production growth and cash flows over the next 12–24 months.
TER: Is the financing market robust right now for small energy firms that need operating capital?
AC: There is definitely some appetite for new issuers on the public equity side. We have seen a large number of energy-only initial public offerings in the last few months, including RSP Permian Inc. (RSPP:NYSE), Athlon Energy Inc. (ATHL:NYSE), Antero Resources Corp. (AR:NYSE) and EP Energy Corp. (EPE:NYSE). I can't speak for the private equity market, but generally the circle of life in the E&P space continues. I don't see any major headwinds aside from the normal concerns about what direction commodity prices will take, which is the top driver in the E&P space.
TER: Will there be an increase in the pace of mergers and acquisitions (M&A) in the E&P sector?
AC: That is hard to say. Generally, M&A picks up when operators feel they can buy properties cheaper than they can organically spend to find/develop them. Lower service costs and commodity price stability would suggest that we'll see more organic options. Smaller deals remain more likely, in my view, than larger-scale ones for the time being.
TER: Andrew, thank you for your time.
AC: Thank you.
Andrew Coleman joined Raymond James Equity Research in July 2011 and co-heads the exploration and production (E&P) team. Since 2004, he has covered the E&P sector for Madison Williams, UBS and FBR Capital Markets. Coleman has also worked for BP Exploration and Unocal in a variety of global roles in petroleum and reservoir engineering, operations, business development and strategy. Coleman holds a Bachelor of Science in petroleum engineering from Texas A&M University and a Master of Business Administration in finance and accounting with a specialization in energy finance from the University of Texas at Austin. He is a director for the National Association of Petroleum Investment Analysts (NAPIA) and a member of the Texas A&M Petroleum Engineering Industry Board, the Independent Petroleum Association of America's (IPAA) Capital Markets committee and the Society of Petroleum Engineers (SPE).
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1) Peter Byrne conducted this interview for Streetwise Reports LLC, publisher of The Gold Report, The Energy Report, The Life Sciences Report and The Mining Report, and provides services to Streetwise Reports as an independent contractor. He owns, or his family owns, shares of the following companies mentioned in this interview: None.
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