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Josh Young Finds Value in Oil and Gas E&Ps
Source: Brian Sylvester of The Energy Report (11/16/10)
Josh Young, a portfolio manager with Los Angeles, California-based Young Capital Management, is a value investor on the hunt for undervalued companies in the oil and gas space. He launched his fund in September, has earned enticing returns so far, and in this exclusive interview with The Energy Report, discusses some of his hedge fund's equity holdings that are poised to get some love in the market.
Josh Young: We're focused on oil and gas investments, and we make those investments generally through oil and gas (O&G) equities. We focus on companies that are generally under-followed and find companies that are trading at a big discount to their intrinsic value, with identifiable catalysts that are going to unlock that value.
On the short side, we find companies with some sort of fraudulent reporting or with very high valuations that are in fundamentally challenging situations that they are unlikely to work out.
TER: You're a true value investor.
JY: Yes, I am philosophically a value investor. I focus on the oil and gas space because there's a lot of volatility and there are lots of changes and catalysts. With the right approach to managing the commodity risk, there are regularly opportunities to generate significant returns and invest at the sort of discount to intrinsic value that can't be found in other sectors these days because there's so much investment competition.
TER: You mentioned that you buy companies that are trading at a large discount to their intrinsic value and that have identifiable catalysts for further growth. Do you have much trouble finding those companies in the energy space? And what are some catalysts you like to see?
JY: The opportunities are there, but it takes a rigorous investment process to exploit them. It's an incredibly labor-intensive process to identify those companies, research them and make sure they are, in fact, undervalued and that the market is missing something. The risk-adjusted returns from this space, and that I've generated running the strategy, justify the effort.
I identify catalysts as a part of my investment process. I look for companies that have already announced that they're going to sell assets or that they're going to do an equity raise that will help them finance substantial growth. Those are some examples of catalysts.
TER: What about drill results? Would you consider those catalysts?
JY: Yes, but those are generally harder to predict and so I don't focus on them as much. Sometimes it's possible to figure them out before the market does, and sometimes the market does not immediately price in meaningful drilling results. But I'm not generally looking to make investments in anticipation of wildcat exploration drilling prospects.
TER: Most of my experience is on the mining side. I noticed when I was combing through your research, a lot of the companies you follow have small share floats compared to mining companies at similar stages of development. Is there a certain range you look for in terms of the float size? For example, if a company has more than 50 million shares outstanding and isn't as far along the development path as a comparable company with 30 million shares, is that a red flag for you?
JY: I'm less concerned with the number of shares outstanding and more concerned with the percentage of shares outstanding that are in the free float versus percentage held by one or more major shareholders, especially when those major holders might have to liquidate some or all of their holdings. I definitely watch for that. But I honestly don't care if there's 1,000 shares or a billion shares outstanding. I care about the fundamentals of the investment and the liquidity of the stock.
TER: So, you don't like companies that are held largely by a handful of shareholders? Is that what you're saying?
JY: It depends on the situation. Let me explain. One of the companies I follow, Gastar Exploration Ltd. (NYSE:GST), had several large shareholders, and the share price suffered as those large shareholders exited their positions. In 2008, about 20%–25% of Gastar stock was held by a hedge fund that dissolved and the Gastar stock got dumped into the market as a part of the dissolution process. That substantially hurt its stock price. More recently, another investment fund that held more than 10% of Gastar also dissolved its energy fund. There were a number of other factors but that, essentially, led to Gastar's stock price falling from $6 to below $3 even though the company was doing better than before. That said, it's actually another catalyst in that when a major shareholder is no longer a shareholder it can create a really positive environment for the stock and allow it to start appreciating closer to its fair value.
TER: During a recent conference, Barclays VP of Commodities Biliana Pehlivanova said the equity markets like seeing gas production growth from companies because the markets consider it a measure of success. She added that the market rewards gas producers for the metric and, further, investors won't punish companies for low commodity prices because they figure it's beyond any one company's ability to correct the situation. Do you believe that's what's responsible for the growing disconnect between share prices and commodity price in the natural gas space?
JY: I think it's complicated. I'm not sure that's necessarily the answer. A few big things have been happening. First, companies have been drilling into a low gas price because they're hedged. They view their hedges as locking in high prices and, even though gas is selling at $3.50 or $4, they make another $2 or $3 on their hedge contract. They're basically producing gas at $7. Investors see the earnings and cash flow as if the company was actually achieving a $7 gas price.
In other cases, companies spent a significant amount of capital on leases in the Haynesville Shale or elsewhere and they're drilling to hold those leases and retain some of the value in relation to the high prices they paid for them. In those cases, companies are growing their gas production by default. I think a lot of the current oversupply in natural gas is actually coming from those first two factors.
The third factor is that the general market wants to be long on natural gas. Retail investors believe in natural gas. They believe in commodities. They're concerned about quantitative easing 2 (QE2), and the general growth of the money supply. People want to be long on natural gas but they've lost money on the natural gas ETF, UNG, so they've been buying natural gas companies. One of the only ways a retail investor can access natural gas is by buying these natural gas companies through either ETFs or directly owning shares. I think that's where some of the disconnect comes from. The people trading natural gas futures aren't necessarily the same people as the people buying the stocks.
TER: Do you think investors should just ignore the low gas price and invest in companies with good balance sheets and solid management, or are there better places for their capital right now?
JY: I'm not sure I should be telling investors what they should and shouldn't do. What I'm doing is finding companies that are trading at a discount to their intrinsic value at the current gas price and on the current forward curve. I intend to benefit both from the undervalued stock price of the company, as well as any uplift they might get from rising gas prices. So I'm not ignoring the gas price completely, but I'm not letting it drive my investment decisions. It's been a headwind and it will be a tailwind at some point going forward, driving additional return for some of my investments.
TER: Let's talk about some of your fund's equity holdings. One company in your hedge fund is Cabot Oil & Gas Corp. (NYSE:COG). It's trading at around $35, which already exceeded a target price set by Macquarie Equities Research. J.P. Morgan has a target of $50, but Oppenheimer has mixed opinions about Cabot. What do you see in the company, and how high do you think it could go?
JY: Cabot has traded down a lot over the past few months, after receiving a lot of negative press about its operating activities in Pennsylvania. My understanding is that the company's operations are not substantially different from other Pennsylvania operators. Cabot just happens to be in Susquehanna County, an area with a very high visibility, and the people there are concerned about the water supply. I think that negative news about Cabot has scared investors. Large investors are reducing their positions or not increasing their positions as much as they would have relative to Cabot's intrinsic value.
Cabot is really in the core of the dry gas window in the northeast. It's in an area of the Marcellus Shale where it and the operators around it have achieved some of the highest and most impressive initial production rates on their wells. Cabot is highly economic even at current gas prices. It has high-quality management, too. I think it's attractive just because it's been picked on so much. To be able to buy a low-cost natural gas producer in the U.S. at a discount to its intrinsic value is extremely rare.
TER: Are there some catalysts there that you're eyeing?
JY: There are a few things going on. First, there's industry consolidation. Atlas Energy, Inc. (NASDAQ:ATLS) recently got bought out by Chevron Corporation (NYSE:CVX), and EXCO Resources Inc. (NYSE:EXCO) is in the midst of a take-private transaction that may not close but is priced much higher than Cabot's current market valuation. There have been a number of deals in the Marcellus, joint ventures (JVs) and acquisitions over the last few years at generally increasing prices. Cabot hasn't done a JV yet in the Marcellus, but it may at some point. The company may even get bought out—it's in the core of the Marcellus. If I were a big multinational oil company and I wanted a large position in the core of the Marcellus, I would buy Cabot or go to the company and make a really attractive JV offer. That's a harder to predict catalyst from a timing perspective; it's something I think may happen over the next couple of years.
Nearer term, it looks as though Cabot is going to monetize a portion or all of its Haynesville acreage. Based on other transactions happening there, I think that would be very positive and provide the company with additional liquidity.
Cabot's acreage is in great locations in the Eagle Ford Shale, and it looks like the company should expect some high return wells there. They are also in the Heath Shale in Montana and the things I'm seeing in the Heath Shale are positive so far. But I don't attribute a lot of value to Cabot's Heath positions right now. Like I said, I don't really invest based on exploration prospects; but it's always nice to have the upside. It's possible that the company could pull in a few good wells in the Heath and that would significantly differentiate it and possibly lead to positive movement in the stock.
TER: You mentioned Gastar earlier. That's an exploration and production (E&P) company with a market cap of about $200 million. A recent Canaccord Adams research report said, "Gastar is an attractively priced Marcellus producer given its relative growth potential." Canaccord has a buy rating of $4.50 on it. Meanwhile, Rodman & Renshaw has a target of $5.50 on Gastar. What are some of the catalysts there?
JY: Well, Gastar just did an acquisition but the stock doesn't seem to have priced in the value creation from that acquisition. The company hasn't announced the metrics on the transaction; but, based on the understanding of some of the research analysts that I've spoken with and some back-of-the-envelope math, Gastar just bought north of 50,000 acres at $1,000 an acre or less in the Marcellus. They bought it in the dry gas area, but in a very good area of West Virginia. That's tremendously positive for the company. There are some big questions, though. What is the exact price Gastar paid? How will they finance the acreage acquisition and development? And did their existing JV partner decide to participate with it in the acquisition, or will they seek an additional JV partner?
Gastar recently sold acreage to its joint venture partner at more than $4,000 an acre, and here it is buying similarly high-quality acreage at $1,000 an acre or even less. That's huge, especially for a company as small as Gastar. Gastar is now likely the most levered company in the Marcellus by enterprise value, at least among those that are publicly traded.
Gastar has really transformed itself to a certain extent into a Marcellus acreage play, and an extremely attractively priced one at that. This catalyst has already played out and it's just a question of the price the company is paying. I think the market will be further surprised by other additional upcoming catalysts, such as the results from their oily Eagle Ford and Glen Rose wells in East Texas—you could see upside to the $5.50 price target that Rodman & Renshaw put out, and I really respect the analysts at both Rodman and Canaccord. Rodman recently upgraded RAME and raised their price target, and I suspect that could happen for Gastar as these catalysts play out.
TER: You mentioned earlier that Chevron took out Atlas. The deal hasn't closed yet, but it's all but done. Atlas has a huge position in the Marcellus. Is that transaction affecting companies like Gastar? Are people adding a little extra value to such companies given the transaction?
JY: I think they should. I think it has affected companies like Cabot and Range Resources Corporation (NYSE:RRC), but I don't think it's affected companies like Gastar yet. I think it's important, even if I don't expect Chevron to buy Gastar or any major oil company to come in and buy a company like Gastar. It is important because Chevron's Atlas takeover is a validation of the play. I think it will give private equity firms and domestic and international oil companies more confidence in doing JVs in the area and buying companies to access their assets. I think it helps highlight Gastar's intrinsic value in the asset market even if it hasn't yet translated into a higher share price.
TER: Another company in your fund is GMX Resources Inc. (NYSE:GMXR). GMX increased proven reserves by about a quarter in fiscal year 2010 (FY10). And it recently subleased a number of drills to cut back on drilling in the Haynesville in order to reduce its capital costs. C.K. Cooper & Company has a hold rating on GMX, whereas both MKM Partners LLC and Stifel Nicolaus have buy ratings with a $6 target. Tell us about your outlook for GMX.
JY: GMX is interesting to me because it has a tremendous amount of proven natural gas reserves on its books and is in the process of reducing the cost of adding additional reserves. Relative to the company's enterprise value, you pay less than $1 per 1,000 cubic feet of proven natural gas reserves. A large portion of those proven reserves are developed and producing. The company is profitable right now—primarily because of its hedges—but it is profitable.
GMX has done a couple of things that have substantially increased the company's value and the value of its assets. First, it has significantly increased the amount of reserves it accesses with its Haynesville well. At some point a couple of years ago, GMX was booking 3–4 billion cubic feet (bcf) of reserves per well. Now it's up to somewhere around 6–6.5 bcf per well in reserves, with associated higher production. Based on the type of improvements the company is achieving, it could get reserves as high as 7–8 bcf per well, comparable to some other places in the Haynesville historically considered more "core" than GMX's area. These are $9 million wells, so GMX's finding costs are pretty low. It's not the lowest-cost producer, but the company has definitely improved its cost structure. That's one really big positive.
Another big positive is that it did a deal with Kinder Morgan Energy Partners, L.P. (NYSE:KMP), one of the big pipeline companies. GMX sold a minority interest in its gathering system in East Texas for more than $40 million. I think it was a 40% stake or somewhere in that range. GMX still has the majority ownership in that system. Valuations on mainstream and gathering assets have gone up a lot since that transaction. So GMX has what's probably a $60–$70 million asset that no one seems to be giving them credit for. The company's valuation is very low because people are worried it will outspend its cash flow. Yet, it has this asset that it will be able to sell to fund its development, increasing expected future reserves and cash flow. When GMX sells that gathering asset, it's really going to unlock value there. It will highlight how discounted the stock is relative to its fundamental value. And this is the kind of discount I look for and the kind of misunderstanding I take advantage of for my fund.
TER: What are some of your other holdings that you'd like to talk about, Josh?
JY: One of my largest positions that has done fairly well recently, but still has a lot of upside potential, is RAM Energy Resources (NASDAQ:RAME). RAME has a number of more mature oil assets, primarily in Texas and Oklahoma. They also have an oil field that they recently did some exploration work on and achieved some really positive results. Their stock is attractive because it is trading at a large discount to its proven reserve value, at a low cash flow multiple, while benefiting substantially from the above $80 price of oil. RAME's enterprise value/BOE is effectively ~$11/BOE, or $11 per barrel equivalent of energy in its proved reserves, which is substantially lower than the going rate for other oil stocks and in the asset market.
On the surface, RAM appears to be overleveraged, but it recently did an asset sale for more than $40 million. The asset they sold appears to have been one of the company's weakest assets. It was a high-percentage natural gas field that was providing a relatively small amount of cash flow to its value. Even though RAM announced positive exploration results on a trend where SandRidge Energy, Inc. (NYSE:SD) and Chesapeake Energy Corp. (NYSE:CHK) have been very successful in a couple of counties west in Oklahoma, RAM's stock has not received much credit for the substantially improved liquidity position nor the recent exploration success. And given that the majority of RAM's reserves are in oil, the company continues to trade at a substantial discount to its proven reserve value, which was calculated at a lower oil price. So, there's even more value there that should be recognized in the market at some point.
TER: Any others?
JY: One more is Lucas Energy, Inc. (NYSE.A:LEI), a micro-cap company. It's a small position for me, partly because it is not the most liquid stock and is a small company, but it's definitely one of the more interesting oil and gas companies. The company is entirely in the Austin Chalk formation and the Eagle Ford Shale. Lucas did a JV with Hilcorp Energy Company, a private company, whereby Hilcorp is going to drill a number of Eagle Ford oil shale wells. Lucas is getting carried on the first couple of wells, and they are going to maintain a 15% interest.
Lucas is currently producing 120 barrels of oil per day (bpd), so it's a very small amount of production. These Eagle Ford oil wells are coming on at anywhere from 500–1,000 bpd, so the company should have one well in production before the end of the year; and it should have a couple of additional wells in the first quarter of next year. Lucas could more than double its oil production just from these first wells that Hilcorp is bringing on. And it has a number of other locations that Hilcorp will be drilling over the next several years, and has recently acquired additional Eagle Ford acreage at prices that were likely compelling. At oil prices north of $80, Lucas' oily Austin Chalk wells should be highly economic. You could expect the company to accelerate drilling there and increase production at very attractive margins in a play that was less attractive at that lower oil price. Even though it's still very small, it's still an interesting company.
As you can see, my investment process entails finding value and taking advantage of misunderstood opportunities, and there are a number of attractive opportunities that I've found recently in the oil and gas space. It takes a lot of research and involves developing an understanding of the companies, but it is worthwhile in terms of the opportunities it generates for attractive risk-adjusted return investments like some of the ones I've mentioned.
TER: Thank you, Josh for your time today.
Joshua Young is the founder and portfolio manager of Young Capital Management, LLC, which launched Young Capital Partners, LP in September 2010. He previously served as an analyst at a multibillion-dollar single-family office in Los Angeles, which was nominated for single-family office of the year by Institutional Investor magazine in 2008. At the family office, he was involved in the sourcing, evaluation, purchase and sale of primarily public equity investments in a value-oriented long/short equity strategy. He also led the energy investment effort, evaluated third-party investment managers and assisted in the development of this relatively new, multibillion-dollar family office. Prior to that, he was an investment analyst at Triton Pacific Capital Partners in Los Angeles, a middle-market private equity firm. And before Triton, Josh was a corporate strategy consultant at Mercer Management Consulting and DiamondCluster in Chicago. He graduated with honors from the University of Chicago with a BA in economics. Josh can be reached at [email protected].
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1) Brian Sylvester of The Energy Report conducted this interview. He personally and/or his family own shares of the following companies mentioned in this interview: None.
2) The following companies mentioned in the interview are sponsors of The Energy Report: Atlas and Ram.
3) Josh Young: I personally and/or my family own shares of the following companies mentioned in this interview: Cabot, Gastar, RAM Energy, GMX Resources and Lucas. I personally and/or my family am paid by the following companies mentioned in this interview: None. I reserve the right to buy or sell any stocks I have mentioned here at any time.