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Andrew Coleman: E&Ps with Margins for Error
Source: Brian Sylvester of The Energy Report (2/1/11)
Andrew Coleman, E&P analyst with Madison Williams & Co., believes that reserves and production growth, especially in liquids-rich oil plays, will continue to drive the share prices of E&Ps even higher. In this exclusive interview with The Energy Report, Andrew provides you with his favorite oil and gas names for 2011, as well as some others with margins stout enough to withstand just about anything the market throws at them.
Andrew Coleman: Madison Williams is effectively the private spinout of the institutional equities business of Sanders Morris Harris Group Inc. Madison Williams was spun out in December 2009, and I joined the firm in May 2010. I was brought in from UBS to spearhead E&P research. At this point I work with one other individual, and we will try to get more than 20 companies in our initial build-out of E&P research. We will then probably bring in some additional help to take us north of 30 companies. We're trying to build a pretty detailed E&P research franchise from the bottom up. Additionally, within the energy vertical, we cover oilfield services and master limited partnerships. Other verticals for Madison Williams include healthcare and coverage of OTCQX-listed companies.
TER: Your investment thesis among the E&P names for 2011 is that reserves and production growth will drive E&Ps higher. With that in mind, you have raised your price targets on 11 of those 14 E&P companies. Could you give us your outlook for 2011 and tell us more about that thesis?
AC: In modeling an E&P company, I focus a lot on its operational integrity and cash margins. First off, I use the forward curve for input commodity prices—as that's the best proxy for where the market thinks commodity prices will go. The key idea that we're seeing out there—and it's been around for at least the last six months— is that the move toward liquids and oil plays is driving E&P returns. To the extent that commodity prices may be higher or lower than the forward curve, I can build those sensitivities into my models. But my bullishness on the space is based on the fact that gas prices are better heading into this year's reserve-reporting cycle than they were last year, and this will be the second straight year that oil prices have been stronger.
Overall, on the reserve side, I expect companies to be able to book more barrels in their undeveloped as well as proved developed reserve profiles. That should drive value, even though short-term margins might be a little bit more pressured on the gas names.
TER: What oil price is that forward curve modeling for 2011?
AC: For 2011, the curve is effectively a little over $90/barrel for oil and about $4.50/MMBTU for gas. On the sell side, and (according to investors I have spoken to) on the buy side, there's a lot more negative bias on gas in the short term, somewhere closer to $4/MMBTU. As we roll through the year, it is entirely possible that gas may not hold at the $4.50 level but given the forward curve, companies continue to hedge at that level. That's giving me a little bit of comfort. Additionally, winter weather and the unfolding situation in Egypt are adding near-term support to commodity prices.
TER: China is making some significant attempts to put the brakes on its overheated economy. Are you concerned that these moves will impact the oil price?
AC: Certainly, oil is a commodity as well as an inflation hedge for people looking at the space. We have high oil inventories, and we have high gas storage inventories. Should global macroeconomic expansion slow or come under pressure that would certainly have at least a short-term impact on commodity prices, especially oil.
However, when I look at the cash margins for the oil companies that I cover, many of them have margins of $35–$40 per barrel. Even if commodity prices were to pull back on the oil side, say to $60, the margins would still be better than what many of the gas companies are seeing now, even with gas at the $4.50 level. I am not worried about oil in the short term, unless we get a pullback significantly below $60.
TER: Your two top picks on the oil side for 2011 are Whiting Petroleum (NYSE:WLL), with a Buy rating and a price target of $142, and GeoResources Inc. (NASDAQ:GEOI), which also has a Buy rating and a price target of $30. Could you tell us about those two names?
AC: When I rank my companies, I'm looking at the cash margins, the EBITDA (earnings before interest, taxes, depreciation and amortization) margins and debt-adjusted production growth to get a sense of things. Effectively, do these companies have the balance sheets and the margins to justify drilling for more than the current year?
The main reason why Whiting and Geo are my favorite picks is that the Bakken oil shale is white-hot in terms of sex appeal and intensity because of the quality of the wells being drilled there. Companies with exposure to that play have really outperformed recently. Secondly, the oil shale business model is relatively new. I think you can make the argument that the Bakken has some of the flavor that the Barnett Shale had a couple of years ago. While investors are starting to look for new oil shales like the Niobrara, Utica, Eagle Ford or Tuscaloosa Marine, we don't know if all of those will be as prospective for oil as is the Bakken. It's far easier to step out on the Bakken and develop more acreage than it is to find a whole new play. Recent M&A in the Niobrara has signaled that play may be ready for "prime-time" too.
Whiting and Geo also have strong cash margins, very low debt, low proved undeveloped (PUD) reserves in their reserve make-up and good acreage positions. Whiting has over 900,000 gross acres and about 580,000 net acres, of which 470,000 are undeveloped. That puts the company in a top-five Bakken acreage position. Geo has 46,000 acres; and given its small-cap size, is also relatively well positioned.
On a comparison basis, Geo trades at about 70% of the multiple of an Oasis Petroleum Inc. (NYSE:OAS) or a Brigham Exploration Co. (NASDAQ:BEXP) and yet, six months ago, Geo and Oasis were about the same size in terms of production. As investors look for the next set of names with the capital and the management wherewithal to develop and accelerate activity in the play, Whiting and Geo are two names that can benefit by putting more capital to work there.
TER: At least on the gas side, the long-term production rates in these hydraulic fracturing plays don't match the early production rates. In fact, the depletion rates tend to go up quite dramatically as production continues. Are you worried about that?
AC: I think it's a good data point to consider. Initial technological improvements always have their fits and starts. What ultimately gives me comfort with names like Whiting and Geo is that as the play matures, the key is who has the ability to generate the economies of scale to grind down their costs across their acreage positions. As we get well data from the entire play and as more wells are drilled, I would expect players like Whiting and Geo, which have those good cost margins, to be better insulated should the price environment deteriorate.
In addition, they have big enough acreage positions that as they start locking up drilling rigs to develop their core positions, they have the size and scale to command the best rates from the service companies. GEOI is partnered with Slawson (a private E&P company in the Bakken) one which has earned high marks from industry for its operational acumen in the play as well.
TER: Tell us more about those margins.
AC: The EBITDA margin in the gas peer group is somewhere around $4.50 per Mcfe and in the oil peer group, the average is almost $8. Using a 6:1 energy equivalence, that translates into $48 per BOE for the oil companies. Thus, on average, the oil peers are almost double their gas peers on a cash-margin basis, which gives me some comfort in that we can see a material reduction in oil prices before we would start seeing margins that are on par with the gas names. If you look at Whiting, in particular, it's just above that average in the oil peer group at about $8.25. Geo isn't quite as heavily oil-weighted as is the rest of my peer group. Geo was at 55% oil at 2009 year-end. But as a comparison, over the last two years, Brigham's asset mix went from about 70% gas to about 25% gas. So my expectation is that as Geo ramps up its spending on its core Bakken acreage, it will have a similar sort of move, and its current 55% oil weighting will get much closer to 70% or 75%.
TER: Your top picks on the gas side are Cimarex Energy Co. (NYSE:XEC), which has an Accumulate rating and a price target of $100 and QEP Resources, Inc. (NYSE:QEP) with a Buy rating and a price target of $41. Tell us more about those names.
AC: QEP and Cimarex have the highest cash margins of the gas peer group. It seems likely that the price ceiling for natural gas is not going to go materially above about $5 in the short to medium term, so it's about which companies have the best ability to maintain their margins. QEP and Cimarex, by virtue of having a higher percentage of liquids production in their production streams, and in QEP's case, the fact that it owns gas processing plants in the Rockies, have more ability to extract value from their operations.
Cimarex has an Accumulate rating because I recognize that the management team is one of the most disciplined in the space. You won't ever hear them talk about production growth for production growth's sake, or F&D costs for F&D costs' sake. Their mantra is "we generate positive returns." In 2008, Cimarex was a top-ten driller in the U.S. from an activity standpoint, but once gas prices pulled back, it went from operating 43 rigs to operating three. They're now saying that they will drill a lot more in the Permian Basin in 2011 and continue to go after more liquid-rich plays. I like that kind of discipline.
TER: What if gas prices weaken again?
AC: While there is concern that gas prices may soften, Cimarex would likely cut back on spending if the market dictates it. The company also has an asset mix that insulates it from most of the storms that could roll through. That gives me confidence that Cimarex will continue to generate value and shareholder price appreciation. On a multiple basis, my target price represents a 6x Enterprise Value (EV) divided by EBITDA multiple; that would be lower than some of the heavily weighted gas peers, but Cimarex's cost margins are much closer to the oil peer group. I think the argument could be made that given those margins, they could trade much closer to an oil peer, where the EV by EBITDA multiple may be 7x or 8x or even 9x, which would then justify a materially higher target than my current $100 price objective.
And for clarification, the reason that I prefer EV is that oil and gas companies tend to utilize leverage. We use enterprise value because it's the market cap plus the debt, vs. price to earnings (P/E) multiples, for example.
TER: Let's go back to your investment thesis for a minute. What are some companies poised to book substantial reserves in oil and gas in 2011?
AC: As I look across my reserve matrix, the companies with the best proved developed producing (PDP) replacement ratio on the oil side are Oasis Petroleum, Concho Resources Inc. (NYSE:CXO) and Brigham. Those are all Bakken and Permian Basin oil players.
On the gas side, you're looking at Petrohawk Energy Corporation (NYSE:HK) because of the Haynesville Shale exposure and their large Eagle Ford Shale presence. And Energy XXI (NASDAQ:EXXI) is a Gulf Coast E&P company that just purchased about $1 billion in properties from Exxon Mobil Corp. (NYSE:XOM). These are high cash-generating assets that were starved for capital under their former owner. Now, Energy XXI is deploying its cash flow to these underdeveloped assets. In the short term we should see a meaningful improvement in their reserve booking, as well as their production from operations. Energy XXI reports on a fiscal June year-end, so we're a few months from seeing that data. Energy XXI did a reverse stock split in January of 2010 and in September they cleaned up their balance sheet and issued some new equity. The company is well positioned as the biggest oil producer on the Gulf of Mexico shelf now. That creates a lot of opportunity for investors looking for the high cash flows that the Gulf of Mexico companies can generate.
TER: It seems Energy XXI is on something of a buying spree. It also bought out its non-operating partner, MitEnergy Upstream LLC (MitEnergy), a subsidiary of Japanese firm Mitsui & Co. Ltd. (NASDAQ:MITSY).
AC: Yes, MitEnergy was a working interest partner in many of Energy XXI's older fields and MitEnergy wanted to monetize those assets. A month later, it turned around and bought into the Marcellus Shale play. I believe buying those assets outright was a great deal for Energy XXI because the company added working interests to its existing operations, without taking on additional staff, facilities or pipelines.
TER: Looking at the chart, Energy XXI has been on an upward trajectory since.
AC: Yes, they also have 15% of the Ultra Deep Shelf trend, which is a new play being tested by McMoRan Exploration Co. (NYSE:MMR). Energy XXI and McMoRan are the biggest leaseholders in that trend. Energy XXI has 15%, McMoRan has 60% and the remaining 25% is spread out between a couple of different companies and a private investor. That play has been driving shares for both companies over the last 12 months, with data points from the three wells currently drilling on the way. In the short to medium term, Energy XXI has additional core assets to fall back upon. Certainly Energy XXI benefits from both the organic growth in operations and potential from the Ultra Deep.
TER: In a recent research report, you said, "E&Ps benefit once commodity prices rebound, and then spend the remainder of the commodity cycle competing with service companies for the remaining margin." That means margins are becoming increasingly important. Could you talk about cost inflation and other factors that are affecting margins?
AC: I made that point by looking at my projected F&D costs and reserve booking data for 2010. This data will be disclosed during the fourth-quarter earnings cycle that will happen over the next four to six weeks as companies disclose year-end reserve information. When commodity prices move upward, the resulting cash flows from producing each unit of production grows and companies are then able to book more reserves.
Here is how it works. Once companies have that higher reserve value, banks can lend against that amount. Investors see that value and get excited about the ability of those companies to use that money to accelerate value creation. Once value creation starts accelerating, it becomes a question of access to services. If it's a tight market for services, as we're seeing in plays like the Bakken, the question is, "how much does each company have to pay in order to access those services?"
The E&Ps first see any upward trend in the commodity cycle in the reserve data and that's usually supportive of the E&P stock prices. After that, it's about the duration of that cycle and that gives the E&P companies and service companies a chance to barter, if you will, for those economic "rents." We are already seeing that across many of the plays. The responses of the services companies to the needs for more rigs, more pressure pumping equipment, etc., will determine whether the E&P companies can retain more of that margin or shift some of those margins to the service guys.
TER: Can you name some companies that you haven't talked about yet that have margins large enough to absorb some unexpected cost appreciation?
AC: The best company on the margin side is Continental Resources Inc. (NYSE:CLR). From my math, Continental trades at a premium in line with Brigham and Oasis in the Bakken peer group, which also includes Whiting and GeoResources. I think Continental's cash margins are a little over $50 per barrel, which means with oil trading at $90, a little over half of that is going to their cash bottom line. That provides Continental with tremendous insulation should commodity prices fall. And it gives them a lot more flexibility as to where they invest their money.
Continental is already the biggest landholder in the Bakken, with 860,000 plus net acres. It also has 250,000 plus net acres in the Cana Shale Play in Oklahoma and 73,000 net acres in the Niobrara. Continental has the cash flow and the operational size to deploy capital across those assets and show meaningful production growth. The company is going to double oil production in the Bakkan in three years' time. For a company that is one of the largest oil peers out there, it's good to grow production that quickly without compromising its margins.
TER: What are you focusing on as we head deeper into 2011?
AC: I am focused on the returns, particularly on the gas side, because there is a huge visible supply that puts a lot of downward bias on pricing. On the oil side, it's a question of how quickly we would end up in that same environment if macro expansion runs out of steam. If that price picture stays positive, then one name you could look at as well is TransAtlantic Petroleum Ltd. (TSX:TNP, NYSE:TAT), an international E&P company trying to develop shale gas in Turkey.
There's lots of opportunity across the globe. We have a chance to look at a little bit of it here at Madison Williams. We believe 2011 is going to be an exciting year, and I am certainly happy to be a part of a growing business.
TER: Thank you for talking with us today.
Andrew Coleman has more than seven years of experience covering exploration and production and oilfield service companies. His industry experience spans petroleum and reservoir engineering, field operations, strategic planning and business development for BP Exploration and Unocal. Prior to joining Madison Williams, Mr. Coleman was a director in the energy research group at UBS. In Institutional Investor's 2008 All-America Research Survey, he was ranked for the Exploration & Production category and received honorable mention for Oilfield Services.
Mr. Coleman has been a member of the National Association of Petroleum Investment Analysts (NAPIA) since 2004 and the Society of Petroleum Engineers (SPE) since 1993. In addition to earning his MBA in finance and accounting, including a specialization in energy finance, from the McCombs School of Business at the University of Texas, he holds a BS in petroleum engineering from the Harold Vance Department of Petroleum Engineering at Texas A&M University.
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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: Energy XXI and Transatlantic.
3) Andrew Coleman: View Andrew Coleman's disclosure.