Natural gas has for a long time offered the potential of being the “bridge” fuel; the link between today’s reliance on dirty fossil fuels (such as coal and oil) and the renewables of tomorrow (solar, wind, biofuels) which aren’t yet remotely capable of meeting our energy needs without substantial advances in technology.
The U.S. possesses 100 years of natural gas supply thanks to huge reserves of shale gas which are now more readily accessible thanks to horizontal drilling. Natural gas is cleaner than other fossil fuels, cheaper (by two thirds) on an energy equivalent basis than oil, and it’s here in the U.S. and not in the Middle East.
The success of shale gas drilling has depressed prices and the profits of E&P companies. But low, stable prices have only served to increase its attraction to utilities planning the next generation of power plants. All that was missing was the catalyst to shift energy production towards this fuel. Meanwhile, investments in pure-play natural gas E&P names with modest levels of debt and low operating costs continue to be the best way to position for the opportunity, since timing is uncertain.
As we’ve written before, Range Resources (RRC) has among the lowest finding and developing costs around at $0.71 per MCF, and has potential reserves of up to 50 TCF. This represents over two years supply for the entire U.S., and while these reserves are potential not proved, at a $1 per MCF profit margin this would represent $50BN of pre-tax cashflow to RRC (compared with a market cap of $9BN). RRC’s reserves are also in the Marcellus Shale in Pennsylvania, conveniently located near large population centres in the north east with virtual year-round heating and cooling needs. We like other similarly focused names, such as Southwestern Energy (SWN), Ultra Petroleum (UPL), Petrohawk (HK) and Comstock Resources (CRK).
Indeed, some of these names are possible takeover candidates. CRK is relatively small with a market cap of $1.4BN. Their drilling activities are in the Haynesville Shale in East Texas and the Eagle Ford Shale in South Texas, and while their production hit a speed bump in 2010 due to shortage of equipment they expect to be back on track this year. Their costs of production are $2.70 per MCF, (only UPL and SWN are lower according to CRK).
The market has been concerned about CRK’s ability to fund its capex needs this year and next, but through sales of non-core assets such as the 3.8 million shares of Stone Energy (SGY) worth $111 million they own, operating cashflow and drawing down on their revolving line of credit they expect to meet this year’s $522 million of capex without issuing equity. In terms of valuing the company based on its reserves, the numbers look like this:
Cash & Equiv
*Discounted at 90%, the most conservative assumption that allows reserves to be classified as Potential.
** Based on current $4.25 MCF price
*** Based on $5 MCF price since timing of production is farther out on the curve.
Meanwhile, many market participants are betting the other way. 9.3 million CRK shares are short, versus an ADV over the past three months of only 884,000 (although the past 10 days it’s risen to 1.37 million). Being short companies like CRK at a time when Japan’s earthquake/tsunami/partial meltdown are causing majors to reassess long term energy needs seems like a short route to ruin.
Needless to say, events in Libya further illustrate the folly of relying on Arab plutocracies to set the price of fuel. And today, even the New York Times weighed in, arguing the benefits of natural gas. The potential environmental dangers of shale gas drilling they wrote about a few weeks ago, while certainly valid, now appear as quaint concerns relative to the risks of a nuclear meltdown.
It might be interesting to watch the shorts in small, thinly traded CRK scramble to cover as the market reassesses the energy landscape.
Disclosure: author is long RRC, SWN, UPL, HK, CRK
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