Amir Arif: Bet on Low-Cost, High-Volume Shale
Source: Brian Sylvester of
Stifel & Nicholas Oil and Gas Analyst Amir Arif believes
cheap natural gas prices shouldn't keep you from making cash in the
gas space. Arif says it's all about companies with production
growth in low-cost shale basins. "Find the companies that are in
these low-cost basins so that you know they have a good margin,
regardless of whether gas is forecast at $4, $5, or $6. . .don't
make a bet on the commodity, which is what we're seeing. Gas
doesn't have positive drivers behind it. You want to make a bet on
the volume without diluting the equity," says Arif, who provides
some of those names and the reasons behind them in this exclusive
The Energy Report.
The Energy Report:
In a February 2010 research report, you said drilling related
to acreage expiration concerns will increase relative to last year
and continue to result in more drilling/supply than what the gas
price should be signaling into 2011. Does that mean investors
should take a serious look at the drilling companies as a way to
play the gas market?
That is one way to do it. I do think the margin in the
drilling activity should be improving, and the level of activity
will be higher than what the commodity prices would suggest. But
the better way to invest in the space, in my view, is to find the
companies that are in these low-cost basins so that you know they
have a good margin, regardless of whether gas is forecast at $4,
$5, or $6. The bigger question is: does the space have volume
growth behind it? Don't make a bet on the commodity, which is what
Gas doesn't have positive drivers behind it. You want to make a
bet on the volume without diluting the equity. And that's something
that was difficult to do in the past; I mean I've covered the space
for over 10 years and worked as a petroleum engineer before that.
You just could never grow your volumes in the double digits without
having to issue equity, unless you got lucky and had great
What's allowing that to happen now?
It's these shale plays! Technology unlocked them, and they're
coming in right at the low end of the cost curve. It's changing the
entire dynamics of the gas market. Marginal supplies still need
$5-$6 gas. But if you're in the Marcellus Shale, where it's only $3
to break even, that's all you need; your excess cash flow is
dramatic. And in this space, you've never had free cash
In another report you said, "On average, undeveloped acreage
expiring as a percentage of total undeveloped acres held will
increase from 11% in 2009 to 16% in 2010 and 20% in 2011." Why is
this a problem? And does it create opportunities for companies to
Well, it's a problem because people are going to produce more
gas than what the economics are telling us to produce. And that's
what we're already seeing as rig counts continue to move up, even
when gas in January went from $6 all the way to March when it
dropped to $5. So, basically, people are drilling more than what
the gas price is signaling, in terms of demand. That's why it's a
problem; it's causing a bubble in gas supply.
But it's a short-term problem, a problem through mid-2011. Does
it create an opportunity for companies? It's creating an
opportunity for a lot of the international integrateds that have
deep pockets. They would like to move into these shale plays,
because, again, a lot of this acreage needs to get drilled. They
can bring the capital to make sure it gets drilled before it
Have you seen that happening?
Yes, we've seen
Total S.A. (
; we've seen a handful of integrateds already in the
Chesapeake Energy Corp. (
Statoil ASA (NYSE:STO; OSE:STL)
Mitsui & Co. Ltd. (
-a lot of them.
Have some of those companies become better investment
opportunities than they were before this happened?
It changes the outlook for companies holding the acreage
because you've got a greater comfort level that they will be able
to hold on to that acreage, and you've got more visible funding. So
you're able to be a little more comfortable with growth projections
going forward for that company. But, again, the growth for one
company isn't necessarily great for the industry as a
What is Stifel & Nicholas projecting for the gas price to
the end of this year and to the end of 2011?
As an average, we're looking for $5.20 gas in 2010, moving up
to $5.75 next year and then long term, $6 flat by 2012.
But even though the gas price isn't going up much in the
short term, you're seeing companies refusing to reduce capital
expenditures, and instead they're allocating capital to
higher-return projects. A couple of examples are projects the
Marcellus and Eagle-Ford plays. What are some companies with heavy
exposure to those?
That's a good point. You haven't see them cut back drilling
and you mentioned a couple of areas where they're putting capital,
but it's not just because those plays are good, it's also because
that's where the some of the acreage-expiring issues are-the
Haynesville's another one. One of our favorite names with exposure
Atlas Energy Inc. (
. Another favorite is
Cabot Oil & Gas Corp. (
. Other companies with a lot of exposure out there would be
Range Resources Corporation (
Ultra Petroleum Corp. (
Rex Energy Corp. (
Let's start with Atlas.
Atlas is our favorite idea in the Marcellus because they
recently did one of these joint-venture deals with Reliance
Industries Ltd., an Indian company, for $1.7 billion. It was a high
marker in terms of what people were receiving in dollars per acre.
We know they're sitting on some sweet acreage. We now know they
have good funding available, meaning no equity dilution needed to
get the growth going. And it's also a company where we see a huge
discount between the stock price and what we think the underlying
value of the company is. That's why that's our favorite.
The other one is Cabot, and the reason we like that one is more
because of where they are; they're in the northeast
Northeastern Pennsylvania (
The NEPA, that's right, and that's where the play gets
bigger; the Marcellus actually breaks into two different zones. You
have the potential to have twice as many locations in the NEPA
versus someone in the southeast part of the Marcellus or the
southwest part of the Marcellus. They are just sitting on a great
location; they've already got the production going, increasing by
15%-20% a year, and we see that production staying in the 15%-20% a
year range for the next five years, all funded with cash
Range is probably the darling in the marketplace right now
for the Marcellus exposure, but that's the reason it's "market
perform - neutral" for us; it's just the valuation. Range
definitely was the first one in the play; they have one of the best
track records in the play. It's just the valuation that keeps it on
the sidelines for us. Atlas and Cabot, in our view, are more
attractive when you look at the stock price and the
Ultra Petroleum. That firm was successful in Pinedale
production in the Rockies. They moved into the Marcellus about
three years ago and they're getting some terrific results. So
you've got the Pinedale giving you a solid base growing in the
single digits, and then you layer on top of that the Marcellus, and
all of a sudden you've got a company with some pretty solid growth,
and again two very low-cost operations-the Pinedale and the
A May research report from your firm concluded that
"producers with materially lower hedged volumes in 2011 vs. 2010
should relatively underperform and unhedged names with clean
balance sheets should relatively outperform." What are some of your
favorite unhedged names with clean balance sheets?
The two names that we really like from that angle would
Southwestern Energy Co. (
Comstock Resources Inc. (
. If you go back over the past four to six months, the companies
that were more unhedged when gas started rolling down were punished
the most; so Southwestern and Comstock both materially
underperformed the rest of the index in the past six
But at this point, when you start looking from 2010 to 2011,
whether you're hedged or unhedged you don't have that great of a
price advantage, whereas in 2009 it was a very big difference. If
you were unhedged, you were getting $4-$5 for your gas, while other
companies had great hedges of $7-$8. That's a big difference in the
cash flow you would receive. But when you go to 2011, even the
companies that are hedged, they're only hedged in the $5-$6 range,
and if you look at where the futures are, it's in the $5-$6 range
as well. The unhedged names have already relatively underperformed;
the disadvantage of being unhedged isn't such a big disadvantage as
you move over to 2011. We think the relative underperformance will
catch up for those two names.
Some investors are looking for opportunities in the small cap
space. What are some companies that you're following there?
Comstock is definitely a name we like in the small cap space;
it's a Haynesville producer, again relatively unhedged, a quality
management team. They don't have to drill just to drill, and they
have a good valuation, and a good asset base.
The other name that we like that we upgraded recently is
Bill Barrett Corporation (
. That's a small cap name that we think has been overlooked by the
marketplace, primarily because it's a Rockies producer; it doesn't
have a sexy shale play to talk to the Street about. It's a
conventional company, and the biggest issue for them has
been-they've always been cheap on an valuation basis-they've been
waiting on an environmental impact approval at the federal level
before they can start drilling their key asset. We believe that
should come in by August or September, and when that comes in this
company will start to grow production dramatically in 2011 and
I was reading several of your research reports and BBG kept
coming up in a number of favorable categories in your charts. But
you weren't trumpeting that stock at that point. I think that might
have been in May.
That's right; at that time and over the past 12 months, to us
it was more of a valuation trap. It looked very cheap, but there
was nothing in place to change the valuation. To us it was just a
value name that would stay as a value name. But once the
environmental impact final approval comes in, which it is expected
in August/September, production should finally start growing
dramatically. And that's what changed our outlook.
How much of a factor are the natural gas liquids now? If
someone has significant assets with a lot of liquids in play are
they getting value for that in their share price?
Companies are starting to push that angle and you see
companies trying to increase their liquid weighting. I think they
realize there is plenty of gas, so the only thing that's really
going to change the price long term is new sources of demand. And
the economics get better when you add liquids to the mix.
But from our perspective, people have already bought into the
liquids-rich gas plays and the risk is that NGL (natural gas
liquids) pricing will come down. If you look at the NGL stream,
most of the value comes from ethane, and if you look at ethane,
it's more of a localized market, certainly not an international
market like crude oil. In the U.S., the key drivers are really
autos and construction. Until you see significant pick up in energy
demand, everyone chasing these liquid plays is going to cause too
much NGL production, which is going to bring the NGL pricing down
for next six months.
For the next six months?
Yes, so the economics will still be better relative to dry
gas, but they're not going to be as good as they look today. But I
just want to point out one thing. We do actually think the gas
price could surprise to the upside over the next month or two. It's
just because there is such a huge short position on gas because
everyone knows there's too much supply out there, but what you also
have is increased forecasts calling for hot summers and high
hurricane activities. I wouldn't be surprised if gas actually has
more upside than downside over the next couple of months. When
storage gets full, gas will definitely have to come back down for
the cash prices. But short-term gas could still surprise to the
Are there any companies poised to take advantage of
short-term gas prices?
I think those are the unhedged names, Southwestern and
Comstock. People have changed their outlook on those a little more,
at least for the cash flow that they're thinking they can
What are some companies that have their costs in check,
strong balance sheets and are always boosting their efficiency as a
means of becoming more profitable in this gas price
It's something you've seen in all the plays as people move up
the learning curve. You either get more efficiencies or you'll go
back to doing what you were doing. But the more recent improvements
have been in the Haynesville and the Marcellus, and we will see it
in the Eagle-Ford over the next 12 months. Right now, people are
still doing a lot of testing in the Eagle-Ford wells; more logs,
more coring, to get a better sense of what they have, but the well
costs are sitting closer to the $6-$7 million range, but as they
start approaching more of a manufacturing approach, those costs
should go closer to $5 million.
What is the average cost of a well?
In the Eagle-Ford today it's probably close to $6-$7 million,
but it's going to get to $5 million. In the Marcellus, it's $3-$3.5
million. The Haynesville is where you need deeper pockets; those
well costs were $12 million in mid-2008; they dropped to $8-9
million in the third quarter of 2009, which was the bottom. Now
they've moved back to the $10-$10.5 million range.
What about some oily names out there?
A lot of the oily names have already dramatically
outperformed, just because oil fundamentally has held up a lot
better than gas with a tighter supply situation. The one name that
we don't think has outperformed as much and still has plenty of
upside would be
Pioneer Natural Resources Co. (
. It's one of our three favorite names; they're 50-50 in terms of
the gas/oil mix, but about 75% of their capital is geared toward
oil, and it's all in the Permian, an older basin. The Spraberry
Field has been in production for over 40 years, probably will go
for another 40 years. It's very low risk, just great cash flow
margins, given the oil price.
You said it was one of your three favorite names. What are
the other two?
If you want a low-risk name, Bill Barrett Group is our
favorite just because it's got a very cheap value to it and that
should support the stock price where it's at. If you want to take a
little more risk, PXD is the next name worth going to. And, again,
it's the high free cash flows you get from their Spraberry field,
plus the Eagle-Ford upside, and they're in the process of doing a
joint venture in the Eagle-Ford. That should get announced soon,
and that should allow them to start accelerating their Eagle-Ford
development plans. If you're willing to take higher risks, then
Atlas is a name worth looking at, but over there I would say have
at least a 12-18 month timeframe to invest in that.
Any final thoughts on the oil and gas market?
Oil has better supply/demand fundamentals on the macro side.
So if investors are looking at oil, they want to be looking at the
high free cash flows, and that is what oil gives you. But if you're
looking at gas, focus on the names with low-cost production
sources, and the names that can grow volumes without diluting
equity. If you do that, you'll have a winning combination on both
Amir Arif joined the Stifel Nicolaus research team in April
2009. He has more than 15 years of experience in petroleum
engineering, investment banking, and investment research of the
energy sector with a focus on upstream oil and gas companies in the
U.S. and Canada. Mr. Arif received his BSc in petroleum engineering
with distinction from the University of Alberta and his MBA in
finance from the University of Calgary. He also holds the CFA and
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1)Brian Sylvester of
The Energy Report
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3) Amir Arif: Stocks mentioned: RRC, SD, SU, SWN, UPL, CRK, XCO,
XTO, ATLS, BBG, CNQ, COG, CHK, CLR, EQT, HK, NFX, FST, GMXR, PXD,
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