Rehan Rashid: Shales Spur New Supercycle of Energy
Source: George Mack of
The Energy Report
Over the next two decades, liquid and natural gas shales could
release a treasure trove of new energy production. But even given
this extraordinary new resource, FBR Capital Markets Head of
Energy and Natural Resources Research Rehan Rashid expects demand
to stay ahead of supply. Rehans's long-term bullish scenario
favors a few select names that he shares with
The Energy Report
in this exclusive interview.
The Energy Report:
Your coverage universe is mid-cap to very large, and I even see a
couple of companies under a billion dollars in market cap. Could
you tell me your basic investment theory?
We believe an energy supercycle is redefining how we look for oil
and gas, thus driving reserve and production growth the likes of
which we have already seen in natural gas and are now seeing
unfold on the liquids and oil side. And yes, this is applicable
to small cap names, perhaps sometimes more dramatically like
we're seeing in
Rosetta Resources Inc. (
Your list looks to be largely tied to commodity price and perhaps
I'm kind of a commodity agnostic. Instead, we are margin-driven.
It's all about margins and what's currently priced into the
stock. It could be oil, gas or something in between. We are more
focused on the platform-the acreage position or the capital
structure that goes into a good bottom up thought process.
You just mentioned your supercycle thesis. We've already gotten
the low-hanging fruit from conventional drilling, but you believe
we're getting this new supercycle of energy from the shales? Is
Yes. U.S. natural gas production quadrupled from 15 billion cubic
feet per day (Bcf/d) in 1950 to more than 60 Bcf/d of dry gas by
1970. That's kind of when the last paradigm shift finally played
itself out and we discovered a lot of what was then known as
conventional gas. So, it's our estimation that yes, history is
repeating itself under a different name.
And this momentum is driven by new technology.
Absolutely. The question in the investor's mind is no longer
whether this new reserve or production growth is really
happening, but rather what is its magnitude and what is the path
that it might take? Also, how fast will this technology
facilitate the harder stuff, such as oil shales or liquids
development, including processing and all the other above ground
How long can this supercycle last?
The answer to that question is probably two-fold. First, we need
to know how long it will take for growth to play out. Second, we
need to know how quickly the market will recognize the value.
Natural gas production took 20 years to quadruple from 15 Bcf/d
to 60 Bcf/d in the last go-round, right? So, physically speaking,
it may take a long time-a decade, two decades-to get the
appropriate volume of oil and gas out of the ground. But the
market will stay multiple years in front of that. The market
typically likes to stay 6-12 months ahead, but in a growth cycle,
it probably goes out 24-36 months. So, in my opinion, the overall
evolution of the trajectory of the growth is going to peak 10-15
years from now, and the stocks will price in 12-36 months going
forward at any given time.
Okay, in light of that, you've lowered your full-year price
forecast on natural gas from $5/mcf to $4.80/mcf, but you're
maintaining your 2012 forecast at $5.50/mcf. Why wouldn't this
I presume you're alluding to the idea that the existing supply of
natural gas may result in pressures at these levels or even
That's my question, yes.
That's a complicated question with a lot of inputs that will
drive gas prices higher going forward. In the middle of 2008 and
early 2009, we were the first ones to lower the long-term price
to $4.50/mcf. We saw what was happening two years ago and said
that gas prices would have to correct to these levels before we
can talk about any change in direction. We saw that two years
ago, but now we're trying to look further out.
What we're seeing slowly but steadily now is that the market
is responding. Chemical companies are coming back and power
generation companies are favoring more and more natural gas.
Plus, environmental regulations are making it more difficult to
burn coal. So, consumption factors are shifting to favor more
demand. In addition, what people forget is that yes, while shale
is going through a massive growth cycle, almost 40 Bcf/d of
existing supply is old, conventional assets that are seeing no
capital investment and is going to decline. I think between
improving demand, continued shale growth and declining
conventional supply, we will see a balance of supply and demand
leading $5.50/mcf gas.
What is your oil forecast?
Well, oil is a much tougher beast because of global drivers. It's
not lost on us that global spare productive capacity is too low.
We also see that global geopolitics are for real and manifest
themselves in a whole host of different ways. The future of the
dollar is under question. So, we will let the broader futures
market aggregate all that and come up with a pricing forecast. We
will take a 10% haircut off that and build it into our models. In
other words, we don't actively forecast oil prices, but we
understand the broader dynamics, and that's why we're okay with
letting the market set the direction.
From your perspective, is the price of oil U.S.
It is dependent on the U.S. dollar, geopolitics, tight spare
capacity and, of course, the continued globalization and
urbanization growth stories that come of out of China, India and
BRIC countries [Brazil, Russia, India, China] in general. It's
dollar; it's geopolitics; and it's economy.
We've seen some recent pull back in nearly all commodities. Could
this be a trend, or is it a normal part of the cycle?
Well, we went from $85/bbl oil to $112/bbl or so. At $4-plus a
gallon gasoline at the retail level, demand could be affected.
The market is going to react with a correction. The direction of
the price will be dependent upon the ability of the world to
absorb the higher oil prices, and the U.S. dollar.
Rehan, you have said that the primary risk in investing in oil
and gas producing companies is depressed commodity prices. How
does the investor manage these risks?
It may be difficult in the near term to be agnostic to commodity
prices, but over time, margins, asset growth and production
growth should really drive value creation. If oil prices drop,
cost structures will also come down and margins will improve
again. But you have to endure that yin and yang over time.
Should investors be adding more exploration and development to
their portfolio weightings?
Yes, they should because in our opinion at the beginning stages
of this supercycle, the risk-adjusted returns are much
How should the companies protect themselves? Is this the time to
have capital structure fixed for the future?
It is always prudent to have a reasonable portion of your
commodity portfolio hedged in the financial markets. The value
proposition for companies is not simply in commodity exposure,
but also in value creation from their technical competence. So,
yes, we like companies that have cash flows to execute the
For equity investors, where are you telling them they should be
To be name-specific, we like
Pioneer Natural Resources Co. (
quite a bit. We like
Newfield Exploration Co. (
. We like
Southwestern Energy Co. (
. We like
Endeavour International Corp. (NYSE.A:END)
. All these companies offer some margin of valuation or asset
growth, or they're not fully appreciated in terms of their
You have Pioneer rated outperform and you said earlier in the
spring that the flow rates from its horizontal Wolfcamp drilling
would set the price direction for the rest of this year. How is
Well, the results are mixed so far, but I am probably repeating
what the market is thinking. Our opinion is that it's just the
beginning, but there's so much oil in place and technology will
ultimately resolve the gap of where their productivity is today
and where it's going to go tomorrow.
EOG Resources Inc. (
validated that recently in its earnings call that Wolfcamp and
Permian horizontals looked good, and they'll get better. So
initially, Pioneer may be mixed, but the industry's saying this
will get tremendously better.
You mentioned Newfield; your target price is $85, which is an
implied return of 20% from current levels. I realize you don't
worry about commodity prices too much, but this is an oil-driven
play. If oil settles at current prices, can Newfield achieve your
Yes, we use $90/bbl oil long term in our metrics and we have not
adjusted the numbers higher for $110/bbl or anything like that.
Our underlying presumption right now is $90/bbl oil long term and
Newfield can very well achieve those objectives.
You mentioned Southwestern. What's the long-term driver here?
Transition to liquids and how successful it will be.
Is there any news on the company's new stealth play?
Not yet, but we're expecting it in the third quarter.
You also threw in a small-cap, Endeavour International. Your
target price implies a 50% upside. Are there any misconceptions
about the risk in this play?
Well, yeah, we think so. We think that the production of the
company from its discovered projects alone could be up seven- or
eight-fold in the next two years. But the asset base is in the
U.K., and the market for small-cap reasons and
international-asset reasons has chosen not to give it the
appropriate credit. It's also pursuing a central-Montana heat oil
shale play and an Alabama shale play that the company believes
looks like the Marcellus. So, yes, to us the risk/reward profile
is very attractive given the material development-driven growth
and a domestic program that could be a game changer with very
minimal capital required.
At current levels, do you think of Endeavour as being value
Yes, very much so.
Okay, so those are your four favorite plays. Did you recommend
No, these are our top four names to think about along with a lot
of different things that can happen in the sector at any given
day, but we are focused on these four.
I enjoyed meeting you very much.
is managing director and head of energy and natural resources
FBR Capital Markets
. He joined FBR in September 1998 as a vice president, covering
the oil and gas E&P sector and most recently initiated
coverage of the liquefied natural gas (LNG) sector. Prior to
joining FBR, he was an associate analyst at PaineWebber,
covering E&P and spent two years at Jefferies Inc. He
received his BS in accounting and an MBA in finance and
accounting from the University of Houston.
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1) George Mack of
The Energy Report
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