The Energy Report: Last week in The Energy Report, Bill Powers, author of "Cold, Hungry and in the Dark," argued that energy reserves from U.S. shale deposits are far smaller than the U.S. Energy Information Administration (EIA) estimates. The difference is significant—approximately seven years compared to 100. Where do you come in on this debate? Is the production growth rate from non-conventional shale plays sustainable?
Josh Young: Making really broad predictions like this is challenging, but I can address a shorter time horizon. It looks to me like there is quite a bit of supply available to come onto the market, with a year or more lead time. Outside the most mature shale plays like the Barnett, there appears to be significant inventory available. In the current market conditions, the Marcellus has lots of inventory, but infrastructure is constrained. At higher price points, much more incremental supply is available from the Haynesville, the Woodford, the Eagle Ford and other plays. In aggregate, there is probably more than five to seven years of incremental inventory. One point that "Cold, Hungry and in the Dark" has right is that higher gas prices are needed to make much of that inventory economic. That is one of the reasons I am bullish on gas prices. I was early, but prices are now rising. Gas prices have some upside bias here, partly driven by shale economics.
TER: What sustained pricing is needed to stimulate investment in the marginal projects?
"The southwestern core of the Marcellus might be one of the most economic places to drill."
JY: I had a long conversation with senior management at Chesapeake Energy Corp. (CHK:NYSE) about this a few months ago, around the time Encana Corp. (ECA:TSX; ECA:NYSE) restarted its drill program in the Haynesville. From Chesapeake's perspective, a reasonable rate of return for these projects is 20%. To get that rate of return in the Haynesville requires a natural gas price of approximately $4.75 per thousand cubic feet ($4.75/Mcf). It looks like the Haynesville will probably be the tipping point—the marginal producing play that's able to balance gas demand and supply. It has a large inventory that can be delivered to the market when the project economics support it. In the medium term, the market price for natural gas may exceed the $4.75/Mcf because there is an upside bias due to rising service costs and project risk over time. From a medium-term price perspective, I'd expect a reasonable balancing point in the $5–6/Mcf price range.
TER: With $5/Mcf required to bring on marginal deposits, what shale plays would be solidly profitable at that price?
JY: The northeastern core of the Marcellus. Potentially even more economic is the southwestern core of the Marcellus, which is liquids rich. I think that might be one of the most economic places to drill. If you look at the different charts that investment banks put out showing the different economics for shale plays [see below], particularly for the shale gas plays, they typically show the southwestern core of the Marcellus as the most economical of the gas shale plays.
TER: As far as non-conventional fields in North America go, is the Marcellus fairly mature? Is there a long enough track record to have a comfort level with the decline rate and the sustainability of the production?
"It looks like the Haynesville will probably be the tipping point."
JY: In "Cold, Hungry and in the Dark," Bill Powers cites Geologist Art Berman, who listed the Marcellus as one of the exceptions to his view that shale gas production was falling short of expectations. Berman noted that the Marcellus had less steep declines than the Barnett, Haynesville and Fayetteville wells, with quicker production leveling off sooner. Compared to other non-conventional plays, the Marcellus seems to have a longer economic life with higher recoverable reserves.
TER: Some of the companies within a given play are more successful than the others for a variety of reasons. What's your take on success factors for companies in the Marcellus?
"From a geologic, political risk and regulatory perspective, West Virginia seems like the place to be."
JY: Considering that the most economic area is in the southwestern core, from both a geologic perspective and a political risk and regulatory perspective, West Virginia seems like the place to be. West Virginia is friendly to natural resources companies. It has a long history of natural resource extraction. It is conservative and pro-business. If you had the same rock in West Virginia versus Pennsylvania, Ohio or New York, you would prefer to be drilling in West Virginia just purely because of the political, tax and regulatory environment.
Given all that, it makes sense to focus on companies with more West Virginia exposure. Of those companies, I find Gastar Exploration Ltd. (GST:NYSE) the most interesting. It stands out because of its leverage to the Marcellus as well as its superb economics. Gastar's valuation on per-share production, reserves and acreage push it to the top of the list. High rates of return on capital expenditures and liquids-rich incremental production are added benefits.
Other companies active in the sweet spot in northwestern West Virginia include Magnum Hunter Resources Corp. (MHR:NYSE.MKT), Chesapeake, and EQT Corp. (EQT:NYSE). Magnum Hunter has drilled a number of excellent wells, but is challenged right now with deleveraging. While Magnum Hunter has had great results in the Marcellus, the company is not a pure play in that area, and has had mixed results in its Bakken area. Chesapeake has a position in West Virginia as does EQT and a few other majors.
TER: You mentioned Gastar during your last interview. At that time, the stock was choppy and trending down. Since then, it has shifted into overdrive. What accounts for the turnaround?
JY: Gastar's turnaround is driven in large part by its exposure to the Marcellus. It's not contrarian for me to say that the Marcellus is an interesting place to invest. Most of the stocks of the Marcellus-focused companies have skyrocketed in the last two years. Range Resources Corp. (RRC:NYSE), Rex Energy Corp. (REXX:NASDAQ), EQT and Cabot Oil & Gas Corp. (COG:NYSE)—these companies have significant exposure to the Marcellus and are up at least 50% in the last two years. Cabot is up 150%. Gastar, which is still down 40%, has a lot of catching up to do. However, when we last spoke, Gastar was trading at approximately a third of its current price.
"As a value investor, I'm interested in buying the best companies, assets and management teams—but the price is what seals the deal."
As a value investor, I'm interested in buying the best companies, assets and management teams—but price is the most important factor. The price is what seals the deal. As an example, let's compare Rex Energy and Gastar. These are similar companies with excellent management, excellent assets and growing production. Note that Rex trades at more than twice the valuation based on earnings, reserves or production. So buying Rex at $16.50 is the equivalent of buying Gastar for $9/share, roughly three times the current price on a relative estimated value/earnings before interest, tax, depreciation and amortization deductions (EV/EBITDA) basis. So, while I like Rex and think Rex is doing an excellent job developing its assets, the value investor in me would love to buy Rex at a lower valuation. If Rex were at $8 and Gastar were at $3, it would be a much more difficult decision, but at current prices, it's a lot easier to identify the value play.
TER: Gastar is in the midst of a large transaction with Chesapeake. Can you explain the dynamic in the industry behind it?
JY: Chesapeake has activist shareholders and they have been pushing for leadership changes for several years. They eventually succeeded in bringing on a new CEO, a new board and a new strategy. Chesapeake's strategy had been to aggregate land, delineate it through exploratory drilling and then resell a portion and get development capital from joint venture partners. Profit expectations didn't match results, partly due to low natural gas prices, and shareholders demanded change.
Chesapeake is now in the process of unwinding the former corporate strategy. Chesapeake used to accumulate speculative land with the hope of being able to resell it into a joint venture. Without former CEO Aubrey McClendon—a brilliant salesperson—leading the process, finding joint venture partners has been more difficult, and deal prices have been less favorable for Chesapeake. One example of the deleveraging is a deal Chesapeake did with Sinopec Shanghai Petrochemical Company Ltd. (SHI:NYSE) in the Mississippi Lime. That deal should have been a high-priced joint venture but it ended up looking more like a liquidation sale. Since that deal, Chesapeake has sold a number of other assets in deals where the previous strategy and management would likely have yielded higher land prices. Rather than spend the capital to drill in order to get high land prices, the company chose to exit the positions and refocus capital on its core areas. The new strategy makes sense, but it is a big change. Chesapeake has a lot of off-balance sheet obligations because of its joint ventures, drilling trusts, midstream agreements and service agreements, so it has a lot of obligations to meet and needs cash and a streamlined asset base to meet those obligations. I understand the strategy, but it has created a buyer's market for Chesapeake's assets, and buyers of Chesapeake's assets like Gastar have benefitted tremendously from that.
TER: This transaction allows Chesapeake to refocus on its core. Is that an industry theme?
"Most of the stocks of the Marcellus-focused companies have skyrocketed in the last two years."
JY: Yes, it is. For example, Gastar announced that it is selling its East Texas field for $46 million ($46M) in order to redeploy the cash into its core areas. Management had previously estimated that it was generating about $4M/year in cash flow from the asset. Call that about 10 times cash flow. The company right now is trading for about 6.5x EV/EBITDA, so it's an accretive sale. In the same way that Gastar is buying this acreage from Chesapeake that's highly prospective for Hunton Lime, the people that are buying Gastar's acreage in East Texas are buying it in part because they want to have exposure to this Eagle Ford/Woodbine oil play, which Gastar has unsuccessfully tried to develop. It's unclear whether that's a geologic, engineering or a drilling issue. Regardless, successful companies focus on what they do best, and refocusing on core assets is an industry trend.
TER: Are there any other less mature, emerging plays that an investor might want to take a look at? How about the Mississippi Lime?
JY: There's one that I'm in with a client called Petro River Oil Corp. (PTRC:OTCBB). It built up a 100,000-acre position in the Mississippi Lime in Kansas along the Nemaha Uplift. It has a tremendous amount of acreage relative to the size of the company. It looks likely that it will bring in either a joint venture partner at a high value per acre or that it will get some other kind of deal so it can get some drilling done on its land. It just did a reverse merger, and that closed relatively recently. Because of that, the stock is not very widely traded. The potential to go from very small to large is there. Petro River is earlier on in its path but with a large land position in a very promising area, it looks like a good opportunity. And Petro River is one of the highest-performing energy stocks in the past 12 months, going from less than $0.03/share to a recent $0.33/share.
TER: Are there any factors you look for besides the geography and geology as key differentiators for an investment decision?
JY: As a value investor, price is very important to me, so price relative to resource in the ground and price relative to cash flow. Management is very important, too. I don't necessarily need to invest with the next Warren Buffett or the next rock star CEO; I just need to invest with competent management that's aligned with my interests. I look for management that is going to take the steps that are necessary to create value for the company in the near to medium term. That's important. The lower the cash flow multiple I'm paying, the less I'm dependent on future growth of the company in order to justify the value of the shares that I'm buying.
TER: You've identified the Marcellus as the hottest shale play. Do you have other companies in the area that you think are noteworthy?
JY: Yes, Gale Force Petroleum Inc. (GFP:CVE). It is active in the liquids-rich Marcellus, right next to Gastar. It is a very small company that appears to potentially be an acquisition candidate rather than an organic growth story given its small size and limited exposure to different large resource plays. But it does have a nice position in the Marcellus, which has increased substantially in value since it got involved.
TER: The stock price has trended sideways since we talked last—very little seems to be happening. Is there any news coming from the company?
"I don't necessarily need to invest with the next Warren Buffett or the next rock star CEO; I just need to invest with competent management that's aligned with my interests."
JY: It is an unusual situation. The largest shareholder wrote a public letter to the board of the company, saying the stock is undervalued. The letter goes on to question the leadership of the company. As a response, the company put out a letter, also highlighting how undervalued the company is and clarified the value in the company. Generally speaking, when an activist shareholder gets involved in a company, the stock does something, and there's some amount of volume. This hasn't been the case with Gale Force. There's been no volume, and apparently no one seems to care, or perhaps, few investors are following the stock.
The activist shareholders and the company both point to a value of more than $60M in proved and probable reserves. The last reserve report of the company showed over $40M Proved reserves. This compares to an enterprise value of around $20M. Between the liquids-rich Marcellus assets and the oil production in Texas, there is embedded value, but what is unclear is exactly what it will take for the market to realize it. It surprises me that nobody seems to notice or care.
TER: Let's summarize the hottest shale play out there in North America.
JY: The hottest place to be in shale development right now is in the Marcellus. The best area is the liquids-rich spot, particularly in West Virginia given some of the political developments in Pennsylvania. There are lots of choices for investment, but a value investing approach will lead an investor to Gastar and Gale Force. Taken as a whole, shale plays may disappoint investors, with the exception of a few key plays like the Marcellus, the Eagle Ford and a few others. Rates of return may not meet expectations and some companies are going to struggle to recycle capital because of challenging deposit economics. Compared to the other shale plays, the Marcellus is a standout. Last, it's beneficial to have exposure to commodities like natural gas that are currently trading at a discount to replacement cost. That provides a tailwind that could potentially help over time in increasing intrinsic value.
TER: As always, it has been great to talk to you.
JY: Likewise; thanks for having me.
Josh Young is the founder and portfolio manager of Young Capital Management, LLC. He is also a board member of Lucas Energy Inc. He previously served as an analyst at a multibillion-dollar single-family office in Los Angeles. Prior to that, he was an investment analyst at Triton Pacific Capital Partners. He was also a corporate strategy consultant at Mercer Management Consulting and DiamondCluster. He holds a Bachelor of Arts in economics from the University of Chicago.
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DISCLOSURE:
1) Alec Gimurtu conducted this interview for The Energy Report and provides services to The Energy Report as an independent contractor. He 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:Chesapeake Energy Corp. Streetwise Reports does not accept stock in exchange for its services or as sponsorship payment.
3) Josh Young: I or my family own shares of the following companies mentioned in this interview: GST, Gale Force Petroleum Inc. and Petro River Oil Corp. I personally am or my family is paid by the following companies mentioned in this interview: None. My company has a financial relationship with the following companies mentioned in this interview: None. I was not paid by Streetwise Reports for participating in this interview. Comments and opinions expressed are my own comments and opinions. I had the opportunity to review the interview for accuracy as of the date of the interview and am responsible for the content of the interview.
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