Description

This is as much a macro as well as a micro investment.  While the past decade prior to 2022 was a terrible one for exploration and production companies (E&P), we think the world has changed instantly and dramatically, and we frankly see a need for stagflation protection.  That entails commodity exposure of course, which we don’t love given energy’s recent track record, but view as necessary for any portfolio today. 

Personally, since the invasion of Ukraine, I have gone from oil negative to oil neutral, which gives me pause with respect to the larger, more diversified E&P names out there.  But on the natural gas side, I am moving from a neutral stance to a positive one, at least with respect to US natgas production and demand.  

For years, investors have complained that “drill baby drill” was destroying capital.  And they were right.  The XLE earned paltry 1.3% annual returns in the ten years ending December 31, 2021. But starting as far back as 2019, and really motivated by these dreadful shareholder returns (not to mention a cash crunch from the pandemic), E&P companies now have pledged to return cash to shareholders and keep production growth down. 

As an example, even amidst over $90 oil, Devon in mid February declared that they would raise production by no more than 5% annually. 

Even though energy stocks have performed well this year to date, investors seem not to care that now they are likely going to be free cash flow machines over the next several years.  They are remarkably still cheap despite a backdrop as favorable as the early 1970's perhaps.

By the way, these returns are adjusted for inflation.

It is interesting to note that in 1980, energy was 29% of the S&P 500, but only 3.8% as of today.

Natural Gas

As most probably know by now, Russia supplies 30% of all natural gas to the EU.  In Germany, that figure is 40%.  Recently European regulators have devised a 10 point plan to cut demand from Russia by 2/3, in just a single year.  The top 3 actions in this plan are 1) no new gas supply agreements with Russia, 2) replace these with supplies from non-Russian sources, and 3) add piles of gas storage.  Sure renewables and efficiency and can help, but we view their impacts as marginal.

Russia annually exports 8.9TCF of gas, 6.9 TCF of which now flows to Europe. Cutting that by 2/3s is unlikely in any short amount of time, as pipelines and LNG capacity take years to construct.  But looking out 2-5 years, and we sense that the US will be more than willing to accommodate that demand.  

Not only that, but while climate change suggests that nobody wants fossil fuels anymore, the reality is that 1) there is no alternative in the next decade, as renewable energy does not provide significant baseload power (some perhaps from wood pellets but small), nor much in the way of heat in cold European climates.  2) The world may just confront the elephant in the carbon room, that is that coal probably needs to go and is a far bigger polluter than cars.  While the race to get rid of internal combustion engines seems well on its way to fruition, the move to rid the world of baseload coal power production seems stalled.  The truth is that our world could de-carbonize more by replacing every coal plant in the world with natural gas fired power, than it could by converting every single gas powered car engine to an EV.  Coal in 2020 totaled a whopping 35% of global power supply.

Enough macro.  The stage appears set for natural gas to reassert itself as the best clean burning fuel alternative.  And the desire to move away from Russian gas in Europe alone could easily lead to 4-6 TCF annually of incremental demand from US producers. The US produces 33.5 TCF annually, so these are meaningful numbers.

We think there is a better than even chance that low valuations and inflation that no central bank can control will lead to energy stocks perhaps dominating returns in the ensuing few years.

As for how to play this, we looked at a number of E&P names from Equinor to Vermillion to Antero, et al, finally settling on the biggest US producer, EQT Corporation in the Appalachian basin.  Certainly companies with direct sales of European produced gas could work (and probably will), but prices already are quite high, and directionally these stocks probably are going to see earnings settle down. 

EQT, using December 31st strip prices (which are conservative given Henry Hub strip prices were $3.72 then, vs $5.00 today), will generate an estimated $10 billion in free cash flow from 2021 to 2026.  They did just under $1 billion in 2021, which means that in the next five years, again assuming strip prices lower than today, EQT will annually throw off $4.77 in FCF per share.  That implies an 18% FCF yield.  Said differently, EQT has a $10 billion market cap, with $5.4 billion of net debt (1.68x 2022 guided EBITDA), and so will generate enough FCF to buy back 90% of its equity market cap in the next five years. Or pay back 100% of its debt and repurchase 40% of the shares outstanding.

Why does this trade so cheap?  EQT has hardly rallied since the war in Ukraine started, perhaps by 15%, consistently trading between $20 and $22 over the past year, vs now at $26.75.  It was near $24 in January.

Couple of reasons we think.  One is simply macro, that the market clearly believes gas prices are too high, war will end and supply concerns will ease.  We simply don’t know how to handicap that one.  I wager that this war could last longer than people imagine.  Putin is determined, ruthless, but set against a very large, very populous country equally determined to defend itself (size of Texas with 40mm inhabitants). 

But even if there is a truce tomorrow, it is hard to see how the EU doesn’t migrate supplies to friendly sources (e.g. to the US and other NATO providers), as fast as humanly possible. 

The second reason is more micro.  EQT has a spotty history of poor management, leverage and awful stock market performance. EQT is down 27% over the past five years, and at one point was 4.0x levered almost on a debt/EBITDA basis.  That is way too high for a company that tends to trade at 5.0-5.5x EBITDA. 

Problems were exacerbated at EQT in 2017 when they purchased Rice Energy for $6.7BB in 2017 for a ridiculously high 11x EBITDA.  Sure, there were some synergies and overlapping/adjacent acreage that could lead to scale economics, but the price was far too high.  The sellers were the three Rice brothers essentially, who built Rice Energy starting with $70 million inherited from their father in 2007.  Not to poo-poo inherited money, but the Rice trio built that $70 million into a billion dollars in a decade (they owned 18% of Rice when it was sold).  Shareholders in Rice Energy made 9.5% a year vs down 2.7% annually in the XLE in the same timeframe.

Soon after the deal closed, management at EQT reportedly had no clue how to follow through on Rice’s drilling plans.  Costs went up, the stock got killed, and investors called former Rice Energy CEO Toby Rice to do something.  A proxy fight led to the board getting revamped and by a convincing 80% vote, the old CEO was replaced by Toby in July 2019. 

While my history with this is short, Toby Rice seems impressive.  He is 40 years old and now resides over the largest natural gas producer in the US (just ahead of XOM).  Lifting costs on their Appalachian acreage has fallen from $1.43/mcfe to $1.26 last year.  Debt has been cut from nearly 4.0x to 1.7x on an EV/EBITDA basis (using 2022 guidance). 

Last May, EQT purchased Alta Resources for $2.9 billion, or about 8.3x FCF and 5.0x EBITDA.  They issued 100mm shares of stock and paid $1BB in cash.  While we aren’t fans of any equity issuance, the deal also helped EQT de-lever further.  They also hedged out 70% of production from Alta for 2022 and 2023 in order to ensure a rapid pay back of capital.

That turned out to be a mistake, and as we look at EQT, the company overall has unfortunately hedged 65% of overall expected production in 2022 at far lower prices.  That also has kept a lid on share price appreciation.  But we aren’t buying this for 2022.  The company is only 40% hedged in 2023, and virtually unhedged in 2024. And despite some mistakes with respect to hedging, we think management is solid.

EQT suggests, and the math supports this too, that Alta probably would fetch upwards to $6BB in a sale today. 

After picking up another $735 million in assets in the Marcellus from Chevron in late 2020, the company now has a PV-10 of $21.5 billion, compared to a TEV of $15.5 billion. 

Here is a slide illustrating their acreage:

Economics

Overall, to perhaps state the obvious, E&P companies are driven by finding costs (or F&D costs) and lifting costs.  Lifting costs were $1.26 per mcfe last year and probably will be similar this year, and we calculate finding and development costs at just under $1 historically (92c on a 3 year average basis), but likely to fall to $0.75.

That means their breakeven is $2.20 give or take (company suggests $2.30) per mcf of gas. 

Given that shale wells can deplete quite rapidly, one positive is that the company has not been in active drill mode.  That means production decline curves are much flatter than is typical for an aggressive shale producer.  EQT has about 15 years of low maintenance replacement reserves on the books today.  They seem mostly now to be spending dollars to keep production at around 2 TCF annually.

Model

Above we assumed guidance at the midpoint of EBITDA, and at the high end for capital spending. Interest costs and share count likely will fall with free cash flow.

Valuation

To get to the current stock price, a DCF at a 10% discount rate assumes that the company earns only an $0.80 margin per mcfe going forward (i.e. $3.10 gas with $2.30 costs all in).  That assumes zero benefit for expansion of their existing assets, and also assumes zero terminal value after 15 years. 

We think that is way too low.  While we do not expect gas prices to stay at $5, there are good odds that they stay well above $3.10, which seems to be what the stock implies (with zero asset allocation to improve that over the years). 

Not only are prices likely to be higher in our view, but also basin differentials could improve (App gas trades 50c cheap to Henry Hub).  The LNG story seems to offer material optionality here not at all baked into the stock.  The EU and the US will undoubtedly grow LNG capacity, and we have heard that LNG operators have already reached out to EQT to provide supply potentially.  Of course, EQT needs an investment grade rating in order to do so, and recently got that from Fitch.  Moody’s and S&P are likely to follow suit this year given that their metrics already look investment grade.  FWIW, an energy company with a high yield balance sheet is doomed to trade poorly. But recognition of an IG rating should help EQT's multiple over time.

By our math, if EQT throws off $1.2 billion in FCF this year, and half is used to buy back shares (on a $1 billion plan), and the rest is used to pay down debt, then they will be roughly 1.3x levered looking into 2023. Their target is 1.0-1.5x.  Theoretically they could be debt free by the end of 2024 or sooner if prices stay high.  

The slides here from EQT make a compelling argument for natural gas in the global climate fight (mostly to replace coal fired power plants) and the need for LNG as well.  These were put together before the Russians invaded Ukraine. 

https://s24.q4cdn.com/922296017/files/doc_presentations/2021/EQT-ESG-Presentation-Slides-June-30-2021.pdf

Slides from Cheniere Energy also make the case that while LNG was oversupplied in 2019, these cycles are elongated and today the world is far short LNG demand.  They are supposedly sold out of LNG capacity until 2040.

https://d1io3yog0oux5.cloudfront.net/_e84b54190a20c7ab059689f878d9b6f4/cheniere/db/778/7447/pdf/11+18+2021+Corporate+Presentation+-+vF.pdf

These slides were from November 2021 too.

As for comps, Anterro trades at 6.1x forward EBITDA, Range at 5.8x and Coterra at 4.8x.  At 4.1x 2023 EBITDA, with almost 2/3s hedged at lower gas prices, we suspect EQT can trade back to that average 5.6x in a year.  We used strip/year end 2021 prices and assumed EBITDA hits $3.6 billion in 2023 from guidance of $3.2 billion this year. 

That puts EQT up 50% in a year or so, to $39, pretty close to our DCF analysis. 

EPS and P/E ratios are not used much in the E&P business, but we note that E&P stocks tend to trade at a 30-40% discount to the S&P to account for their cyclicality and lower free cash flow characteristics. That got us 11x earnings and a $40+ stock price too.

There are lots of other options to this story.  EQT might purchase more assets accretively.  They have some gas transportation contracts that will save them $0.18 per mcfe in costs over the next few years.  That could help on the economics.  Gas prices are lower in the Marcellus/Appalachian basin, as takeaway capacity is limited.  The Mountain Valley Pipeline has been a nightmare to complete, but probably will come online in 2023.  Certainly, political winds may swing in favor of natural gas too, helping out on the production side.  We suspect there could be less regulation either after midterms or perhaps even in 2022 given inflationary pressures.  BIden has been asking for more production from suppliers all over the world.  He probably would rather keep inflation in check than worry about offending the environmentalists who hate all fossil fuels.  But obviously we don’t know, just speculating.

We also DCF’d the stock at $1.25 per mcfe margins, $3.50 gas and $2.25 costs.  That gets us $41.50 in equity value on a PV basis (at 10%).  

On the downside, we estimate the risk is low $1-3, barring a truce and the EU happily continuing to purchase gas from Russia.  Also a risk, while US gas in storage is below 5 year averages, by next winter, we might see warm weather, weaker draws and more certainty with respect to Russian supplies.  That could happen before LNG capacity ramps up, driving gas prices back to $2.70 again perhaps. That works out to $1.78 in FCF/share, and perhaps a high teens stock again.

Catalyst

Free cash flow generation, growth in production/takaway capacity/LNG projects