National Fuel Gas (NFG) is a century-old utility company based out of NY and PA with a record for increasing its dividend every year for decades. The business is fairly well understood by analysts and their sum-of-parts valuations are consistently in the range of $35 to $40 per share. The company owns a sizable amount of land sitting on top of the Devonian shale, but since shale contains dense formations of natural gas that has traditionally been uneconomical to drill due to extremely low permeability, analysts have always valued this resource at zero. However, a number of companies have recently been aggressively acquiring mineral rights to the Devonian shale with the intent of using new technologies to extract the gas. Applying valuations that are being assigned to the Devonian shale acreage of other E&P companies on NFG’s Devonian shale asset would imply as much as $50 per share in additional value.

 

There should be a number of catalysts over the next year as other major E&P companies begin to ramp their drilling programs in the Devonian shale that will highlight the value of this asset and thus at current prices, NFG represents an extremely cheap lottery ticket on its shale asset with very limited downside.

 

Capital Structure			2006 Financials
Shares Outstanding	82.4		Revenue	2,312
(+) Option Dilution	4.6
Diluted Shares	86.0		EBITDA Margin	24%
			EBITDA	560
Share Price	$43
			(-) D&A	(180)
Market Value	3,698		EBIT	381
(+) Debt	1,137
(-) Cash	(70)		(-) Interest (6.4%)	(73)
Enterprise Value	4,765		EBT	308
Dividend	$1.20		Tax Rate	36%
Dividend Yield	2.8%		(-) Taxes	(111)
			Income	197
Forward EPS			EPS	$2.29
2007 Guidance (02/07)	$2.15-2.35		(+) D&A	180
2007 Estimates	$2.34		(-) Capex	(294)
2008 Estimates	$2.57		FCF	83
			FCF/Share	$0.96

 

 

 

NFG has owned a sizable amount of land and mineral rights in NY and PA on which the company has built a number of verticals wells to extract natural gas from the Devonian Sandstones that can be found 800 to 4,500 feet deep in PA but has only recently begun to think about extracting gas from the shale that lies about 3,000 feet beneath the sandstone.

 

In the last year, it has become apparent that the value of the shale resource was likely to be unlocked in the near future. Higher gas prices, horizontal drilling, and new fracing technologies have made natural gas drilling in the shale economical. One of NFG’s largest shareholders commissioned Schlumberger to analyze NFG’s acreage and based on very favorable results, encouraged management to refocus its attention on this untapped asset.

 

 

Recently, NFG announced a JV with EOG to begin a drilling program in its Devonian shale acreage where EOG offered their 130,000 acres in the region on top of NFG’s 770,000 acres for a total of 900,000 acres. EOG will pay all costs associated with building and operating new wells. In return, and depending on drilling results, EOG can earn a 50% working interest in up to 200,000 of NFG’s acres and NFG can earn a 50% working interest in all of EOG’s acres. EOG has told us that they have studied the Devonian shale and “really like” where NFG has acreage. Their current plan is to drill 10 wells in 2007, 2 horizontal 8 vertical, across the combined acreage. These initial wells are exploratory in nature and because they were designed to get EOG up the learning curve, each well will utilize slightly different drilling and fracing methods.

 

In addition, NFG is in the process of completing a third-party study that will estimate the unproven reserves underlying the company’s acreage in Appalachian, which management expects to either complete or provide investors with an update by the end of 2007. 

 

 

Despite the massive hydrocarbons in most shale plays, the limiting factor has always been recovery rates. In most shale plays, initial recovery rates were zero. Typically, some experimentation with spacing, refracing, and drilling would get the recovery rate of early vertical wells up to 5-8% and then ultimately to 15-20% with horizontal wells and multiple fractures.

 

Early vertical wells in the Barnett, Fayetteville, and Woodford shale plays were either unprofitable or marginally economic but, after around 100 vertical wells, all three began to turn into horizontal plays. A number of operators are betting that the Devonian shale evolves in a similar fashion. Relying upon the production records of 400 wells previously drilled in the shale, Range Resources (RRC) has been aggressively acquiring Devonian shale acreage. On the company’s Q4 call, COO Jeff Ventura suggested that recovery rates in shale could even get as high as 40% over the next decade, “If you're in an area with a lot of gas in place, I'm betting on it that technology, smart people, and technology over time are going to get more and more of that hydrocarbon out.”

 

RRC has told investors that its current land position of 410,000 acres represent 2.5-5.0 Tcf of natural gas. As of late February the company had 15 vertical wells and one horizontal well online. The vertical wells have an estimated reserve of 0.6-1.0 Bcf each and the horizontal has an estimated reserve of 1.5 Bcf. Due to initial success, the company has expanded its drilling program from around a dozen vertical wells and one horizontal well 2006 to at least 60 vertical wells and 8 horizontal wells in 2007. Two additional horizontal wells were slated to be completed in March with the remainder to be drilled in a row starting in late April.

 

Another promising data point came on March 29, when Equitable Resources (EQT) significantly increased its probable and possible reserve potential to 3.2 Tcf from a prior estimate of 1.1 Tcf, largely as a result of improving horizontal drilling results in its Devonian shale acreage. The company announced that four of the five horizontal prospect areas tested in Kentucky were successful while also unveiling plans to drill at least 25 more horizontal wells during 2007. The company issued a presentation which had a few slides clearly demonstrating EQTs progression across the learning curve. While the first 7 wells drilled ran $600 per horizontal foot, the last 3 wells averaged only $178 per horizontal foot. 

 

Citigroup recently applied its forward estimates and valued the company’s collection of businesses at $35 per share and its undeveloped acreage in New York and Pennsylvania at less than $1 per share for a total of $36 per share. This method applied 8x to the $139MM of 2007 EBITDA generated by the Pipeline & Storage segment. Using a more appropriate 10x multiple, given the valuations that are currently being assigned to peer companies, would add more than $3 per share and increase the total valuation to $39 per share. Below is a sum-of-the-parts analysis that represents our view of consensus valuations of everything excluding the Devonian shale asset.   

 

Segment	Value ($B)	Share	LTM EBITDA	Multiple
Exploration & Production	1.400	$16	266	5x
Utility	1.350	$16	147	9x
Pipeline & Storage	1.250	$14	126	10x
Timber	0.150	$2	15	10x
Energy Marketing	0.070	$1	9	8x
Enterprise Value	4.220	$49	563	7x
(-) Net Debt	1.067	$12
Market Value	3.153	$37

 

Below is a brief description of the company’s business segments:

Exploration & Production (Seneca): Excluding the Devonian shale asset, Seneca has 58MMbl and 233Bcf of reserves in CA, NY, PA, TX, LA, AL, and western Canada. Produces approximately 50 Bcfe per year, of which 45% is oil. 

Utility: Regulated utility serving 727,000 customers in NY and PA.

Pipeline & Storage (NFGSupply & EmpireState Pipeline): 28 storage fields, 4 storage JVs, 2,967 miles of pipeline.

Timber (Highland): More than 100,000 acres of black cherry hardwood and two sawmills, predominantly in PA. 

Energy Marketing (NFR): Markets and brokers natural gas between 25,000 customers within the company’s geographic region.

 

 

RRC was an aggressive buyer of Devonian shale acreage in 2005, licensing mineral rights on approximately 250,000 acres for around $300 an acre. Range has stated that its sees huge upside in the Devonian shale and that it continues to acquire acreage in the region despite the higher prices required for new leases. If Range is correct, the upside here will be significant. Morgan Stanley, in a January 16, 2007 report, valued RRC’s interest in the Devonian shale play at $2B, slightly over $5,500 per acre. Morgan Stanley’s assumptions could easily prove too conservative. For example, the analyst assumed that wells could be put on only 40% of the acreage and that only vertical wells would be drilled.

 

It is clear that the value of NFG has the potential to be significantly more than the current share price. Applying $5,500 an acre over NFG’s 770,000 acres would suggest that the Devonian shale asset is worth $4.2B or $49 per share. The valuation gap is so apparent that the company has finally begun to take advantage of the opportunity. NFG has been a net issuer of its shares every year in the last decade until 2006, when uncharacteristically, NFG bought back 2.5MM shares for slightly less than $34 per share. In Q1 2007, the company bought another 1.2MM shares for an average price of more than $36 per share. The company still has more than 4MM shares left under its repurchase program.

 

 

As far as the sell-side goes, the analysts have opted to be precisely wrong rather than approximately right. Utility analysts tend to be on the other end of the conservative spectrum relative to technology analysts, so rather than put a wide range on the potentially immensely valuable Devonian shale asset, they have instead chosen to further fine tuned their valuations on all other assets, while taking a see no evil, hear no evil approach to the Devonian shale. Here are some recent quotes from three different analysts.

 

 

 

 

The technology needed to extract natural gas from these hard-to-permeate reserves is constantly advancing. It may be the case, as in other shales, that as technology advances and companies advance up the learning curve, resources that formerly were unrecoverable suddenly become economic.

 

The irony with the Devonian shale is that NFG’s analysts point to the lack of disclosure from the public companies as a reason why investors should not get overly excited about the opportunity, and yet most of these companies are at the same time still leasing acreage in the play and therefore have zero incentive to provide any commentary that could potentially put upward pressure on lease rates. Not surprisingly, the perception of upside in Devonian shale changes drastically when we look at commentary from sell-side analysts who cover Range Resources:

 

 

NFG’s analysts have been slow to acknowledge that the Devonian shale asset is much more valuable than conventional acreage in Appalachia and thus their valuations tend to be way too low. For example, Citigroup’s analyst applies a valuation of only $100 per acre and in late February, Lehman Brothers wrote, “Our assessment of value of conventional Appalachia program equates to $2.33 to $7.35 per share with both extremes dependent upon flawless execution of hypothetical base drilling programs.” This would imply a price per acre of $260 to $800. Given what some operators are currently paying for short-term mineral rights with fairly high-royalty rates, these numbers appear overly conservative.  

 

 

NFG’s IR has been recently seeing an increased interest in their Devonian shale assets which we expect will only increase over the next year as new wells come online each month. Once analysts see a few more successful wells in the shale play, they should begin to incorporate more and more of this asset into their valuations. 

 

Management has talked about expanding its pipeline to take advantage of the distribution assets that will be needed to support the shale play as well as exploring an MLP structure for its pipeline assets. Either of these initiatives would help unlock some embedded value, but if RRC and other E&P companies continue to succeed in the shale, a monetization or spin-off of the shale assets would unlock a significant amount of value. At the very least, the results of the company’s internal study should give investors a better sense of the potential size of the company’s natural gas reserve and enable analysts to revisit their valuations.