|Shares Out. (in M):||248||P/E||16.1||11.8|
|Market Cap (in $M):||3,350||P/FCF||45.8||42.4|
|Net Debt (in $M):||4,012||EBIT||423||451|
|TEV (in $M):||7,362||TEV/EBIT||17.4||16.3|
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I am long Range Resources (NYSE: RRC) at $13 ½. Yes, it’s a gas-levered E&P that has been getting destroyed, so I realize this is going to take some convincing. But if anyone wants to come with me, this moment will be on the ground floor of something real and fun and inspiring and true in this godforsaken business and we will do it together. Who’s coming with me?
Cliff Notes Summary
Range’s Marcellus position in Southwest Pennsylvania has some of the best recycle ratios and deepest drilling inventories in the entire industry. It is epic. They generate >3x recycle ratios on unhedged basis and have 33 years of inventory at the 2017 drilling pace. At $3/mcf Henry Hub, $50/bbl WTI and NGLs at 29% of WTI, I estimate their Marcellus position can grow production at a 13% CAGR for 15 years while still generating free cash flow, with mid to high single digit FCF yields through year 5, double digit FCF yields for years 5-9, and >40% FCF yields in years 10-27. On an NAV basis I value the equity in this scenario at $38/sh, for 180% upside. Liquids are 40% of revenues, and if I run $60/bbl WTI through the model I get a value of $55/sh, for >300% upside.
Alternatively, they could go into maintenance mode and only invest enough to hold production flat indefinitely. At the strip they would generate FCF of $3/sh, a 22% FCF yield, for decades to come. Capitalize that at 10x and the stock would be worth $30/sh. A 15x multiple would put it at $45/sh.
In order for value to be impaired I believe Henry Hub needs to sustain in the low 2s forever compared with the strip in the high 2s.The risk/reward appears to be highly skewed to the upside.
So why is it down 85% from its all-time high of $95.41 in 2014, down 30% from its low at the trough of the energy cycle in early 2016, and flat since 1997? Because their capital allocation has been disastrous. First, they took on too much debt executing their “growth at low cost” strategy in the Marcellus during the good times, although the debt is manageable and a clear path to deleveraging is available. Second, they blew $4.4 billion acquiring North Louisiana gas producer Memorial Resource Development (MRD) in late 2016. They assumed $1.1 billion of debt and gave them 31% of the pro forma equity. Investors were skeptical of the deal from the beginning, and their concerns climaxed last month when Range lowered their MRD type curves. The deal grew their debt by 50% but it only grew their production by 27%, and now it looks like the PUDs are not worth very much. Yikes!
But this is the opportunity. Management has lost its credibility with shareholders and they are boxed in from doing anything besides selling non-core assets and executing on Marcellus development, which admittedly they have done a great job with. They have already committed to a financial strategy that prioritizes meaningful free cash flow over production growth. If a credible activist shows up, they would likely meet little resistance from shareholders, and the process of crystallizing value through the generation of FCF would be accelerated. The playbook is simple. Change management. Sell non-core assets. Draw a line under the MRD acquisition by writing it down and selling it off, even if they only get PDP value for it. Sweep some FCF to further reducing debt, and implement buybacks and a meaningful dividend with the excess. The stock should be an easy double under those circumstances. Sailing Stone owns 11% of Antero and just filed a 13D. It’s worth noting they also own 13.6% of Range.
This stock is hated by energy investors right now. Everyone who bought it in the last 10 years and still holds it has lost money. The short interest is 13%, or >$400 million. For anyone who is tempted to believe the stock is down so much because gas prices are weak, the answer is absolutely not.
Credit Suisse initiated coverage on the group back in December when Bill Featherston moved over from UBS. Here is a list of the P/NAV for every E&P in his coverage. This group runs the gamut from oily to gassy, underleveraged to overleveraged, deep inventory to light inventory, good capital allocators to bad capital allocators, and so on. RRC was materially cheaper than every single one of them by a mile.
When RRC lowered their MRD type curves last month the Street went absolutely berserk and the stock fell 10% in a day.
The analyst at Morgan Stanley lowered his bear case from $5/sh to $3/sh to account for “additional risk from multiple compression”. At $3/sh the stock would be at 4x EBITDA, the province of subscale E&Ps with Tier 3 economics. To further highlight how ridiculous $3/sh is, the stock is worth $4/sh just on PDPs alone, and I’m pretty sure the Marcellus PUDs are worth some non-zero figure.
One brave sell-side analyst put out a relatively positive note highlighting the company’s new emphasis on free cash flow over growth. A sales guy at his firm told me he had four clients – two long only and two hedge funds – call him and scream at him.
Here’s how hated the stock is right now. Two other gassy E&Ps – Comstock (CRK) and Eclipse Resources (ECR) - have released their YE2017 reserves and PV-10 values. Neither company is even on the same planet as Range’s SW Marcellus position in terms of inventory depth or economics, and CRK has a far worse balance sheet, yet they trade at material premiums to Range in terms of EV/PV-10.
Finally, there were 169 million shares out before the MRD deal, and the closing price the day before the deal was announced was $42.01. With the stock now at $13 ½, the 169 million shares have given up $4.8 billion of market cap, $400 million more than the entire value of the MRD deal, implying some level of value destruction to the Marcellus business if you assume the current trading price has some economic rationale behind it.
Range’s SW PA well economics have seen some improvements since then and their wellhead realizations have improved materially, so it would seem hard to argue that asset has gotten worse.
Range is the 7th largest gas producer in the U.S. and the second largest identified NGL producer. Their headquarters is in Dallas. People think of Range as a gas company, but their liquids exposure is significant at 33% of production and 40% of revenues in Q3’17.
The thing that stands out from that table is 73% of their production comes from Southwest Pennsylvania where they generate fantastic well-level recycle ratios of 4.2 – 4.9x (thanks in part to the liquids-rich content) and have 32 years of drilling inventory. Their consolidated recycle ratios are the best among dozens of E&Ps I have run the numbers on. You can count on one hand the number of E&Ps that are in the same ballpark.
The company was formed in 1979 as Lomack Petroleum and went public in 1980. From inception through 1988 they drilled over 500 oil and gas wells, primarily Appalachia. The company was restructured in 1988 after it succumbed to the commodity price downturn. Thomas J. Edelman was appointed chairman as part of the restructuring. He co-founded Snyder Oil (now part of Devon Energy) which had thrown Lomack a lifeline. One of his colleagues at Snyder, John Pinkerton was appointed CEO.
I have never met Edelman but from studying parts of his track record he seems like the type of guy who could teach you a thing or two about making money in the oil patch. After Lomack he went on to co-found Patina, which he sold to Noble Energy. Patina generated industry leading recycle ratios for a number of years in the early 2000s and now serves as the cornerstone of Noble’s position in the DJ Basin. He took NBL stock in the deal. He still serves on the board and owns 3.0 million shares worth $96 million.
The new strategy for Lomack after Edelman and Pinkerton took over was to grow by acquiring mature properties in Appalachia and in the Permian Basin. That was back when dry hole risk was much higher and it was much safer to build reserves by acquiring them rather than exploring for them. Management owned 8% of the stock so even though debt grew from $4 million in 1989 to $727 million by 1997, at least you could say they were eating their own cooking.
The strategy worked. The stock went from the low single digits to $11, supported by tailwinds of a cooperative price environment and magnified by growing leverage.
See if you can spot the parallels with present day Range in what happened next…
By the late 1990s Appalachia was a real cornerstone asset for the company. Operating cash flow was $30 million and maintenance capex was less than half that, so free cash flow was very nice. Its reserve life was also substantial at 17 years, so they had enough to keep them busy.
Then two things happened. First, they went off the reservation and bought a company that didn’t seem like a natural fit - an offshore Gulf of Mexico producer called Domain Energy in this case. (They changed the name of the surviving company to Range Resources.) Investors hated the deal because the two companies were a study in contrasts. Lomak’s consolidated reserve life was long at 15 years while Domain’s was short at 8 years. Lomak was onshore and Domaine was offshore. Lomak was an acquirer and Domain was an explorer. Then, commodity prices turned down.
Debt/EBITDAX looked manageable at 2.5x in 1997. By the end of 1998 after the deal closed and commodity prices had fallen, debt/EBITDAX rose to 6.2x. The stock fell 93% from a high of $14 in 1998 to a low of $1 in 2000.
The similarities with Range’s current situation are eerie, particularly in light of the fact that many of the company’s senior managers today have been there a long time and several were around during that episode.
Let’s fast forward…
After surviving a second brush with death they resumed their strategy of active portfolio management, buying and selling a bunch of different assets. The most noteworthy asset they acquired was a privately held company called Stroud which owned 20,000 net acres in the Barnett, the original shale basin, and came with key technical personnel who were part of the original team at Mitchell Energy, the company widely acknowledged as the original shale innovator. That deal got Range into the shale game, and over the next 18 months they entered five shale plays and increased their shale holdings nearly fivefold to 880,000 net acres.
They recognized similarities with the Barnett in Appalachia, and in 2004 they were the first company to drill a horizontal/fracked well in the Marcellus. They tried a “Barnett-style” slickwater frack to test the concept. From what I read, the initial horizontal well results were somewhat disappointing, but vertical results obtained as part of the initial tests showed enough promise to make them went to lease a lot more acreage.
They play was on fire across the industry by 2008 and it seemed like the Marcellus gave producers the best of both worlds – high quality rock in a repeatable play and close proximity to premium markets. At the time, gas in the northeast still sold for material premiums to Henry Hub. As the land grab settled out it became apparent Range had a huge position in some of the very best rock in Southwest PA. Range decided to pursue a strategy they called “growth at low cost” and started outspending cash flow in order to grow production as quickly as possible. It made sense. If you’ve got the rock and you’ve got the scale then there is some logic to outspending cash flow as long as your EBITDA is growing at least as fast as your debt.
For a while it was, but the industry became a victim of its own success in the new shale gas plays. U.S. gas production grew so much that Henry Hub went from $6-8/mcf in the early years of the revolution to $1.60/mcf at the low in early 2016, and northeast basis differentials went from healthy premiums to significant discounts. Range’s debt metrics blew out.
They survived thanks in part to the extraordinary quality of the rock and the depth of the inventory. They had successfully made it through the hardest part of the E&P lifecycle – the exploration and delineation phase – with a massive crown jewel position, and were in a position to deal only with high class problems associated with the development phase like achieving incremental productivity gains and seeking new markets for their prolific output. With the rebound in energy markets starting in Q2’16 Range’s credit metrics started to heal and they had survived.
So what did they do? They went out and bought another company in an unproven basin that was still in the delineation phase! Coincidentally, I just finished reading Deals From Hell and this deal checked a number of boxes that are the hallmarks of bad deals. One of the hallmarks was dubious industrial logic. Range didn’t need to acquire more reserves. Nor did the deal help them high grade their assets.
The consensus explanation for the motivation seems to be that it was a backdoor way of deleveraging. They had just sold a big asset package in late 2015, but commodity prices continued to slide and even on a pro forma basis their EBITDAX interest coverage was barely above the minimum level required by one of the covenants on their revolver. The company still needed to deleverage a bit, and for some reason they did not do a secondary after the capital markets re-opened along with virtually every single E&P in existence. The MRD deal was technically accretive to their leverage metrics, so I guess from that point of view it temporarily solved the leverage problem, but it came at a cost that would ultimately be significant.
At the time of the deal MRD had three type curves that generated recycle ratios of 3.9x, 2.6x, and 1.5x. The two best curves were the main curves. Last month, after a series of disappointing well results, RRC consolidated the curves down to just one that has a recycle ratio of 1.9x. That is terrible. Above 2.0x is the level at which E&P value creation begins, so if you’re not even at 2.0x at the well-level, by the time you roll all the land, seismic, and corporate expenses into the mix you are destroying a lot of value.
How did this happen? It’s tempting to just chalk it up to management not owning a lot of stock and more, and I think that’s part of it. The management team used to own 8% of the stock. Now they only own 0.6%. But, if they didn’t care about the stock then why try so hard to avoid dilution? They have told me in the past that everyone in the organization owns stock and that is something they seem to have promoted for a long time.
The truth may simply be that like a lot of E&P teams they are good at executing and bad at allocating capital. Mastering the craft of resource exploitation is something almost the entire industry is well schooled in. It’s an education process that starts in college and continues over the course of their careers as they rise up the ranks. Capital allocation is a topic that receives much less attention.
The Nature of My Bet
Paying $13 ½ for shares of Range gets you a combination of asset quality and value that has rarely been available outside of broad market dislocations. At this price you get assets that are capable of delivering a 22% free cash flow yield for decades, assuming flat production.
I am betting that 1) large pools of private capital exist, 2) some percentage of the decision makers who run them will become aware of Range, and 3) a subset of those decision makers will be motivated by the prospect of a 22% FCF yield.
Alternatively, a corporate buyer like Shell might see the logic in buying a major producer of NGLs at a 22% FCF yield whose main field is in the same neighborhood as Shell’s new cracker, which will consume 88 kbl/d of ethane when it is fully up and running.
With respect to commodity prices, my bet with Range is that I don’t need to be right about what the market clearing prices will be with much precision. I just need to be reasonably sure that the company’s rock is good enough that the rest of the industry will not be able to achieve well productivity gains faster than Range. It’s not about the price. It’s about the margin. As I will show later on, Range has been very good at driving efficiencies.
Tier 1 shale E&Ps are on the verge of making the transition from being businesses that are perpetually riding the changing trajectories of basin lifecycles, rarely spending much time in any particular phase and therefore only investable by specialists who speak the industry’s unique language of EURs and type curves, to being businesses that can stay in the development phase for years and years, generate free cash flow on a sustainable basis, and are investable by a much wider group of generalists who can appreciate universal concepts like FCF yields.
Don’t get me wrong – there are dozens and dozens of publicly traded E&Ps and the vast majority of them will not make the leap to becoming FCF machines because they don’t have the asset quality or the scale. There are maybe only 10 that can make the transition and Range is one of them. If Range’s free cash flow power crystallizes for investors the stock could make the jump to hyperspace.
I was largely self-taught when it came to investing. I started out reading Peter Lynch who emphasized investing in what you know. I read even more from Buffett who emphasized brands, moats, and pricing power. That all resonated deeply with me, so naturally over the years I fell in love with energy, which offers a smorgasbord of B2B companies that don’t meet any of those criteria!
E&Ps don’t have much in common with businesses like See’s Candy. They don’t have pricing power. They’re capital intensive commodity producers. Any moat they have starts with the rock, and it only lasts until the asset is depleted. Generating free cash flow is almost unheard of. It’s extraordinarily easy to destroy value because the companies have to reinvent themselves every so often in the search to replace reserves. The industry also has a long history of promoters taking advantage of investors. Still, I spend a lot of time studying E&Ps because everything that happens in energy stems from the upstream, but I rarely invest because of those characteristics.
My energy investments have prioritized business models that can grow earnings in line with shale production volumes. I believe shale is poised to take market share on a global basis for years to come because it is low cost, it has scale, and the shale business model is endowed with characteristics that support continuous efficiency gains at a speed that other resource types can’t compete with. It also can’t be copied outside the United States except in select locations for a variety of reasons. It’s hard to predict commodity prices but at least I know the volumes are going to move.
To that end I have mainly been investing in midstream companies and royalty vehicles aligned with low cost and scalable shale resources because the main driver of their earnings growth is volumes. These are the closest to Buffett-like businesses in the oil patch. They tend to generate consistent free cash flow and have meaningful capital return programs, two characteristics that E&Ps have lacked. Midstream companies even have pricing power if they own the right assets. However, the time has come to start making exceptions for E&Ps like Range because I don’t know where else you can find the potential to generate >20% FCF yields on a sustained basis.
Every basin goes through a lifecycle, from exploration and new discoveries in the identification phase, to delineation in the optimization phase, and development in the standardization phase, followed by a reinvention phase when operators employ secondary and tertiary recovery techniques or discover new zones that are commercially viable.
Note: This graph is five years old so you can ignore what it says about the lifecycle point of the basins. Just focus on the concept.
The identification and optimization phases are particularly dangerous and I am certainly in no position to invest during those periods because my technical knowledge base is not strong enough. Rather than majoring in petroleum engineering in college I thought it would be super smart to major in business, a tremendous mistake. What’s done is done though and a man has got to know his limitations.
There are good reasons why people seek their fortunes in the E&P business in spite of the long odds. One reason is scale. The upstream offers the potential to hit it out of the park in a way that very few businesses can offer. It’s no coincidence that a number of people who became some of the richest in the world did it in the upstream business, from H.L. Hunt to J. Paul Getty in the olden days to Harold Hamm today.
The goal of most E&Ps is to build up a large base of producing wells, which is a very desirable asset, as quickly and cheaply as possible. By the time you get a large base built up, the risks associated with exploration and dry holes have already been absorbed, and so have the capital costs of making the wells. Sure, production from wells is constantly declining and commodity prices are unpredictable, but the incremental costs of operating the wells are minimal. As such, producing wells will be profitable under almost all circumstances. Profitability is a sure thing. The only question is just how profitable will they be. 80% EBITDA margins are common.
For many years the independent E&P business model was to build the PDP base, and then seek an exit before production from the depleting asset rolled over by selling to a major or a large independent who saw M&A as a low risk way to replenish reserves.
However, it has been apparent for a while now that shale’s characteristics are very different from those of conventional resources. Drilling success rates are often 98-100% (meaning dry holes are rare) compared with 50-60% prior. I’ll use Noble Energy (NBL) as an example since they have a long time series of history and have participated in the shale game. Notice the spike in success rates in 2005-06 as the shale revolution got under way.