Fadel Gheit: Gas Sector M&A Activity About to Ramp Up Source: Brian Sylvester of The Energy Report 6/10/10
When folks want the straight goods on the oil and gas sector they go to Oppenheimer's sage Managing Director Fadel Gheit. That's what we wanted, too, when we asked him to spend some time with The Energy Report. In this upfront interview, Gheit rails against government inaction on oil price speculation and predicts low gas prices will soon lead to more M&A activity. Gheit's market commentary is frank and insightful and could certainly impact your investment decisions.
The Energy Report: The oil spill in the Gulf of Mexico (GOM) continues to get daily headlines. Is the spill affecting the oil price or only the prices of companies with exposure to the Macondo accident?
Fadel Gheit: The spill really did not have any impact on oil prices. Oil prices are basically reflecting increased concern about global economic growth and China slowing down its economy; Europe is obviously having problems with the bailout of Greece and the expectation of bailouts for Portugal and even Spain. That casts a shadow on global economic growth and therefore demand for oil is likely to be a lot lower than earlier forecasts. That's why oil prices came down from $86 to $70. The Gulf incident really did not have any impact.
FG: Well, we have not changed our recommendation on BP. We downgraded Anadarko because its exposure to future liabilities relative to size is almost 1.5 times the impact on BP. It is less financially flexible than BP, so BP can go and borrow $10 billion and still have a relatively acceptable debt ratio while Anadarko is pretty stretched out as far as its financial flexibility. They are two totally different companies, but unfortunately they are in the same boat. Their stocks have suffered significantly over the last 30 days.
TER: But at the beginning of May, well after the accident, you still had an outperform rating on Anadarko.
FG: Correct. Anadarko and BP both lost 29% of their market value in the last month. I thought for a while that Anadarko could withstand the pressure a little bit because it has tremendous upside potential as far as drilling. But then a lot of people concluded, including myself, that it has very high exposure to offshore drilling, which is likely to enter a new phase of government regulations. That would make it less appealing than it was only 30 days ago. That's the reason for the downgrade.
TER: In another May report you had EOG Resources (NYSE:EOG), Pioneer Natural Resources Co. (NSYE:PXD), and Occidental Petroleum Corp. (NYSE:OXY) rated as outperform due to their lack of exposure to what's going on in the GOM. Tell us about these companies.
FG: By definition companies that have very large exposure to an unconventional play are immune to what is happening in offshore as a result of the oil spill. Companies like EOG have very little footprint or none when it comes to offshore. It is going into production in the U.S. and focusing on liquid production growth and because oil is selling at a significant premium to natural gas. EOG and the rest of the independent oil and gas producers have increased their focus on growing their oil production at a much faster rate than they had planned only a few months ago. That's one of the reasons that we still like EOG. We still like Chesapeake Energy Corp. (NYSE:CHK). We still like Devon Energy (NYSE:DVN). All these companies are basically or predominantly natural gas but they are increasing their focus on oil.
TER: Are there other buying opportunities related to the Gulf?
FG: I do not follow services companies, but obviously increasing regulations will force producers to use more services to do more tests and be more careful going forward. Money will go to the service provider, whether it's a helicopter company or companies that do basic drilling platform maintenance to make sure that we are safe and sound. There will be winners in the new era of government regulations.
TER: In another Oppenheimer report it's stated that investors dumped companies with exposure to the GOM after White House comments regarding a possible moratorium on new drilling. Nonetheless, drilling in the Gulf continues. Might this be a good time to pick up some of those companies?
FG: Investors will shy away from companies that are making headlines for whatever reason. But a company like Apache Corp. (NYSE:APA), for example, is the largest operator of shallow offshore platforms and a very good operator. It has a clean track record. Obviously the stock came down very sharply on the news that there could be a moratorium on drilling and permitting. It also has a pending acquisition of Mariner Energy Inc. (NYSE:ME), which is focused on deepwater prospects. A lot of investors looked at the acquisition as negative and sold off. I like Apache, it has a very good management team, a very strong balance sheet, a very strong track record, too. It has become an investment opportunity.
TER: You were on MSNBC the other day talking about supply and demand fundamentals in the oil price. In another piece you said that some of the big financial players like pension funds, Goldman Sachs and Morgan Stanley are manipulating the oil market. Can you tell us how that works and what sort of role this price manipulation is playing in the oil price right now?
FG: I truly believe that speculation is driving or has driven oil prices in the last four or five years. Congress believed it too that's why there were hearings. I testified before Congress on that subject. The CFTC (Commodity Futures Trading Commission) chairman, who is a former partner of Goldman Sachs, believed exactly what I believe. The question is can we get Congress to really limit speculation by financial speculators. That becomes a tall order because of politics and lobbying and all these sort of things. I believe that if we put limits on commodity trading by non-principals-basically the financial players-I think you are going to see little volatility. I think you are going to see the restoration of supply/demand driven markets instead of future speculation driven markets, which we have right now and have had for the last five years.
TER: Do you believe the government will step in?
FG: I'm not sure. Elizabeth Warren, who is overseeing financial regulation in Washington, said publicly that the financial lobby and the financial industry is extremely powerful. Basically, when there are bought politicians on both sides of the aisle it becomes really difficult for Congress to push through this kind of regulation. The fact is even the CFTC chairman could not convince Congress to impose restrictions because his own staff shut him down. I am not hoping for change.
TER: Are you saying that consumers can expect artificially inflated oil prices for the foreseeable future?
FG: It's not only in oil prices. We've seen it in real estate and look what happened-we had the financial meltdown. We're seeing it in commodities because of knee-jerk reactions, because of misinformation, because of a lack of government regulation. It's sad but this is the environment we live in. Government is either incompetent or corrupt and they put us in debt as a result. Like I said I'm a realist; I don't daydream a lot. If we believe that we are going to have (oil price) regulations, then we will be daydreaming.
TER: In your view what should the oil price be?
FG: Theoretically speaking, in my calculations I don't see oil prices justifiable above $60. There is an old rule called the one-third rule. Basically the replacement cost should be about one-third of what the oil price is. Right now the industry replacement cost is less than $20, so the commodity price should not exceed $60. This rule has been in place for 30 years and we haven't really changed much. Actually a company like Occidental Petroleum, they limit the replacement cost of a barrel of oil to 25% of what they think the price of the commodity is likely to be. Having said that, they'd love to see $80-$90 oil but they'd like to keep the replacement cost under $15.
TER: What is Oppenheimer predicting for oil in the next six months and then the next 12 months?
FG: We really don't predict too much because if you play the game by the rules and everybody else is cheating you're guaranteed to lose. I don't enjoy losing so in our income model we tell people what we fear and what we think. When we do our earnings estimate, we basically link our benchmark to whatever the NYMEX is telling us. If the futures index is telling us it's going to be $80 next year, we use 5% discount on that number. Right now we're looking at oil prices on average to be about $77 this year and about $80 plus dollars next year.
TER: How do investors profit from $75-$80 oil?
FG: There are a couple of things. Stable or lower oil prices will always favor larger companies like Exxon Mobil Corp. (NYSE:XOM), British Petroleum, Chevron Corp. (NYSE:CVX), ConocoPhillips (NYSE:COP) but if oil prices or natural gas prices increase significantly for whatever reason, whether through speculation or market events, investors usually flock into the stocks of the independent oil and gas producers because they have a higher beta. On the way down they decline the most and on the way up they gain the most. So I'm still very bullish longer term on domestic oil and gas producers.
TER: What do you see happening in the domestic oil and gas producer space?
FG: I think two things will take place. The survivors will get bigger. They will acquire smaller companies. Apache is buying Mariner at a decent premium, but they will extract good value out of it. I'm very surprised that we have not seen more mergers and acquisitions. If natural gas prices remain close to the current level and oil prices don't go much higher, I think we are going to see a lot of pressure on the smaller companies that have been waiting for a very, very big payday that might not come. These companies will probably settle for a lot less than what they had in mind; we are going to see a lot of mergers and acquisitions. As a result the independent oil and gas producers are very ripe for the picking by larger companies, whether domestic or international. And, as I said before, that will create value. These smaller companies have real growth. The larger companies have little or no growth. So I still like the oil E&P (exploration and production) stocks. I think this is the future. Investors are basically thinking the same way.
TER: Are there any high percentage takeover targets that you're looking at?
FG: Companies don't buy other companies for one or two reasons; they want to see the best fit. They look at value, not necessarily what they are paying for the company. I mean one plus two should not be three. It should be 3.5 or 4 or even 5. Then you're creating shareholder value. I would say most if not all the independent oil and gas producers are potential takeover targets. It's unrealistic to think all oil E&P companies are going to be taken over. Probably 10% of the independent oil and gas companies-if oil and gas prices don't move much higher from the current level-are likely to be acquired over the next couple of years.
TER: Are we more likely to see takeovers of onshore E&Ps? Offshore E&Ps? E&Ps in the oil sands? E&PS in the Bakkens? What's the focus going to be?
FG: The consolidation onshore is going to accelerate because I don't see any real spike in natural gas prices any time soon. It's going to be survival of the fittest. We are going to see consolidation in the major and unconventional plays whether the Bakken Shale in North Dakota or the Marcellus in Pennsylvania or the Eagle Ford in Texas or Haynesville in Texas and Louisiana. Timing will depend on where the commodity prices are going to be six months or a year from now.
TER: You see most of the consolidation in the gas and shale plays?
FG: Yes, because this is the area where people were betting on higher prices that never materialized. Most of them are beginning to think realistically. I mean don't hope for $10 gas because it's not going to come any time soon. You have to readjust your valuation of your assets so you're most likely to accept a much lower bid than you had in mind. That's essentially what XTO Energy (NYSE:XTO) did with Exxon. XTO is one of the largest E&P companies. It basically set the tone for what to expect in futures mergers and acquisitions.
TER: What sort of models are you using for the gas price?
FG: Almost everybody thinks that gas prices at best will reach $6 in two or three years. Might even reach $7 but that's about it. Any higher prices would bring more supply because everybody has perfected the technology-everybody. This is no longer an exclusive, private club. The smallest of the companies drilling in Haynesville or Eagle Ford or wherever can do a better job than the largest player in that play. If prices rise, supply is going to come at much faster rate. The market will have to reach an equilibrium. Every time we see higher prices, you're going to see more production. More production will bring the price back down and so forth. The $5 to $7 range is probably good for the next four, five, six years.
TER: A recent Oppenheimer report stated that replacing reserves at competitive costs is by far the biggest challenge facing oil and gas-producing companies. To what extent does this make secondary oil companies more likely to be takeover targets?
FG: This is the basis for our thesis that there are fewer and fewer areas for the large companies to go. National oil companies have taken over. They are no longer in the passenger seat-they are doing the driving. The oil companies basically serve those companies. Nationals want to pick their brains of the oil companies and give them whatever.
TER: Why is that?
FG: Because there is no access to large resources anywhere in the world. Iranco is just as good as Exxon or BP at drilling onshore. It's their backyard-every rock and stone in the desert. Why would they need an Exxon or BP or Chevron to share their wealth? Russia is learning very quickly. Five years ago they were inviting every company to go over there and invest a lot of money. They learned the game. Now they want to play it, so they try to push companies out. Venezuela! Hugo Chavez confiscated the assets of Exxon and ConocoPhilips. The fiscal regime is getting tougher. Terms are getting tougher. The profit per barrel in North America as a result of these changes is now the highest in the world for the large oil companies or for whatever companies. After all is said and done companies make more money per unit of production in North America than in any of other country.
TER: The last time you talked with us you talked about Exxon, Royal Dutch Shell Plc. (NYSE:RDS.A), ConocoPhilips and Chevron. Please give us an update on those companies.
FG: Conoco is undergoing major restructuring. They are selling some of their assets. These steps will generate about $15 billion. They are going to use $5 billion to pay down debt; $5 billion to buy back their stock. The other $5 billion will go to capital spending, growth projects, tactical acquisitions or to buy back stock. And to increase its dividend because they believe growing the dividend at a higher rate is appealing to shareholders.
Exxon is waiting for the final approval of the XTO acquisition, which could be the catalyst needed to get Exxon on the right track. Exxon stock has not done well at all in the last two years. The acquisition is not really going to move Exxon's production or reserves but it's going to double Exxon's gas production in North America. It will basically give Exxon all the tools of horizontal drilling, which XTO perfected, to use on a global scale. That's where the growth is likely to come. Royal Dutch is basically going through organization and cost saving measures to improve their competiveness and lower their operating costs under new CEO (Peter Voser). He used to be the CFO so he's focused on costs. I wish him luck and he seems to be doing a good job.
Chevron has the second best stock performance among major integrated oil companies. It has a very strong balance sheet with very low debt, and a very high level of cash on hand. It has a very rich portfolio of projects. They are progressing with one of the largest natural gas projects in the world-the Gorgon field in Australia. The gas in Australia is going to be converted into LNG onshore and then shipped to customers in Asia. It's a $42 billion dollar project-the largest in the company's history. It's going to take four or five years to build. They have a lot of projects that will be following this one, unfortunately they are mostly natural gas, which is what most of these companies are focused on right now.
TER: What are your ratings on these companies?
FG: We have perform ratings on all of these companies, unfortunately, they have been underperforming the market. Although the market so far this year is down about 4% all these stocks are down on average about 17% or 15%. The only stock that has outperformed the S&P 500 this year is ConocoPhilips. It's down but it's down less than the market.
TER: Are you more bullish on natural gas or oil producers at this point?
FG: You have to recognize the fact that oil is trading at 200% premium to natural gas. It's an undeniable fact. A lot of companies, if they have a choice, will increase their drilling on oil deposits instead of gas. They will keep gas until the price is right and to them the price is not right. Why waste the resource in an overcrowded and oversupplied market? Longer-term I think we should all be more bullish on gas. It's cheaper. It's cleaner. We should have plenty of it. The technology has been perfected by E&P companies and now the big and mighty from all over the world are coming to the U.S. to learn the technology at the hand of the masters. The masters happen to be the small E&P companies, whether it's Chesapeake, whether it's EOG, whether it's Range Resources (NYSE:RRC). It is really the future of this country. It's a commodity that relative to oil is undervalued and in more abundance now than oil and less political, which is very important. If the blowout in the Gulf of Mexico had been a gas field, we might not be in the mess we are in now.
TER: Who do you like among the independent gas producers?
FG: We like Devon Energy a lot. Devon recently sold its offshore assets and is now an onshore North American play. The safest you can get. The most stable area you can do business in. The focus is mostly on natural gas in the U.S. and unconventional oil, which is basically the oil sands in Canada. They are using the most advanced seismic deep technology, which is basically in situ processing. They produce oil by injecting super heated steam into the deposit and collect the oil. They are already producing from one project-Jackfish 1. They are duplicating it and have almost completed Jackfish 2. They have a permit to do Jackfish 3. Each project produces 30,000 barrels a day. Very profitable, very long reserve life, clean technology and a very well-managed company. Devon was one of the pioneers of horizontal drilling in the Barnett shale. They drilled more horizontal wells than any other company so they are expanding in other plays. The recent sell-off program gave them over $8 billion, which exceeded the high end of the forecast of $7.5 billion. The money is going to be split. Half of it is going to go to share buyback, which will be about 15% of the shares outstanding. The rest will be used to pay down debt. Two things that are likely to push the stock price higher. The reason the stock has not done much is basically because it's a predominantly natural gas play.
TER: Are there any thoughts you'd like to leave us with?
FG: I think price volatility will continue. I think it's a shame that the government knows what's going on and either does not want to do or cannot do anything about it. I think market transparency should be the norm, not the exception. I think it's the volatility that really hurts planning and future investment. Companies do not know how to budget if they don't know where gas prices will be a week from now or a year from now or whenever. Unfortunately, financial players can gain at the expense of consumers that have to pay dearly for the commodities that they are using.
Fadel Gheit is a managing director and senior analyst covering the oil and gas sector for New York-based Oppenheimer & Co. He spent six years with Mobil Oil and five years with Stone & Webster. He has been an energy analyst since 1986 with Mabon Nugent and JP Morgan and has been with Oppenheimer & Co. Inc. since 1994. He has been named to The Wall Street Journal All-Star Annual Analyst Survey four times and was the top-ranked energy analyst on the Bloomberg Annual Analyst survey for four years. He is one of the most quoted analysts on energy issues and has testified before the U.S. Senate and the U.S. House of Representatives about oil price speculation, and is a frequent guest on TV and radio business programs. Fadel holds a B.S. in chemical engineering from Cairo University and M.B.A. in Finance from New York University.
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