FBR Capital Markets remains positive on the Marcellus Shale as a catalyst for banks in Western Pennsylvania, following a recent investor field trip.
"We recently visited with management teams at First Commonwealth Financial Corp. (FCF), FNB Corp. (FNB), Northwest Savings (NWBI), and S&T Bancorp (STBA), as well as a commercial real estate professional from CB Richard Ellis and a project director from the Marcellus Shale Coalition to learn more about the impact and opportunities created by the Marcellus Shale, the second-largest natural gas formation in the world," said Bob Ramsey, an analyst at FBR Capital.
Ramsey said all four banks were excited about the economic benefits and growth opportunities from the shale. Given that banks are highly leveraged to their local economies, the shale creates a favorable secular tailwind for these institutions, particularly at a time when the industry as a whole seems unable to grow.
Still, this is a long-term catalyst, and many bank customers are using new-found wealth or profitability to de-leverage, limiting loan growth despite economic growth, Ramsey said.
Ramsey said wealth management seems to be one of the greatest opportunities for these banks, given the significant, long-tailed annuity stream of payments that landowners receive. Outperform-rated FNB is his favorite shale-related name, and he also upgraded First Commonwealth to "outperform" from "market perform" following a recent meeting with management and recent weakness.
"Our upgrade reflects: shares trade at 1.0 times of tangible book, which we consider inexpensive given the company is profitable, building book, and should generate an 8 percent return on total capital employed (ROTCE) in 2012; the company's exposure to the Marcellus Shale should benefit both its growth prospects and credit quality; and recent M&A activity in Pennsylvania, all substantially above tangible book and at sizable premiums to the market, highlights the value of FCF's franchise," said Ramsey.
If FCF is unable to generate sufficient shareholder returns, Ramsey believes it could sell above the current price. While there could still be some volatility in the company's provision expense, trading at 1.0 times of tangible book, he believes that this risk is more than reflected in current valuation.
Ramsey reiterated his $7 price target, equal to 1.2 times of 2011 first quarter tangible book value. He has adjusted 2011 operating EPS estimate to $0.33 to reflect the company's revision of 2011 first quarter provision expense. His 2012 estimate of $0.45 is unchanged.
Ramsey said drilling in Marcellus was insignificant before 2008. From 2008 through 2010, nearly 2,400 wells were drilled. In 2011, it is estimated that 2,200 wells will be drilled, a 58 percent increase from the number drilled in 2010, and the number of new wells drilled is expected to grow annually for at least the next 10 years.
While a significant amount of mineral rights leases may have already been signed, the drilling process is in the early stages and drives employment and economic activity (everything from manufacturing pipe and building roads, to wastewater removal and treatment), and landowners earn royalties for decades over the life of the extraction process.
Ramsey said early exploration of the Utica shale, located deeper below the Marcellus shale, suggests that it could be even more prolific than Marcellus, although technological advances are still needed to make extraction economically viable.
Ramsey said a well site employs 30 to 60 people at any given time, and including site prep, drilling, pipe manufacturing, waste water treatment, etc., it is estimated that every well requires 30 to 59 contractors and 240 to 450 workers over a six-month period. Since fourth quarter of 2009, Marcellus has added 48,000 jobs in Pennsylvania, with an average annual salary of $70,000 to $75,000.
Shell recently announced that it is evaluating establishing an ethane cracking plant in the Marcellus region. Cracking plants, with a cost of up to $2 billion, are used to create petrochemicals from natural gas, and a plant in the Marcellus region could be within 400 miles of 47 percent of all plastic converters in the U.S.
Given the proximity to an abundant source of natural gas, and related outputs such as those created by a cracking plant, it is reasonable that the shale could also stimulate manufacturing expansion in the region.
"On our trip, we learned that often the first thing a landowner does with a bonus payment is pay off his or her mortgage, or debt against farm equipment, etc. Similarly, as ancillary businesses experience a pickup in activity, many are paying down loans, and using strengthened profitability to fund purchases and working capital, rather than taking out bank loans," said Ramsey.
Ramsey said while stronger economic activity should be good for lending, at this time borrowers are putting a high priority on de-leveraging.