Rehan Rashid: Shales Spur New Supercycle of Energy Production
Source: George Mack of The Energy Report (5/17/11)
Over the next two decades, liquid and natural gas shales could release a treasure trove of new energy production. But even given this extraordinary new resource, FBR Capital Markets Head of Energy and Natural Resources Research Rehan Rashid expects demand to stay ahead of supply. Rehans's long-term bullish scenario favors a few select names that he shares with The Energy Report in this exclusive interview.
The Energy Report: Your coverage universe is mid-cap to very large, and I even see a couple of companies under a billion dollars in market cap. Could you tell me your basic investment theory?
Rehan Rashid: We believe an energy supercycle is redefining how we look for oil and gas, thus driving reserve and production growth the likes of which we have already seen in natural gas and are now seeing unfold on the liquids and oil side. And yes, this is applicable to small cap names, perhaps sometimes more dramatically like we're seeing in Rosetta Resources Inc. (NASDAQ:ROSE) today.
TER: Your list looks to be largely tied to commodity price and perhaps M&A activity.
RR: I'm kind of a commodity agnostic. Instead, we are margin-driven. It's all about margins and what's currently priced into the stock. It could be oil, gas or something in between. We are more focused on the platform-the acreage position or the capital structure that goes into a good bottom up thought process.
TER: You just mentioned your supercycle thesis. We've already gotten the low-hanging fruit from conventional drilling, but you believe we're getting this new supercycle of energy from the shales? Is that correct?
RR: Yes. U.S. natural gas production quadrupled from 15 billion cubic feet per day (Bcf/d) in 1950 to more than 60 Bcf/d of dry gas by 1970. That's kind of when the last paradigm shift finally played itself out and we discovered a lot of what was then known as conventional gas. So, it's our estimation that yes, history is repeating itself under a different name.
TER: And this momentum is driven by new technology.
RR: Absolutely. The question in the investor's mind is no longer whether this new reserve or production growth is really happening, but rather what is its magnitude and what is the path that it might take? Also, how fast will this technology facilitate the harder stuff, such as oil shales or liquids development, including processing and all the other above ground infrastructure issues?
TER: How long can this supercycle last?
RR: The answer to that question is probably two-fold. First, we need to know how long it will take for growth to play out. Second, we need to know how quickly the market will recognize the value. Natural gas production took 20 years to quadruple from 15 Bcf/d to 60 Bcf/d in the last go-round, right? So, physically speaking, it may take a long time-a decade, two decades-to get the appropriate volume of oil and gas out of the ground. But the market will stay multiple years in front of that. The market typically likes to stay 6-12 months ahead, but in a growth cycle, it probably goes out 24-36 months. So, in my opinion, the overall evolution of the trajectory of the growth is going to peak 10-15 years from now, and the stocks will price in 12-36 months going forward at any given time.
TER: Okay, in light of that, you've lowered your full-year price forecast on natural gas from $5/mcf to $4.80/mcf, but you're maintaining your 2012 forecast at $5.50/mcf. Why wouldn't this price drop?
RR: I presume you're alluding to the idea that the existing supply of natural gas may result in pressures at these levels or even lower?
TER: That's my question, yes.
RR: That's a complicated question with a lot of inputs that will drive gas prices higher going forward. In the middle of 2008 and early 2009, we were the first ones to lower the long-term price to $4.50/mcf. We saw what was happening two years ago and said that gas prices would have to correct to these levels before we can talk about any change in direction. We saw that two years ago, but now we're trying to look further out.
What we're seeing slowly but steadily now is that the market is responding. Chemical companies are coming back and power generation companies are favoring more and more natural gas. Plus, environmental regulations are making it more difficult to burn coal. So, consumption factors are shifting to favor more demand. In addition, what people forget is that yes, while shale is going through a massive growth cycle, almost 40 Bcf/d of existing supply is old, conventional assets that are seeing no capital investment and is going to decline. I think between improving demand, continued shale growth and declining conventional supply, we will see a balance of supply and demand leading $5.50/mcf gas.
TER: What is your oil forecast?
RR: Well, oil is a much tougher beast because of global drivers. It's not lost on us that global spare productive capacity is too low. We also see that global geopolitics are for real and manifest themselves in a whole host of different ways. The future of the dollar is under question. So, we will let the broader futures market aggregate all that and come up with a pricing forecast. We will take a 10% haircut off that and build it into our models. In other words, we don't actively forecast oil prices, but we understand the broader dynamics, and that's why we're okay with letting the market set the direction.
TER: From your perspective, is the price of oil U.S. dollar-dependent?
RR: It is dependent on the U.S. dollar, geopolitics, tight spare capacity and, of course, the continued globalization and urbanization growth stories that come of out of China, India and BRIC countries [Brazil, Russia, India, China] in general. It's dollar; it's geopolitics; and it's economy.
TER: We've seen some recent pull back in nearly all commodities. Could this be a trend, or is it a normal part of the cycle?
RR: Well, we went from $85/bbl oil to $112/bbl or so. At $4-plus a gallon gasoline at the retail level, demand could be affected. The market is going to react with a correction. The direction of the price will be dependent upon the ability of the world to absorb the higher oil prices, and the U.S. dollar.
TER: Rehan, you have said that the primary risk in investing in oil and gas producing companies is depressed commodity prices. How does the investor manage these risks?
RR: It may be difficult in the near term to be agnostic to commodity prices, but over time, margins, asset growth and production growth should really drive value creation. If oil prices drop, cost structures will also come down and margins will improve again. But you have to endure that yin and yang over time.
TER: Should investors be adding more exploration and development to their portfolio weightings?
RR: Yes, they should because in our opinion at the beginning stages of this supercycle, the risk-adjusted returns are much higher.
TER: How should the companies protect themselves? Is this the time to have capital structure fixed for the future?
RR: It is always prudent to have a reasonable portion of your commodity portfolio hedged in the financial markets. The value proposition for companies is not simply in commodity exposure, but also in value creation from their technical competence. So, yes, we like companies that have cash flows to execute the program.
TER: For equity investors, where are you telling them they should be today?
RR: To be name-specific, we like Pioneer Natural Resources Co. (NYSE:PXD) quite a bit. We like Newfield Exploration Co. (NYSE:NFX). We like Southwestern Energy Co. (NYSE:SWN). We like Endeavour International Corp. (NYSE.A:END). All these companies offer some margin of valuation or asset growth, or they're not fully appreciated in terms of their platform.
TER: You have Pioneer rated outperform and you said earlier in the spring that the flow rates from its horizontal Wolfcamp drilling would set the price direction for the rest of this year. How is that looking?
RR: Well, the results are mixed so far, but I am probably repeating what the market is thinking. Our opinion is that it's just the beginning, but there's so much oil in place and technology will ultimately resolve the gap of where their productivity is today and where it's going to go tomorrow. EOG Resources Inc. (NYSE:EOG) validated that recently in its earnings call that Wolfcamp and Permian horizontals looked good, and they'll get better. So initially, Pioneer may be mixed, but the industry's saying this will get tremendously better.
TER: You mentioned Newfield; your target price is $85, which is an implied return of 20% from current levels. I realize you don't worry about commodity prices too much, but this is an oil-driven play. If oil settles at current prices, can Newfield achieve your target price?
RR: Yes, we use $90/bbl oil long term in our metrics and we have not adjusted the numbers higher for $110/bbl or anything like that. Our underlying presumption right now is $90/bbl oil long term and Newfield can very well achieve those objectives.
TER: You mentioned Southwestern. What's the long-term driver here?
RR: Transition to liquids and how successful it will be.
TER: Is there any news on the company's new stealth play?
RR: Not yet, but we're expecting it in the third quarter.
TER: You also threw in a small-cap, Endeavour International. Your target price implies a 50% upside. Are there any misconceptions about the risk in this play?
RR: Well, yeah, we think so. We think that the production of the company from its discovered projects alone could be up seven- or eight-fold in the next two years. But the asset base is in the U.K., and the market for small-cap reasons and international-asset reasons has chosen not to give it the appropriate credit. It's also pursuing a central-Montana heat oil shale play and an Alabama shale play that the company believes looks like the Marcellus. So, yes, to us the risk/reward profile is very attractive given the material development-driven growth and a domestic program that could be a game changer with very minimal capital required.
TER: At current levels, do you think of Endeavour as being value priced?
RR: Yes, very much so.
TER: Okay, so those are your four favorite plays. Did you recommend any others?
RR: No, these are our top four names to think about along with a lot of different things that can happen in the sector at any given day, but we are focused on these four.
TER: I enjoyed meeting you very much.
RR: Thank you.
Rehan Rashid is managing director and head of energy and natural resources research at FBR Capital Markets. He joined FBR in September 1998 as a vice president, covering the oil and gas E&P sector and most recently initiated coverage of the liquefied natural gas (LNG) sector. Prior to joining FBR, he was an associate analyst at PaineWebber, covering E&P and spent two years at Jefferies Inc. He received his BS in accounting and an MBA in finance and accounting from the University of Houston.
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1) George Mack of The Energy Report conducted this interview. He personally and/or his family own shares of the following companies mentioned in this interview: None.
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