Ramping up domestic North American liquid natural gas production for export to pricier international markets could be a game changer for struggling junior explorers. In this interview with The Energy Report, C. K. Cooper & Company's Jeff Grampp tells us why drilling in domestic gas fields for export is a good idea. . .if the Feds play along. And he identifies promising juniors with leaseholds in particularly desirable fields.
The Energy Report: Jeff, if the Obama administration continues to authorize liquid natural gas (LNG) exports, will that benefit the juniors as well as the big producers?
Jeff Grampp: I believe all U.S. natural gas producers will generally benefit from an increase in LNG exports. Historically, the pricing dynamics of natural gas in the U.S. have been linked to local supply-demand dynamics. With an increase in the potential to export, domestic natural gas producers would be able to access higher priced markets internationally, particularly in Europe and Asia. There will also be local economic benefits tied to the creation of jobs at newly constructed exporting facilities.
Of course, an increase in natural gas prices potentially could burden U.S. consumers. Politicians will have to gauge public opinion as new export facilities open and if natural gas prices increase. I believe the situation will not necessarily be governed by Economics 101, where the U.S. would maximize exporting to realize higher international prices, because powerful political factors will be in play.
TER: How does the domestic supply situation affect consumer prices?
JG: We have seen a recent correction from when prices bottomed at the sub-$2 per thousand cubic feet (Mcf) level. The natural gas rig count has gone down tremendously over the last couple of years. But, at the same time, there remains pent-up potential gas supply that's not being tapped, due to the more attractive economics of the oil- and liquids-rich plays. As natural gas prices creep up and export facilities enter the equation, producers may increase activities in natural gas plays. We could also see a yo-yo effect as prices go up, and supply may build up incrementally. But if supply ramps up too much, of course, then prices could fall.
TER: Will exporting gas from North America reduce the supply available for domestic consumption?
JG: If producers can sell natural gas at much higher prices internationally, then it would obviously make sense to access those markets. Supply could be diverted from domestic consumption for export, possibly leading to more uniform global natural gas prices, which would be more similar to oil. As it currently stands, oil is the more transportable commodity, so oil prices tend to trade more in sync around the world, whereas natural gas supply-demand dynamics have historically been a function of regional supply-demand factors. But with more global exports potentially in play, we could see natural gas prices trade more in line internationally in the near future. Therefore, we could see natural gas prices fall in regions where they are higher, and in lower-priced regions, such as the U.S., prices could rise.
TER: What are the obstacles for opening up the North American market to export?
JG: I believe the federal government will be reluctant to allow substantial exports of natural gas early on, given our dependence on fossil fuels to run the economy. The federal government will likely be hesitant to ramp up LNG export facilities, even though international demand may warrant more facilities. The Feds are taking a measured approach in their approval of export facilities, as they are watching to see how early facilities play out before accelerating the permitting process. There are also environmental concerns to consider, in terms of where these operations can be built, especially in Alaska. But there is also political pressure to open up the market for exporting.
TER: If we do start exporting more natural gas from the U.S., what kind of competition would we face globally?
JG: Australia exports LNG. Some U.S. producers are also looking at exporting LNG from their international assets. A vast amount of natural gas potential globally is not being fully realized, partly due to regional supply-demand dynamics. Traditionally, if natural gas demand is low in a local economy, it has not made sense to develop the resource because exporting potential was limited. But if producers can access international markets, where prices are higher and supply is limited, it definitely makes sense to develop the assets.
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TER: Is there demand for U.S.-derived LNG in the Latin American and Central American markets?
JG: The demand in those developing economies is not as robust as in Europe and Asia, as they tend to rely more on diesel fuels and oil than upon natural gas.
TER: How do you assess President Obama's recent statement that energy is booming in America?
JG: It truly is booming, due to the technological revolution in horizontal drilling and increased exploitation of oil and gas deposits that were previously considered to be uneconomic. As technology continues to evolve, and with more efficient fracture stimulation and completion methodologies, many previously marginal plays will begin to bear fruit.
TER: With junior energy stocks at all-time lows, what should investors look for when assessing a mid- or micro-cap company in exploration and production (E&P)?
JG: We've actually seen a number of quality junior players appreciate nicely recently. At C. K. Cooper & Company, we look for strong management teams with proven track records. We also try to identify companies with growing production bases and a strong level of current running room for exploiting potential drilling locations. Accessing capital markets to acquire drilling locations and production can work, but there can also be a lot of uncertainty in terms of available capital and obtaining the right asset to integrate into a company, so we like to find companies with solid assets in place, rather than those that will rely primarily on potential future acquisitions.
TER: Is the problem of finding capital improving for the juniors?
JG: Given today's very favorable interest rate environment for issuers, the debt market can often be an attractive source of capital, if junior E&P firms are prudent. Investors should watch out for firms that have overleveraged through accessing the debt side too much. The equity side remains difficult. There is only so much capital available, and equity investors are being judicious in allocating capital to only the companies with the highest returning prospects.
TER: Is this a good time to buy in the mid-cap E&P sector?
JG: There are good buying opportunities. We just initiated on Midstates Petroleum Company, Inc. (MPO:NYSE) with a Buy rating and an $11 price target. The company had an initial public offering (IPO) in April 2012 with some conventional Gulf Coast assets, and it made two producing property acquisitions this past year in the Mississippi Lime and Anadarko Basin. These two assets give Midstates significant running room in two midcontinent plays with lower-risk, liquids-rich horizontal drilling opportunities. On the Gulf Coast assets, Midstates is testing horizontal wells in conventional reservoirs with some pretty encouraging early results. The firm has a very strong management team, and we see a lot of upside with the name.
TER: What names are attractive to you in the natural gas space?
JG: On the gas side, we like FX Energy Inc. (FXEN:NASDAQ), which has assets in Poland. It has several large exploratory blocks and recently announced a very solid production test on an exploration well in a 100%-owned block outside of its Fences concession. The Fences concession has been one of FX Energy's more successful blocks and news of the company's drilling success outside of the Fences concession is particularly positive. FX Energy plans to drill more wells near this most recent find after it acquires three-dimensional seismic data and there is good potential in 2013 for FX Energy to capitalize on its recent success.
TER: How do international pricing dynamics affect FX Energy's position in the Polish market?
JG: Most of Poland's natural gas is supplied by Russia, with natural gas prices in Poland being quite high given its lack of domestic production. FX Energy's strategy has been to take advantage of the localized natural gas pricing dynamic. In the long term, it would not be out of the question for Polish imports of LNG to impact natural gas prices in Poland, but it seems unlikely to have a major impact over the next couple of years. For the time being, these guys are producing natural gas in the right place given that they receive nearly $7 per Mcf.
TER: Moving back to North America, are there any other companies that canny investors should buy?
JG: We really like the Wattenberg Field names at C. K. Cooper & Company. We cover Bonanza Creek Energy Inc. (BCEI:NYSE), PDC Energy Inc. (PDCE:NASDAQ) and Synergy Resources Corp. (SYRG:NYSE.MKT), which all operate in the Wattenberg Field. We like finding smaller players in areas with a lot of offset operator activity, particularly by the larger independents and majors. The two largest players in the Wattenberg Field are Noble Energy Inc. (NBL:NYSE) and Anadarko Petroleum Corp. (APC:NYSE). Both of these companies are spending billions of dollars testing aggressive down-spacing and upside potential in a variety of targets in the field. That activity allows the smaller firms to sit back and watch, and then play catch-up in the patterns that work. Noble and Anadarko are testing different "benches" in the Niobrara and the underlying Codell formation. Their de-risking of the potential of the targets then trickles down to the Bonanzas, PDCs, and Synergys. These smaller companies are starting to do their own testing of aggressive horizontal targets, because the big guys have shown that it works.
TER: How big is the Wattenberg Field?
JG: It is a relatively smaller field within the DJ Basin in northeastern Colorado. It's a liquids-rich play with well costs typically running between $4–5 million ($4–5M). Noble is also drilling long lateral wells to enhance recoveries, and is seeing encouraging results. Companies are targeting different benches within the Niobrara Formation, which are generally referred to as the A bench, the B bench and the C bench. The Codell Formation underlies the Niobrara and is also prospective for horizontal development, potentially yielding four different horizontal targets. And the firms are testing down-spacing, with as tight as 40-acre spacing for a horizontal well. Ultimately, there could be between 8 and 16 horizontal wells per target in a section, which could translate to significant value for these companies' leaseholds.
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TER: How do you assess the potential for mergers and acquisitions (M&A) in the Wattenberg, given the lack of equity capital available at the moment?
JG: M&A definitely comes into play in the Wattenberg. Given that the Wattenberg is a relatively small field, with very few players holding significant acreage positions, it stands to reason that Noble or Anadarko could look at expanding their positions through M&A deals. Conversely, a large company not yet in the Wattenberg Field would likely need to go through one of the smaller companies with leaseholds to establish a sizeable position. Many E&Ps have also tried to find similar success outside of the Wattenberg Field in the greater DJ Basin, but results have been mixed. We really like the Wattenberg Field because it offers good upside potential that is lower risk.
TER: Do companies like Noble and Anadarko have capital available for M&A?
JG: Their ability to raise capital would likely be a little easier than smaller independents, given their size, reputation and longevity as public companies. They are not small companies with unproven management teams trying to raise equity to explore vast acreage positions. The capital markets generally like having the comfort of knowing their capital is being allocated to something that could generate a solid return and is also lower risk. For the larger players, convincing the market that expanding leaseholds in the Wattenberg Field is a good play should be a no-brainer.
TER: How do you set your buy and sell target prices?
JG: Our price targets are generally based on net asset value. We evaluate the company's current proved reserves and back out any debt and senior securities to get a proved value for the common equity. We then value the upside potential on the company's acreage by calculating how many wells it could potentially drill, and estimating how much a given well is worth on a net present value (NPV) basis. We then assume that these wells get developed over a number of years to arrive at an NPV of the company's entire leasehold position. We believe this generates a value that is comparable to what a fair value price would be for the company in an M&A deal, which is often how value is realized for micro-, small-, or mid-cap names.
TER: Do you have any final investing advice for people looking to get into or stay in the junior energy space?
JG: It's important to identify a strong management team that can execute a development plan. Look for companies with strong assets and good offset operator activity that will allow them to risk share or jointly determine the best and most efficient way to develop the assets.
TER: Thank you very much, Jeff.
JG: You are welcome, Peter.
Jeff Grampp is a senior analyst in the research group at C. K. Cooper & Company, a full-service investment bank. Grampp joined C. K. Cooper & Company in 2011 and has been instrumental in publishing research and assisting in covering E&P companies across the firm’s entire oil and gas universe. Grampp is primarily responsible for covering the E&P sector at C. K. Cooper, with a focus on mid- to micro-cap names. He is currently a CFA Level III candidate and is a licensed FINRA broker: Series 7, 63, 86 and 87. He received his master’s degree in business administration from Chapman University, where he also received a bachelor’s degree in business administration and accounting with emphases in finance and marketing.
By. Peter Byrne of the Energy Report