Finding Value in Energy with Morningstar’s Jason Stevens
At the 2014 CFA Institute Financial Analysts Seminar, energy analyst Jason Stevens of Morningstar shared his views on the shale gas and tight oil revolution, which has been driven by fracking, the combination and application of horizontal drilling and hydraulic fracturing that has unlocked the vast potential of trapped oil and gas. During his presentation, Stevens discussed which companies and countries are best positioned to make full use of that potential.
The technique behind fracking is largely attributed to the persistent efforts of George Mitchell, CEO of Mitchell Energy Corp, who perfected the technology through 20 years or so of trial and error. Mitchell’s company was sold to Devon Energy in 2002, and the technique was subsequently emulated by a number of other manufacturers in the United States.
Over the next several years, implementation of fracking technology ramped up significantly, reaching critical mass in roughly 2009. Consequently, US gas and oil production spiked by 35% in 2010, dramatically reversing a long-term trend of declining domestic production. The productivity of these wells has been exceptional. Although these wells are three to four times the cost of traditional wells, the expected recoveries are four to six times the production of traditional wells, with two to four times the returns.
The initial production of a well that employs fracking is much higher than in a traditional well. For instance, vertical rig production at Spraberry began at 80 barrels of oil equivalent (BOE) per day, whereas the horizontal fracking production of the comparably sized Wolfcamp project started at 500 BOE per day. This initial ramp up in production also moves forward the associated cash flows, delivering superior returns for manufacturers. Consequently, massive capital has flowed into the exploration and production segment of the oil and gas industry in the United States.
Many have worried that increased regulations from the US Environmental Protection Agency might hamstring the industry before it even has a chance to reach its full potential. However, Stevens assured delegates that the industry should embrace regulation as it will clarify rules of operation and help weed out bad players.
Around the world, many countries hold geologic potential for shale development. Among many, Stevens highlighted Argentina, Russia, and China — noting that each has massive untapped shale resources. However, there are 1,300 or so international rigs outside the United States, and none of them have expertise in horizontal drilling and fracturing. So, taking up fracking around the world will happen, but it will take time.
Commodity prices tend to mirror the marginal cost of production. In reviewing production costs in the energy market, Stevens indicated that the marginal cost of production had risen during the mid-2000s, which drove up energy prices sharply between 2003 and 2008. After bouncing around in the crisis, energy prices have largely normalized at a much higher plateau, with oil prices in the $90–$100 a barrel range and gas in the $3.50–$4.00 per mcf. Although fracking production has risen dramatically since the crisis in 2008, the energy team at Morningstar has yet to see any meaningful change in the industry’s marginal cost of production. Consequently, Stevens does not expect a material change in marginal costs and hence no material change in energy prices.
Given their expectations of commodity prices, Stevens said their collective discounted cash flow valuations suggest that the exploration and production (E&P) industry as a whole is fairly valued. Of course, within the group, several appear attractive on a relative basis and several appear more risky. Attractive names in terms of valuation highlighted were Apache Corp (APA), Whiting Petroleum Corp (WLL), Denbury Resources Inc (DNR), and Chesapeake Energy Corp (CHK). Names that he highlighted as having the highest risk were Denbury, Hess Corp (HES), Halcon Resources Corp (HK), and SandRidge Energy Inc (SD).
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