Natural Gas Weighs Heavy On E&p Near-term Prospects
TWST: Pavel, as you look at the E&P space, where are we at this point?
Mr. Molchanov: We've been in a bifurcated commodity market for the better part of the last three years, where the global oil market is in pretty good shape - not too ebullient but certainly trending in the right direction from a supply/demand standpoint. Natural gas - and for these purposes we're really talking about North American natural gas - on the other hand is a complete disaster and has been, as I said, for the past several years. We see no hope for North American natural gas to meaningfully recover anytime soon, and that's why as we look at the companies, our focus has been and remains on the producers that are more oil focused, and if they have North American natural gas exposure, then at least the companies in the low-cost producer category.
Mr. Weiss: I think Pavel did a pretty good job of summarizing things. I mean, we definitely have this bifurcated market, and we have an increasing number of companies that have been dedicating capital to the oilier plays, or the wetter plays. They've been trying to move things away from dry gas because the pricing is not supporting a lot of activity, but yet on the other hand, I say that and there has been an artificial support of activity because of a few factors: hedges that companies put in place last year that give them better prices for gas than they can get in the spot market; the formation of a lot of joint ventures bringing in a lot of foreign capital, and also because some of these companies have HBP, or held by production, leases where basically they're drilling at least a well or two in a location in order to protect their lease so that they don't lose it. That's kind of inflated activity on the natural gas side and contributed to the excess supply that we have. Like Pavel said, I don't see an easy turnaround in terms of more favorable natural gas pricing either because if you believe the figures that there are for the potential, with all these unconventional natural gas resources, unless we have legislation that helps increase demand for natural gas, it seems like we're going to be in an excess supply position for awhile. On the other hand, the oil side of the market still looks pretty good - pricing is pretty good, we know that most projects are economic. So companies that have more of a focus on and a good amount of oil production are certainly better situated right now.
TWST: Is the problem on the natural gas side purely a supply/demand imbalance?
Mr. Weiss: That's part of it; I guess that's the biggest part. We're talking primarily U.S. North American market here. But if you look at the storage figures, there is still a lot of gas in storage. Supply is still above the five-year levels; it's a little bit below last year, but that's after we had a really hot summer and a really cold winter, and we still have all this activity going on and that's the biggest thing. Longer term I do like the natural gas market; my concerns about it are more in the short to medium term. Over the long term, I think if we continue to push forward with initiatives aimed around reducing hydrocarbon emissions and reducing our reliance on foreign oil, at some point there is going to be legislation that benefits natural gas demand. A lot of people, I think, see that more on the power side; I can see some areas as a transportation fuel that can be used, e.g., for short-haul truck fleets as well as for taxi and bus fleets. But I think it will be more challenging to see natural gas used to power the cars we drive. So I think over time, as natural gas gets used more for power generation or something else, that can help to change that supply/demand imbalance. But until it does, I think we're kind of stuck here, and that's why the outlook for natural gas isn't that great.
TWST: Pavel, is your take the same? Is the natural gas problem more of a short-term than longer-term issue? Might there be some light at the end of the tunnel?
Mr. Molchanov: I agree that it would take some meaningful policy action in Washington to take U.S. natural gas demand to a significantly higher level that would ultimately rebalance the market. U.S. natural gas has been trading below what we call BTU parity versus oil for essentially the last five years, and that ratio relative to oil has not gotten better - it's actually been progressively getting worse. So the idea that cheap natural gas would automatically yield a demand response and rebalance the market just has not panned out. Even though demand has been in relatively good shape, supply has just completely overwhelmed any increase in demand from fuel switching. Natural gas vehicles are one of the few realistic possibilities to rebalance the market through greater demand. To put that in perspective, we have 120,000 natural gas vehicles in this country out of 200 million; Brazil, Argentina, Pakistan all have more than a million each. With the right incentives in place, we could certainly get to a multimillion vehicle NGV market, but it has not been a priority in Washington. The best efforts of T. Boone Pickens notwithstanding, like I said, it's going to be a long, hard slog.
TWST: In general, natural gas is not a particularly bright space for the E&P guys.
Mr. Molchanov: The simple reality is that it's not. There are, within the context of a brutal gas market, some better-than-average opportunities in the lower-cost unconventional plays, but as a whole it's pretty bleak.
TWST: Is that reflected in gas drilling activity?
Mr. Molchanov: It's not and that's precisely why this supply drought is just not going away. In other words, if everybody cut back on drilling with natural gas at $4/Mcf, then the system could rebalance pretty quickly. But the whole point is that they're not, and that's why we've seen U.S. gas supply creeping higher for most of the last 12 months, even though prices have just been stuck in the $4 to $5 range. The very simple premise is that if supply is growing at $4 to $5 gas, why would prices need to go higher?
TWST: Phil, do you see the same thing, supplies continuing to grow and no real balance occurring?
Mr. Weiss: It sure seems that way; it just doesn't seem like a rational market to me. Normal economic theory would tell you that if the prices were insufficient to make your drilling economic, then you should cut back. But yet, I mentioned those factors earlier, with the capital from the foreign firm, the HBP leases, the hedges and the willingness of banks to fund activity, that have helped it stay at high levels. Now I do expect a little bit of a decline next year, but even still, if they move towards the oilier places, there is still associated gas, so it's not like that is going to stop. The bottom line is this environment just doesn't seem rational, but it seems like it's going to continue.
TWST: What's happening on the oil side? With the Gulf issue solved, where do we stand?
Mr. Weiss: As far as the Gulf goes, certainly there's no more leaking oil, which is a good thing, but we still have the moratorium's aftermath. While I expected the moratorium to be lifted early, I don't know that it will make that much of a difference in the near term. According to what I've read, I believe on the shelf there used to be an average of 12 permits per month; now over that same time frame, we're getting one, and there is no moratorium in the shallow waters. So all these changes that are being brought about are slowing down the process. So just because we end the moratorium doesn't mean that activity is going to start right away. I think it's still going to be at least the second quarter of next year before you start to have more meaningful deepwater activity. Companies are trying to plan ahead, but it's still going to take time for companies to adapt to all the new standards to get their equipment approved and also to get their permits approved. So I think that at the end of the day, we're probably going to have projects in the Gulf that are going to be pushed back a year - maybe a little bit more if we figure that things kind of slowed down around May 1, just about week or two after Macondo. On the onshore side, you do have places like the Eagle Ford, the Bakken and the Niobrara that are moving ahead and have a decent amount of oil; that activity is still continuing. Based on some of my recent conversations with companies I cover, I anticipate that while the rig count is still artificially high, it's not going to come down as much as some people think because a lot of those rigs are going to be moved to oil-based activity. So you're going to have some of those rigs move to some of these other plays where they can apply some of these same techniques that they've been using in the unconventional gas wells to unconventional oil plays. Perhaps even more important, over time the same techniques could be applied to legacy fields where only vertical wells were drilled in the past, meaning there's a lot more potential, I think, to get more oil onshore over time. One company presentation I heard recently indicated they were able to increase recovery factors from an old field by 10% to 20% by applying horizontal drilling techniques.
TWST: Pavel, what's your take on the oil side? Is it little brighter?
Mr. Molchanov: Yes, the global oil supply/demand balance is actually more bullish today than six months ago, and a lot of that has to do with the Gulf of Mexico moratorium, which will certainly hinder U.S. oil production not just in 2011 but really for the next several years, as projects keep getting pushed out. Also the declines that have been already happening are continuing in some of the other major oil-producing countries, for example Mexico, U.K., Norway; Russia is barely growing, and that puts a lot of the brunt on OPEC's shoulders to meet whatever global demand growth there is. In 2011 we actually project non-OPEC supply coming down and, on the other hand, we're projecting global demand up 1.5%, which is 1.2 million barrels a day. Where is that incremental demand going to come from? It will have to come from the 12 OPEC members, mainly Saudi Arabia, which is pretty much the only country left that has significant spare production capacity. By definition, as OPEC uses up some of its spare capacity to meet demand, that tightens up the global oil market balance, which is certainly positive for prices.
TWST: At whole prices? Or do you actually expect them to go up from this kind of mid-70s level?
Mr. Molchanov: We expect prices to go up in the course of 2011, subject to demand remaining at relatively decent levels. We're not overly bullish on demand because of the macroeconomic uncertainty that all of us are obviously observing right now, but if demand is up 1.5% in 2011, which is less than what it's up this year, then prices should be getting into the mid-to high 80s by the end of next year.
TWST: Phil, what's your take on pricing as we look forward in this space?
Mr. Weiss: I think it's fairly similar for the rest of this year. I think we've been in this mid-60s to mid-80s range for quite some time, and we expect that to continue but maybe a little bit more towards the low end of that range for the rest this year into next year. The macro environment is certainly weighing down demand, and we see that improving somewhat as 2011 progresses probably more so in the second half of the year. So where we start to see more improvement in oil prices and get back up towards the higher end of that range, and maybe even a little above it, is in the second half of 2011, when the economic backdrop hopefully starts to improve and then some of that excess supply that we have in the systems starts to come out.
TWST: As you look at the oil side, are the prospects still bright in the U.S. as companies move into some of these unconventional plays you touched on?
Mr. Weiss: I think that they are. Some of those plays are pretty promising. The first ones I think of are the Bakken, the Eagle Ford and the Niobrara, and I think the prospects for those are pretty good, especially, like I said, as we apply some of these unconventional techniques to those plays. Another play that I think is really interesting is the one that Occidental (OXY) has out in California, in Kern County, where I think that there is really good potential and the company has been pretty conservative in terms of what they talked about in terms of possible resource potential. So I do think that we have some positives onshore for oil in the U.S., yes.
TWST: Pavel, where do you see the opportunities over the next year or two? Are they domestic, international?
Mr. Molchanov: I certainly agree with the comments about the Bakken, Eagle Ford, and the Niobrara; those are some of the few oily unconventional plays in the United States. The vast majority of U.S. resource plays are gassy, and that's why we have the gas glut that we do. I would add that there are some interesting overseas opportunities in what we call frontier exploration areas. By frontier exploration, what we mean is oil exploration in countries that today do not produce any oil or produce it in de minimis quantities. We've seen in the last one to two years a lot of the larger E&P companies as well as the integrateds coming into frontier exploration plays because those are some of the few areas that can truly move the needle for their resource base.
What are some of the hotter frontier exploration plays? Probably the hottest right now is Ghana in West Africa. When we see Exxon (XOM) duking it out with the Chinese for a multibillion-dollar investment in one of the world's largest recent oil discoveries, we know that's a hot play. So Ghana has certainly been an extremely high-profile frontier area with a lot of activity. Somewhat lower profile are places like Suriname, on the South American coast, which has some intriguing look-alike characteristics to nearby Brazil. Greenland may be the ultimate frontier area, not just geographically but also because this is Arctic drilling; it's extremely complicated terrain climatically speaking. But we've seen the first-ever discovery made there just a few months ago. Some places that people rarely talk about are Philippines, Tanzania, New Zealand; there are a lot of opportunities in those emerging exploration areas. The caveat, of course, is that you can't make an omelet without breaking eggs. There is lot of risk involved on the way to exploration success, so there are going to be a lot of dry holes.
TWST: Are companies turning to these frontier areas because of difficulties in the U.S. post the blowout in the Gulf?
Mr. Molchanov: Not really. They've been going into frontier exploration long before the moratorium went into effect. As I said, there are relatively few places left worldwide, particularly on the oil side, where discoveries can truly move the needle for the major oil and gas companies. Certainly plays like the Bakken can move the needle, too, but a lot of the acreage there has already been picked out by other companies. So virgin territory where there has been minimal activity historically offers more room for drilling upside.
TWST: Phil, as we look at this space, will costs in the future be higher because of tighter regulations following what went on in the Gulf?
Mr. Weiss: We certainly expect that costs are going to be higher because I think with some of the safety measures that are going to need to be taken, that's going to increase costs because they are going to create redundancies. Plus it's going to take longer to drill and get permits approved, which will also cause costs to increase over time. Economically, current projects in the Gulf probably work in $55 to $65 oil price range; we expect that number to go up post Macondo. It's kind of hard to say how much yet, but that's kind of the expectation, as both costs and project time are both going to increase.
TWST: Will this likely spread to these worldwide markets, as everybody becomes a little more cautious?
Mr. Weiss: I tend to think so. I mean, there are some markets where they have better regulations than the U.S. - Norway would be one example. But over time, I expect that in some of these places, at least they are going to increase their safety regulations. It's harder to say what may happen in West Africa because they may have different economic needs and different views. I'm not sure that it's going to go everywhere, but certainly in the regions that we're more familiar with, I do expect that there is going to be some increases in terms of cost and stronger safety measures elsewhere as well, yes.
TWST: Pavel, do you see the same thing - higher costs due to tighter standards and more watchdogs?
Mr. Molchanov: Yes, regulation never helped from a cost standpoint, but I would say an even bigger driver from a cost standpoint is actually going to be insurance. It's not just the rules from Washington or Brussels, but it's the insurance premiums that companies will have to pay to protect themselves against the prospect of legal liability. That may be prohibitively high for some of the smaller operators, and so our stance is that we will probably see more companies exiting the Gulf of Mexico that would have drilled there otherwise. That will mean that only the largest players, the mega caps and some of the large independents, will be drilling in the deepwater, and the smaller, especially private players, will probably take their chances elsewhere.
TWST: Pavel, does that mean we'll see ongoing consolidation in this space?
Mr. Molchanov: Certainly if companies with acreage in the Gulf of Mexico decide to exit, then almost by definition that opens the door to M&A activity, where some of the larger players will act as consolidators to buy up either entire companies or at least acreage and drilling prospects from smaller players. So, yes, that's exactly right.
TWST: Phil, will see ongoing consolidation here?
Mr. Weiss: It certainly seems like it, at least as far as the deepwater plays. But it could just be on an asset basis; it doesn't necessarily have to always be on companies combining. Devon (DVN) had the good fortune to have sold out of its deepwater positions before Macondo, and you could certainly see at least some other companies decide to make similar decisions. What future legislation does in terms of setting liability caps will likely be a key factor, as it could be just too expensive and too risky for many of the smaller players to own resources in the Gulf. That could be a negative for the industry as well because some of those plays, as they get smaller in terms of barrels that they produce, they become too small for the majors. As a result, you need some of those smaller players to be involved in some of those, and it will be interesting to see what happens over time on that end as well.
Mr. Molchanov: There was actually an interesting M&A transaction announced just yesterday, where Hess (HES) acquired an increased stake in one of the major deepwater projects called Tubular Bells, and the seller was none other than BP (BP). What makes this transaction unique is that to my knowledge, it's the first time since the moratorium that we've seen M&A in the deepwater Gulf. So here we have Hess, which is not a mega cap but certainly a large company, putting its money where its mouth is in what is essentially a bet that there will continue to be good opportunities in the Gulf. It's encouraging that companies are not writing off the Gulf altogether and are willing to consider future opportunities there.
Mr. Weiss: The only other thing I'd add to that was that on the rig side, over the summer Noble Corp. (NE) bought Frontier, and at the same time that they did that, they got big commitments from Shell (RDS) on some rigs and actually agreed to build some new rigs. Noble had one rig that was being built on spec, and Shell snapped that one up and put a contract on it, and also agreed with Noble to build a second rig. Shell was also a big customer of the company that Noble acquired, Frontier, an independent company. That transaction and the Hess one Pavel mentioned are the only two I've seen so far.
TWST: So we are seeing some activity.
Mr. Weiss: A little bit at least, yes.
TWST: Does that reflect the fact that these companies have good cash flows but limited opportunities?
Mr. Weiss: I certainly think that can be part of it. Probably the biggest issue that this whole group faces is access to resource, and one of the things that made the Gulf an attractive area to go to is because there's resource there and generally the U.S. has been a pretty favorable place to drill. However, post Macondo that's probably a little bit more of a question than it was before. The sense that I get from talking to companies, though, is more of they are taking a wait-and-see attitude. So it was interesting, even though it was only $40 million, to see Hess make that move yesterday because so many companies just said that they want to wait and see. I mean, even on Hess' last conference call, they talked about a little bit more of a wait-and-see approach. So I think that once the regulations and the new policies going forward are set, we'll see more activity. But it is encouraging to see that the companies are acting like they still think there's going to be a business there.
TWST: Pavel, what's your take? Are we seeing companies step up now and do what they need to do?
Mr. Molchanov: From an M&A standpoint, there has not been a great deal of North American oil and gas M&A in the last three years, and part of the reason is that financing has been generally tough for obvious macroeconomic and capital market reasons. The notable exception is Exxon's purchase of XTO Energy that was largest E&P deal in U.S. history and definitely the exception to the rule. There have also been some smaller deals, particularly foreign companies coming into some of the shale plays, whether as outright buyers or in joint ventures, but nothing that was really transformative outside of Exxon-XTO. In 20/20 hindsight, I suspect Exxon is maybe regretting that move because it destroyed quite a bit of shareholder value, given how much natural gas prices deteriorated between the end of last year and today.
TWST: The companies' balance sheets look pretty good at this point. What will they do with their cash, looking out over the next year or two?
Mr. Molchanov: Certainly some of the larger players have ample access to capital and, as you said, balance sheets are pretty robust. We've seen in general more focus on reinvestment. Most of the companies that had share buyback suspended it in 2008 and for the most part have not been returning to share buyback in a material way. Dividends have been growing slowly for the companies that pay them. So the focus has been absolutely on resource growth. Some of the examples of that are joint ventures for North American shale opportunities, more entry into some of the frontier exploration plays, like Ghana, and Greenland and Tanzania, and just generally more reinvestment as a percentage of cash flow.
TWST: Phil, what's your take? What are they going to do with the capital?
Mr. Weiss: There definitely seems to be less of an interest, like Pavel said, in buying back shares than there was, especially by some of the larger players, so I don't see it going there. I still think that companies are acting a little bit scared or concerned about what might happen on the economic side, so it's kind of a mix between reinvestment or just retaining the cash. They've become more conservative in paying dividends; they've become more conservative in buying back stock; they have been trying to invest to develop resources. So many of them are trying to take advantage of the better oil price environment as much as they can, and you see companies that are increasing their oil production relative to their total production base - I mean, EOG (EOG) has made a big move in that direction, Chesapeake (CHK) is trying to make a move in that direction. Definitely on the resource side, that seems to be where the organic development seems to be the biggest focus, especially where possible.
TWST: Is that what they should be doing, Phil?
Mr. Weiss: As a general rule, as long as they can find projects that they can invest in, that they believe will provide a return that's above their cost to capital, that's the best thing for long-term shareholder value. So many companies, if we look back in the 2007-2008 time frame, destroyed a lot of value by buying back stock and then either having to issue debt or having to issue stock to raise cash after they spent a considerable amount of capital buying back stock. Now their stock is at a lower price, so they really destroyed a lot of value. If they have good projects to invest in, I think that that should be the first and best use of capital.
After that, I favor dividends over buying back stock. There's also nothing wrong with saving some of the cash for the down part of the cycle. The only question I have with some of that capital deployment is there are companies that I feel, especially with the natural gas prices where they are, that tend to be investing to almost grow for growth's sake. Some companies act as if they're going to get rewarded if they continue to grow production, and they need to maybe rethink that a little bit and focus more on how economic that production is, and does it make sense to invest in growing it.
TWST: Pavel, are we seeing kind better management of the companies and their resources?
Mr. Molchanov: Definitely a focus on returns is, I think, more common today than it was during the upcycle of 2004 through 2008. There are exceptions to that. Certainly some of the natural gas-focused independents have continued to be just perpetually drilling. They are often hardwired for production growth, despite the depressed gas pricing, and that is certainly not a very value-additive strategy. But among the larger integrated players, definitely a focus on being selective about which projects to pursue and less of a willingness to destroy value by getting into subpar or non-economic opportunities, and that's why, in addition to some companies entering into new areas and acting as acquirers, there have been plenty of asset sales. BP is doing that right now on an extremely large scale; Conoco (COP) has been doing that, Marathon (MRO) has been doing that; Devon, as was mentioned earlier, restructured its portfolio. So as companies try to position themselves for the next upcycle, I think there is an emphasis on becoming a leaner, more focused business.
TWST: Given where we are in the cycle, Pavel, what's the level of investor interest in this space?
Mr. Molchanov: Plenty of interest. It's not been an easy year for energy stocks. On average, depending on which subsector we look at, stocks are generally flat to down year-to-date, a bit worse than the S&P 500. It's really been a stock picker's market. There have been E&P companies that are up 50% year-to-date, but there are those that are down 50% year-to-date. It's been a very wide spectrum of performance, and it really depends on each individual company's portfolio characteristics, the success they've had in their drilling program and other factors. So it's been absolutely a stock picker's space.
TWST: Phil, what are you seeing in the way of investor interest in the space?
Mr. Weiss: There definitely is still a lot of interest in the space but, like Pavel said, it's more of a stock picker's market because there has been such a divergence of performance among the companies in the sector. The companies that are more oil focused are generally doing better; companies with a lower cost structure generally do better, and then among those focused in the natural gas space, I think that those that are more focused in fewer plays rather than many plays have generally been stronger performers. I think a lot of it is, especially with what happened in the Gulf, there has been a lot of interest but people aren't sure about what's the right time because there is a lot of uncertainty, which I'd attribute primarily to two factors: what regulation and costs will look like post moratorium, and whether the economy is in recovery or if a double-dip recession is in store. The economy has such a big impact on hydrocarbon demand.
TWST: Phil, what are you telling investors to do?
Mr. Weiss: Among the E&Ps and the integrateds, one of the companies I happen to like is Devon Energy. As I mentioned earlier, management had the good fortune of deciding to exit the Gulf at just the right time. Devon has a decent amount of oil production because they own oil sand assets up in Canada. They have Jackfish - the first phase is already on line, the second phase is getting ready; it should start, I think, next year, and then there is a third phase planned in the future, and each one of those gives them 35,000 barrels a day of oil production. So that helps Devon have a little bit more oil in its production profile and reserve base than some of its peers. It also has a pretty strong balance sheet because of the proceeds it got from selling its deepwater and international assets primarily to BP. That's one. I like Occidental, which is kind of a cross between a pure E&P and an integrated, as while it doesn't have a refining business, it still does have a commodity chemicals business. OXY produces strong cash flow; in fact, it's highly free cash flow positive. OXY is primarily an onshore play, has some good domestic U.S. assets, primarily in California in the Permian Basin. I mentioned Kern County, which has lot of promise. It does have some Middle Eastern assets. It has virtually no assets offshore and none at all in deepwater. It also has one of the strongest balance sheets of any company in my coverage universe and is a low-cost operator. It's been able to grow production in the mid to high single digits over the last five years and looks to be well positioned to continue growing at that pace for the next year. OXY is also able to grow opportunistically through acquisitions. It prefers to buy a combination of current production along with drilling potential, as such transactions provide better returns. In my opinion, OXY also has one of the industry's best management teams as well.
TWST: Pavel, where are you pointing investors?
Mr. Molchanov: The top pick that I have among the integrateds is Hess, which is just an extremely well-positioned company from both a portfolio standpoint as well as its exploration opportunities. It's about 70% oil; there is almost no North American natural gas exposure, there is a relatively small amount of refining exposure, and the exploration outlook for 2011 is very exciting. Four high-impact exploration prospects - one in Brazil, two in Ghana, one in Indonesia; between the four of them theoretically this could increase the company's resource base 2.5 fold, and I think that none of that is currently baked into the share price. It's not a yield stock, this is very much on the higher-beta growth side; but the valuation looks very intriguing right now and, as I said, none of the exploration outside is baked in. I would point out that Ghana, one of the frontier markets I referenced earlier, is one of Hess' key areas for 2011. Murphy (MUR) is another name that I think looks interesting; similar story as Hess, though somewhat more expensive - also an oily asset base, not much North American gas exposure. In terms of exploration overseas for Murphy, two countries in particular should be focused on, Congo and Suriname. Suriname is one of those frontier exploration areas. Among the mega caps, none of them offer much in the way of catalysts, but Chevron (CVX) continues to be, in my view, the best positioned of the supermajors in terms of its oil orientation, and the valuation, at less than 10 times next year's p/e, looks pretty interesting as well. Nice yield on that one, 3.5%, but as I said, not a great deal of excitement either.
TWST: Pavel, you mentioned a disparity in performance. Any names that investors should avoid at this point because valuations are at a lag or due to prospects that aren't there?
Mr. Molchanov: The theme that we talked about earlier is that North American gas is just going to be a train wreck for a long time, and with that in mind, companies that have an overweight on North American gas are generally names to avoid. Conoco is a company like that. It's actually been a surprisingly strong stock year-to-date, but a lot of that has come from multiple expansion, as the company has shrunk its asset base through divestitures, repaid debt and resumed some share buyback. So they've been taking some of the right steps, but Conoco still has by far the highest exposure to North American gas in its peer group. Exxon, for a lot of reasons, just not a very exciting company these days. Lack of catalysts, for a $300 billion company, I suppose goes without saying, but Exxon also really shot itself in the foot by diluting returns through the XTO acquisition, which explains why it's been such a problematic stock over the last 12 months.
TWST: Phil, any names that worry you in the space?
Mr. Weiss: The first name that comes to mind is Chesapeake for a couple of reasons. One, it's got a tremendous focus on North American natural gas, even though it's trying to lighten that up a little bit. Two, it's got a pretty weak balance sheet. A third reason is the company, although I say it's got a lot of natural gas, it's doing so many different things that it's becoming less of an E&P - it's almost been more of a hedge fund because it's buying properties and building up big positions in some of these plays, looking to turn them into joint ventures later. Just last week it announced a joint venture in the Eagle Ford; one is expected in the Niobrara early next year. Chesapeake also has a really robust hedging program, but I have a lot of concerns because it's put some hedges in place that go out as far as 2020. I think it's hard enough to figure out what oil prices and natural gas prices are going to be in the next month, in the next six months, in the next year - forget about 10 years from now - and so I harbor some concerns about hedging out that far. In addition, the accounting methods it uses to capture costs is different than what peers use. As a result, CHK buys these properties and net sells a portion of them to a joint venture partner. It takes the gains on them, and then those gains go into cost pool that they use to figure out unit costs, which makes them look low but they're really not. I've also reviewed the language in their 10Ks over a period of years and noted a number of changes in the footnotes that were likely made to benefit reported earnings and cash flow. All in all, while I like the assets, there are too many concerns for me to support an investment in it. As a result, it's definitely one that I would think of as a stock to avoid.
TWST: Phil, anything else that we should touch on, or any wrap-up thoughts?
Mr. Weiss: Overall I think this is a good sector for investors, especially if you can think out a couple of years. As I expect when the economic situation ultimately improves, that prices are going to get a little bit better at least on the oil side. There are some companies here for those that are interested in yield or look at total return, too. Pavel mentioned Chevron, which is certainly one that has a nice yield. The sector's had a tough time, the BP incident hurt the sector, the economy has hurt the sector, but I think that with a little bit longer-term view, that there are some companies that you can invest in in this space and make some money, especially over the next few years.
TWST: Pavel, any final thoughts?
Mr. Molchanov: I would certainly echo the sentiment that volatility is going to be with us for a long time, and the focus should be, as always, on companies that can create value over the long run. Right now we're seeing a nice uptick in the broader market as well as oil that will not last forever; but over time, companies that can carve out a nice niche for themselves and develop interesting plays with a low cost structure are the ones that are going to win.
TWST: Thank you. (TM)
Note: Opinions and recommendations are as of 09/25/10.
Raymond James & Associates, Inc.
880 Carillon Parkway
St. Petersburg, FL 33716
(800) 248-8863 - TOLL FREE
PHILIP H. WEISS
Argus Research Company
New York, NY 10006