After several days of group outperformance, the market faded today’s ‘in-line’ OPEC decision, with the SPSIOP down -2.7% vs. a modest gain for the SPX of +0.4%. YTD, the comparative is dramatic with the SPSIOP down -18% vs. SPX up +8%. We believe near-term stock and commodity risks remain, and thus continue to favor defensive exposure to the group with a preference for natgas leverage. While we understand the market paying up (premium multiples) for defensive, low break-even Permian growth, we believe there is more value in select natgas levered stocks. Two stocks we cover stood out. Our revisit of the key drivers of multiples expansion suggest OP rated RICE and GPOR provide peer leading production growth, margins, and leverage while trading below the group average.
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This week, 4 of our 7 Appalachia basin producers - RRC on 4/24, EQT and SWN on 4/27 and COG on 4/28 - reported. On the whole, results came in better than expected driven more on realized pricing and lower unit costs vs. production. Judging by the muted market response, we believe the Street may be placing too much emphasis on flattish N-T production guidance and not enough on an improving 2H17 margin expansion story. Our top natgas picks remain OP rated AR and RICE that highlight this theme.
Last month we noted that both the commodity and group stock price underperformance contradicted a positive read of February’s sentiment indicators (link). Our March update suggests a shift in sentiment, albeit a modest one, that captures a neutral to modestly negative delta from February.
We hosted a Permian basin bus tour March 8-10 with several Tier 1 operators including EOG (OP), OXY (OP), and PXD (OP) covered by Paul Sankey, and OP rated CXO and XEC from our SMID-cap coverage.
We are hosting CXO and XEC management teams as part of a broader Wolfe Research Permian basin bus tour March 8-10. CXO and XEC remain our preferred ways to invest in SMID-cap oil growth. We believe both provide the right balance between offense (high oil production growth rates) and defense (lower break-evens, strong balance sheets and liquidity). Ultimately this translates to higher returns and cash flows underpinning their premium multiples. Stay defensive and differentiated. Reiterate OP on both stocks.
With the Permian buzz reaching a creshendo, it is no surprise that EPE management has focused its growth ambitions around its Wolfcamp drilling program in Reagan and Crockett Ctys, in the TX Permian. Management now believes their Permian wells represent the highest rate of return in the portfolio (over the Eagle Ford) with oil in the low-$50s and as it highlights similar industry trends incorporating higher sand loadings, tighter stage spacing, and efficiency gains from shorter drilling times. Clearly EPE is making progress, although with such high rates of return and an improved balance sheet, we are a little surprised by the recently announced drilling carry, with its sliding scale around working interest based on well IRRs. We think it will be difficult to track proportional contribution of the JV wells (disproportionate amount of ’17 program) as a result and therefore make comparisons vs. consensus on production and capex problematic. Moreover, given the recent pullback in SM shares (-26% YTD, -16% from our upgrade), we see much greater value vs. EPE. We prefer SM’s Upton and Howard Cty. assets vs. EPE’s Reagan/Crockett and believe you get better returns starting with the ’18 growth profile and with better leverage metrics and a lower valuation. See valuation table in the body of the note for a comparison. Reiterate our UP rating.
AR connects a number of key dots impacting valuation (1) production growth (within cash flows/strip); (2) lower unit costs thru increased efficiencies from cycle time improvement and economies of scale around higher recoveries per 1k ft., (3) protecting realized prices by hedging (100% of ’17 natgas at $3.63/mcf and 100% of ’18 at $3.91/mcf; note, NYMEX front month natgas settled today at $2.77/mcf) and firm transport including a critical drop in 4Q16 net marketing expense; and (4) securing additional processing, fractionation, and takeaway to address improved liquids pricing outlook. Sure the rub is higher leverage (3x at ’16 YE) vs. Appalachia peers, but we would expect management to address this on the call. At a 1-turn discount (8.2x ‘17E EV/EBITDAx vs. 9.2x group avg.), we like the risk/reward and reiterate our OP rating.
YTD, COG has modestly outperformed the SPSIOP, -4% vs. -7%, benefitting from a recent rally in shares post FERC’s certificate approval for the Atlantic Sunrise pipeline (1bcfd FT/FS; 40% of our ‘19E production) on Feb.3. With this update, we got another look under the hood of the ‘Ferrari,’ aka COG’s Susquehanna County acreage. Just when you thought the Dimock field hit its technical limit, COG comes back with another bump up to its EUR post its fourth generation completions 4.4bcf/1k ft., vs. prior 3.8 and vs. industry averages for the broader Marcellus play of 1.7 – 2.3. With this level of well recovery, it is not difficult to see in our view, how it arrives at peer leading cash unit operating costs of $1.16/mcfe and all sources Marcellus F&D of $0.26/mcfe. Moreover, it is also why COG has the capacity to be a FCF machine once its regional takeaway issues are resolved.
SWN shares have significantly underperformed YTD, down -23% vs. -7% for the SPSIOP, due to, in our view, its higher portfolio break - even vs. its Appalachia peers, and its significant natgas leverage (90% of production). Thus, with its stated goal of living within discretionary cash flow, we were not surprised by its more conservative 3% production growth rate for ’17, factoring a $835mm D&C budget as natgas prices corrected over these past few months. We are starting to see some green shoots including the 20% ramp in SW Appalachia, with a tilt toward liquids rich completions, better cost controls with modest D&C inflation as a byproduct of owning rigs and frac spreads, flattish unit operating costs, and higher expected liquids realizations. From the call, we would expect an update on its deep Utica dry gas tests, type curve updates across the plays (we miss having them in the press release), and handicapping of takeaway capacity given its exposure to Rover (200mmcfd FT; 9% of our ‘18E production) and to a smaller extent Constitution pipelines (we found the natgas realization guidance to be more conservative vs. its Appalachia peers). Given its much improved balance sheet, liquidity and operating cost structure, we believe there is a risk of market disappoint over the more conservative ’17 growth target, but we would expect management to walk through scenarios for a more aggressive ’18 plan, especially with its expected 60 well DUC inventory at ‘17YE and the company-owned frac spreads.
YTD, RRC shares are down -13% vs. -7% for the SPSIOP. Shares have struggled in recent weeks post worries over Rover pipeline (400mmcfd FT) start-up and weaker natgas/NGL pricing due to warmer temperatures. To their credit, management directly addressed these concerns highlighting the inclusion of N. Louisiana production (22% of 4Q natgas production receiving GC pricing), 400mmcfd of combined takeaway in late ’17 from Adair Southwest and Leach and Rayne Express, and improved ethane/propane supply/demand balance due to a combination of contracted volumes and colder European weather attracting greater exports.
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