Who Will Survive The Natural-Gas Shakeout?

With prices on the rise and a cold winter approaching, some gas names have already begun to rally. But Andrew Coleman of Raymond James takes a cautious approach -- that's why he looks for oil and gas companies that can survive a tough market. In this exclusive interview with The Energy Report, Coleman shares how to gain exposure to promising shale plays using defensive investing tactics. Read on to learn which companies are measuring up with strong balance sheets, dominant acreage positions and top-tier technology.

The Energy Report: In your last interview, you talked about raising price targets on energy sectors and individual stocks with promising reserves and production growth. Is that still your view, or have circumstances changed?

Andrew Coleman: What we're more worried about at this point is that the U.S. economy has been slower to recover than we expected. Meanwhile, the situation in Europe is getting worse and China's growth is slowing. To help us evaluate oil and gas markets in this context, our team here at Raymond James put together a bottom-up supply model looking at the oil shales, which was a follow-up to work the team had done on gas shales a couple of years earlier.

The gas outlook has remained cautious, although not nearly as bearish as it was a couple of years ago. We have, however, become much more nervous on the short-term outlook for oil. We have a $65 per barrel (bbl) forecast for West Texas Intermediate (WTI) and an $80/bbl forecast for Brent for 2013. The forward curve on gas is getting better, and certainly 2013 gas is over $4 per thousand cubic feet (mcf) right now. Oil is our big concern and back in June we downgraded virtually every name that we follow in the E&P space to the point where we now have no strong buys in our coverage group.

The uncertainty on the demand side and increased production growth due to the shale drilling technology indicates a significant inventory oversupply by the second quarter of 2013, which should lead to lower oil prices. Although prices have remained relatively robust in the U.S., we're waiting to see the supply and demand fundamentals even out before we get more constructive on the space.

TER: So, you figure that these prices are going to be affected worldwide, even with the difference between WTI and Brent?

AC: Yes, over time. We're still looking for a $15 differential between Brent and WTI. In North America, there's a lot of supply in just a few basins and transport options are still evolving to get those barrels to the most favorable markets. A reversal at the Seaway pipeline and the approval of Keystone XL would definitely help. The conclusion of the presidential election would remove one more big uncertainly, and the next step would be getting through any transition of power and seeing what happens with the fiscal cliff. Having a few more months of macro data never hurts either.

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TER: Is the current gas supply and price playing any role in this?

AC: Yes and no. Generally speaking, oil is a transportation fuel. Natural gas is a power generation fuel. Natural gas and coal compete quite hardily. Gas prices have rebounded recently, but there was a tremendous amount of utilities switching from coal to gas. As natural gas goes higher, more plants might switch back to coal. Gas remains cheap relative to oil and my view is that oil is still probably a better medium-term commodity to be in. The current headwinds for oil point to it potentially falling by 25%, which would be very bearish for oil stocks in the short term.

The warmer-than-normal winter last year caused an excess supply of propane (and natural gas), which in turn put pressure on ethane. Average natural gas liquids (NGLs) prices followed gas prices lower, putting pressure on the entire gas value chain. With winter just around the corner, there is some optimism that normal weather will improve both the gas and NGL price outlook. If not, then weakness in oil prices would further hurt gas producers, as liquids revenues comprise up to 50% of total unhedged revenues for even the heaviest gas producers.

TER: Your downside price for oil is lower than what I've heard anyone else talk about. What's your upside for the next year or so?

AC: Longer term, we're looking for $80/bbl WTI, and with a $15 differential for Brent, so we're looking at $95/bbl. The current large crude stocks and diminishing storage for all that crude, along with continued production growth, mean that pricing could fall in the early part of 2013. We think the price will average $65/bbl next year, based on our math, which suggests $65/bbl is the price at which most U.S. oil drilling stops. Remember, in the fourth quarter of 2008, WTI averaged around $60/bbl followed by $40/bbl in the first quarter of 2009 before averaging $62/bbl for the year. We think that WTI may bottom at $60/bbl and then start rebounding back to $80/bbl by 2014.

TER: That will make for a lot of happy drivers, but isn't it going to change the planning for companies in the production business?

AC: We've continued to hear expectations of service-caused cost deflation from exploration and production (E&P) companies. A couple of years ago, everybody needed frack crews, frack sands, rigs, drill pipe and lots of other service components. Now with most companies not investing in any dry gas production and with oil price uncertainty and additional services capacity being brought to the market, we see an opportunity for service costs to come down a little, which would be a positive for the E&P guys.

TER: What factors are you considering most important in deciding which stocks look like the best buys at this point in time?

AC: We definitely try to do a lot of work at the beginning when we select companies for coverage. Between nine analysts and fourteen associates, our energy team covers around 150 energy stocks. On the E&P side, we start by looking at where the most activity currently occurs and where we think that activity will be in a couple of years. We also look at the major players, like Anadarko Petroleum Corp. (HK ), which we do not cover. Swift recently closed its 2012 funding gap, but its higher beta would make it a stock to watch should (a) the pricing environment improve, and (b) the TMS data points surprise to the upside in 2013.

TER: What do you see in the near term for the O&G sector and how should investors approach this market to take best advantage of what lies ahead?

AC: Clearly, gas has some sex appeal at the moment. The forward curve has moved up north of $4/mcf and heading into earnings season, we'll be watching to see if these producers are adding price protection (e.g., hedges) for 2013+. On average, shares of gassy E&Ps are up 10% in the past three months, with a name like Southwestern Energy Co. (SWN) leading the pack.

In the short term, some exposure to gas certainly doesn't hurt. If we think oil is going to suffer, perhaps gas can be the beneficiary as we go into the winter heating season. We should get a sense in the next couple of months as to what winter weather will be like and if we can repair the NGL market, which is the next leg of the gas market. Then we'll get some views as to what's going to happen with oil, based on global demand, supply growth and this economic expansion. Heading out of winter, we'll have to see if we have enough data to say that the oil players can hold up, or if it is still time to be cautious. That's why we don't have any Strong Buys and remain defensive, with maybe a little bit of gas exposure, heading through year-end.

TER: When do you think there might be a turnaround in the whole picture?

AC: I'd still like to see gas production decline. No company that we follow is drilling any dry gas wells but they're still drilling wet gas wells to get the NGLs, and oil players are getting associated gas with their production. A meaningful slowdown in gas production should be positive for prices. Also, if we get increased demand due to colder weather, that would also help to underpin a more positive sentiment on the space.

From a funding standpoint, credit remains relatively accessible, but we are in the period when company credit facilities are reevaluated. Any pressure here could lead to more producer hedging, but overall we are not overly concerned. Recent high-yield deals have been done at rates between 5% (large-cap companies) and 7–8% (smallcaps). The improved sentiment for gas likely points to improved liquidity. While we're worried about the short term, we don't see a huge amount of distress right now.

TER: We appreciate your thoughts and insight today, Andrew, and we'll be watching to see how all this turns out.

AC: Thanks for having me.

Andrew Coleman joined Raymond James Equity Research in July 2011 and co-heads the exploration and production (E&P) team. Since 2004, he has covered the E&P sector for Madison Williams, UBS and FBR Capital Markets. Coleman has also worked for BP Exploration and Unocal in a variety of global roles in petroleum and reservoir engineering, operations, business development and strategy. Coleman holds a Bachelor of Science in petroleum engineering from Texas A&M University and a Master of Business Administration in finance and accounting with a specialization in energy finance from the University of Texas at Austin. He is a director for the National Association of Petroleum Investment Analysts (NAPIA) and a member of the Texas A&M Petroleum Engineering Industry Board, the Independent Petroleum Association of America's (IPAA) Capital Markets committee and the Society of Petroleum Engineers (SPE).

DISCLOSURE:
1) Zig Lambo of The Energy Report conducted this interview. He personally and/or his family own shares of the following companies mentioned in this interview: None.

2) The following companies mentioned in the interview are sponsors of The Energy Report: Energy XXI Ltd. Interviews are edited for clarity.

3) Andrew Coleman: I personally and/or my family own shares of the following companies mentioned in this interview: None. I personally and/or my family am paid by the following companies mentioned in this interview: None. I was not paid by Streetwise Reports for participating in this interview.

Written By: The Energy Report