Written by George Mack of The Energy Report
With energy prices flat to down in a murky global economy, MKM Partners Managing Director Curtis Trimble says investor agility is essential. In this exclusive interview with The Energy Report, Trimble talks about his favorite names and some of the fuel-rich plays that make them interesting.
Companies Mentioned: Approach Resources Inc. - ATP Oil and Gas Corp. - Chesapeake Energy Corp. - Clayton Williams Energy Inc. - Concho Resources Inc. - Energy XXI - EOG Resources, Inc. - Gastar Exploration Ltd. - GMX Resources Inc. - Goodrich Petroleum Corp. - Pioneer Natural Resources Co. - Rex Energy Corp. - SandRidge Energy Inc.
The Energy Report: Curtis, what is your overall theme right now?
Curtis Trimble: Agility is probably the best theme I could come up with for the current environment. The debt overhang and political gridlock in the U.S. combined with similar events coming out of the European Union around the viability of Greece, Italy, Ireland, Spain, Portugal, et cetera have been unnerving. In the energy market, and crude oil in particular, China remains the 800-pound gorilla with somewhere between 40–50% of world crude oil demand stemming from its growth expectations.
TER: Clearly the global economic outlook is not optimistic for the near- or even the mid-term. What does that mean for energy prices?
CT: While we have seen some substantial discoveries off the coasts of West Africa, Brazil and even the U.S.—off the Gulf of Mexico along with crude oil coming out of the Bakken and Canadian Oil Sands.—there is nothing in the next three-year landscape even close to the level of discovery successes we've seen over the past three years. I will use Will Rogers' adage to buy land because they are not making any more of it, and for all intents and purposes that is going to apply to crude oil as well.
I think you are going to have a much wider trading range than what we have seen in the last year with West Texas Intermediate (WTI) lows in the mid- to high-$70s per barrel (/bbl) and highs in the $120/bbl range. A lot of that is going to center on expectations not only for current economic conditions, but probably more importantly over an 18-month out view for future economic growth. Again, China will remain amongst the most important drivers for those crude oil price expectations.
TER: Do you have a timeframe for reentry into economic growth?
CT: I think it is probably going to take 12–18 months to get some solid insight into U.S. policy and the other developed markets I just mentioned. Most likely we won't gain any clarity until we work our way through the election season, and that is still a year off. We will continue to see gridlock as a policy response here. Without U.S. leadership, it is going to be very difficult for the balance of the world to step up and make adequate policy decisions to rectify their economic shortcomings.
TER: Will energy prices lead or lag economic growth?
CT: I think one of the more interesting phenomena we have seen over the last 12 months is crude oil as a store of value. My guess is that we are seeing some trickle-over from gold prices, which have historically been an inflation hedge. Gold prices have become quite heavy over the past few years, and some of that is expectation for hard assets, which is propping up crude oil prices. I would expect more of that based, again, on the scarcity argument. Over this next 12–18-month period we will likely see crude oil prices lead and prepare for reinvigoration of economic growth.
TER: Do you have a near- and mid-term forecast for oil and gas?
CT: Sure. For 2012, our estimate for WTI is at $90/bbl, and our estimate for natural gas is $4.16 per million British thermal units (MMBtu). Certainly if we continue to see what I deem a store of value phenomenon for crude oil, that $90/bbl level likely will prove conservative. But, in terms of generating valuation estimates for equities, I would rather be conservative than not, especially given the backdrop of volatility that will likely continue into the foreseeable future. As we look further out, we've got a 2013 estimate of $100/bbl. We see recovery in natural gas prices to $4.75/MMBtu as we move toward that 2013 timeframe.
TER: How does an MMBtu correlate to an Mcf (thousand cubic feet) for natural gas?
CT: It's basically a 9% differential in the conversion. It's going to end up being a rounding error in terms of generating valuation estimates for equities.
TER: Do you use them interchangeably?
CT: Yes, I generally use them interchangeably.
TER: Are energy equities a value now?
CT: I generally break up the various cohorts into micro-, small-, mid- and large-caps. I think the mid- and large-caps are reflecting fair value right now. The smaller guys, where we generally anticipate outsize growth and merger and acquisition premiums occurring, are probably a little ahead of their value, given near- to medium-term crude oil and natural gas price expectations.
TER: Do you expect to see value created before we emerge from these flat to downward trending energy prices?
CT: Given the overall backdrop of questionable economic conditions, flat to rising service costs and transportation issues concerning some of the quickly emerging shale basins, such as the Eagle Ford and the Marcellus, I think value creation in equities is likely going to be a function of takeout premiums and/or the actual realization of those takeouts. I think it is going to be difficult for the small-caps through micro-caps to post the outsize growth and value realization over the next 12–18 months. That's not to say that reserve values in 2013, '14, '15 and beyond aren't significant for these guys; I just think they are probably ahead of themselves.
TER: You speak about rising costs and transportation constraints that are a negative for small-cap companies, but I'm noting that at least two of your three top picks are small-cap energy companies.
CT: Generally, you see a pretty significant disconnect between small- and micro-cap companies' ability to develop and bring their reserves on and realize that significant growth. The factors that discount future cash flows include constrained credit, access to capital markets and the headwinds of a higher-cost environment. It takes these guys a little bit longer to put the pieces of the puzzle together and bring those reserves to production. Nevertheless there are a couple of guys out there such as Gastar Exploration Ltd. (GST:NYSE) and Energy XXI (EXXI:NASDAQ) that we think are on the cusp of being able to realize significant production ramps. But truthfully for many small companies, it's going to end up being a function of near-term oil performance.
TER: Do you expect smaller-caps to outperform in 2012?
CT: I think it's going to be difficult for them next year. I would expect credit conditions to remain tight and natural gas prices to remain low compared to the 10-year historical price average. And even though many of the micro-cap and small-cap companies have a fairly substantial legacy base of natural gas reserves and production, I think it will be difficult for the average company to see significant reserve value expansion, and therefore their access to credit facilities is going to be difficult. I think it's going to be difficult for the average company to do much better than it may have done in 2010 and 2011.
TER: Curtis, what are Q3 earnings telling you? Did you note any trends from earnings calls?
CT: One overarching trend you will see time and again is that investors will continue to latch on to outside positive news, and certain stocks will continue to benefit from incrementally beneficial news flow. For example, we have seen stocks like Rex Energy Corp. (REXX:NASDAQ) with significant exposure to the Utica Shale and upside from a Utica well bid up substantially in the context of a down-trending market. The counterpoint is GMX Resources Inc. (GMXR:NYSE), which produced a marginal initial well at its Bakken program and traded down significantly. So we see many illogical moves in the market in response to news flow.
Another overarching trend is the market's ability to extrapolate companies' positive results, such as the Wolfcamp results from EOG Resources, Inc. (EOG:NYSE) and Pioneer Natural Resources Co. (PXD:NYSE) across a wider base of companies, such as Concho Resources Inc. (CXO:NYSE), Approach Resources Inc. (AREX:NASDAQ) and Clayton Williams Energy Inc. (CWEI:NASDAQ). We are seeing some return to logic and the desire to extrapolate reserve value across equities out of third quarter earnings, which is interesting in the backdrop of a flat overall market.
TER: I believe you have about 18 companies in your coverage universe. What are your top picks?
CT: Chesapeake Energy Corp. (CHK:NYSE) has been one of our top picks for the mid- and large-cap space. It recently announced a substantial joint venture for its Utica Shale position, which is on the magnitude of 1.5 million acres. Shares actually traded down on the heels of that announcement, and I think that has more to do with investors' distrust of management's ability to constrain capital expenditures for incremental acreage acquisitions than it does for anything operationally with the company. That's unfortunate, in my opinion, because I think its convergence to substantial liquids production from an extremely large base in natural gas production has gone extremely well. Management has basically grown its liquids production to the size of a Continental Resources Inc. (CLR:NYSE) in a matter of 18 months. Yet we don't see that reflected in the share price.
As we look to some of the smaller companies, Gastar Exploration is a micro-cap company that I expect good-to-very good things out of in terms of reserve and production growth. I think the Marcellus program has been extremely aggressive for a company its size and is going to be the primary catalyst for that growth. Gastar should have upwards of 14 wells drilled and completed with potential for production over the next two quarters. For a company that is basically at 20 million barrels per day (bbl/d) of production ending Q3, that prolific basin should be a distinct and substantial equity value driver in a fairly compressed period of time.
TER: Do you expect to hear market-moving information on Gastar's Marcellus play by the end of the year?
CT: I do. It has a handful of wells that are in various stages of completion that should turn to production between now and year end.
TER: You recently raised your target price on Energy XXI from $32 to $36. It's a mid-cap at $2.3B. Why do you like it?
CT: Energy XXI has a number of tailwinds at its back right now. A significant premium is being paid for Louisiana Light Sweet crude oil, which is likely going to add somewhere between 10–15% to its cash-flow. Also, it has an extremely deep bench of potential drilling projects, including what appears to be an absolute homerun acquisition of some legacy Exxon Mobil Corporation (XOM:NYSE) properties contiguous to its shallow-water Gulf of Mexico core operations. Then there is its ultra-deep exploration portfolio in which it is participating with McMoRan Exploration Co. (MMR:NYSE) and several other partners. The Davy Jones, Blackbeard East and Blackbeard West wells are going down 36,000 feet deep or deeper. Initially, at least, the company is finding absolutely monstrous structures that appear to be a continuation of the extremely large structure found onshore in the transition zones of Louisiana that define some of the most prolific crude oil and natural gas fields in the history of that state.
TER: Energy XXI shares have performed quite well over the past 12 weeks, even with some weather-related issues during Q3. It was the best-performing stock in your coverage during that period. Why has it performed so well?
CT: First, most of that weather issue was related to tropical storm Lee, and that was fairly well known. It is really more of a production deferral than a production loss. Second, the upside performance is related to higher crude oil price realizations than what a lot of folks, including me, expected. And, again, that's the tie-in to Louisiana Light Sweet crude. And, third, I think its building expectations for a Davy Jones production test sometime mid-December followed by first production shortly thereafter.
TER: Were there some small caps that you could talk about?
CT: A number of small caps looked comparably attractive in the long-term. One name worth some attention is Goodrich Petroleum Corp. (GDP:NYSE), which has become quite active in the Eagle Ford Shale and was among the first to investigate the Buda Lime Shale. This is another company transitioning out of lower value legacy natural gas assets to more liquid-rich crude oil driven areas like the Eagle Ford. The company has to work its way through some liquidity issues, and questions still remain to some degree about funding the 2012 capital budget. But, I think if it continues to post Eagle Ford results like it has the past few quarters, those liquidity concerns will give way to enthusiasm for growth in the crude oil volume.
TER: Are you implying that the Eagle Ford play has not been discounted into the stock price?
CT: Not anywhere close by my estimates. And, in a number of instances we see capital flowing disproportionately into larger players like Petrohawk Energy prior to its acquisition by BHP Billiton Ltd. (BHP:NYSE; BHPLF:OTCPK). EOG Resources continues to be on a very nice run in the Eagle Ford. Pioneer Natural Resources is also realizing some benefits there. But, I think the smaller-cap players have been disproportionately affected by transportation issues and have yet to fully realize the same degree of value as have the larger players such as Swift Energy Company (SFY:NYSE).
TER: Was there one more small cap?
CT: A large one that I would point to is SandRidge Energy Inc. (SD:NYSE). I'll call it a Chesapeake junior, if you will. I say that because Chairman and CEO Tom Ward was one of the co-founders, president and CEO of Chesapeake before leaving that company and striking out on his own to build SandRidge. In terms of investor sentiment, SandRidge is quite striking in similarity to Chesapeake as well. The thesis of asset quality has been working for me over the past 5-7 years and ultimately it wins out. I believe SandRidge will continue to put points on the board with its oily growth out of the horizontal Mississippian and, certainly, as it continues to bring growth to the forefront of its Central Basin Platform property.
TER: Will SandRidge be able to fund its greater capex requirements associated with other projects?
CT: It will, and 2012 should not be at all problematic for SandRidge.
TER: A while back you said that small-cap GMX Resources Inc. was your top pick. How do you feel about it now?
CT: We maintain a Buy rating on it, and I think the shares are worth $5 as our estimates stand now. But, largely that is going to be predicated on the balance of the near-term well results. If we see further evidence of marginal performance out of the Bakken program it's going to be very difficult to remain bullish on GMX without some substantial step-up in well performance.
TER: You have ATP Oil and Gas Corp. (ATPG:NASDAQ) rated as a Buy. It has had good relative strength over the past 12 weeks. You have a $16 price target on the stock, and that implies a substantial return of more than 100%. What is your thesis here?
CT: Our thesis remains intact. By my estimates, ATP was probably the most negatively affected by the federal government drilling moratorium after the Macondo oil spill tragedy, largely because it carries a substantial amount of leverage with about $2 billion of debt outstanding. Its largest development program, Telemark, was on the cusp of first production when that drilling moratorium was handed down. That put the company's ability to pay down its debt load in a significant lurch. The forecast for Telemark was to have peak production of 30 thousand bbl/d, which would have more than doubled the company's existing base of production. In a very recent conference call, the company noted that the production rate on one of the three wells in production has been lowered, which should act as a production deferral rather than a production loss. But investors have reacted negatively.
TER: Thank you very much for the time.
CT: I appreciate your time as well.
Curtis Trimble joined MKM Partners in August 2010 as an analyst covering the oil and gas exploration and production (E&P) sector. Mr. Trimble previously covered the U.S. E&P sector for Natixis Bleichroeder, ranking second in the 2010 Wall Street Journal analyst survey for that sector. He also followed the oilfield services sector for Canaccord Adams and Sterne Agee, ranking fourth in that space in 2006. Mr. Trimble holds a Bachelor of Arts in economics from Swarthmore College and a Master of Business Administration with a focus in finance from Rice University.
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1) George Mack 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.
3) Curtis Trimble: 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.