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dexion10 (28.25)

Outperforming Jim Cramer's Nat Gas Stocks - Part 4 of my Energy Series - The simple formula

Recs

15

August 21, 2008 – Comments (14) | RELATED TICKERS: XTO , CHK , SD

While Jim Cramer has got you KILLED in nat gas stocks. Some bloggers here at CAPS (Demon Doug, VTEngineer, myself, etc)  have been SPOT ON regarding the "surprise" move in commodity stocks - particularly Natural gas.

As part of my series on natural gas stocks I've been sharing my stream of consciousness and my developing thoughts on how to value natural gas stocks.

This has easily been my favorite topic to blog on in recent months so I hope you enjoy it. Also please note that at the beginning of this series I wasn't sure if nat gas stocks were buys or sells... but as I've rsearched the investment thesis I've concluded nat gas stocks are "raging buys" on a risk / reward basis unless someone can disprove the marginal cost / floor for nat gas is ~$7.50. 

FYI - later my last blog will debate the bear case for nat gas stocks... what if $7.50 isn't the floor??? That is a possibility especially if production increases don't slow or if oil and coal don't stay at high prices. 

 

*** NOTE: PLEASE RECOMMEND THIS POST IF YOU FIND IT USEFUL

 

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TABLE OF CONTENTS

- short cuts to this blog

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1.) If you have read my previous blogs:  please skip right to the "SIMPLE VALUATION FORMULA" section of this post. I've got a very simple formula that is helping me measure risk reward at various natural gas / oil stocks.

2.) If you just want to SKIP RIGHT TO THE BOTTOM LINE - go to "THE BOTTOM LINE" section.

3.) If you haven't read my previous blogs - I can catch up up in the section below "QUICK RECAP".

 

4.) What are my favorite natural gas /oil stocks stocks (price I'd buy): STR ($50) , SD ($31) , WLL ($84), EOG ($93), TXCO ($8.50

 See details on each of my favorite nat gas companies here (rec the blog if you do):

 

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QUICK RECAP from Parts 1-3 of this blog series

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**** See Previous Posts in My 5 Part Series Here ***

 

Many of you may have read my earlier blog "Why Cramer is getting you KILLED in nat gas stocks"

In that late night post riddled with mis-spellings I explained that nat gas in the U.S. is on the verge of over production in the near term and that there is a real risk that the only floor in the price of nat gas will be the marginal cost of production.

Marginal cost of production - is otherwise known as: the cost of producing the last cubic feet of gas demanded by the market - produced by a marginally viable or higher cost producer. 

THE BIG IDEA: 

I've recently found a source online that suggest the marginal cost of production for nat gas is $7.50 and the marginal cost of production for oil is $63 (oil sands production). estimates: from Sionna Investments & Sanford Bernstei......

Since many natural gas stocks are being valued at around $6.50 natural gas I thought the market was creating a buying opportunity for natural gas stocks if not for oil stocks. Although as you'll see later I am also an oil bull - even though oil is well above marginal cost of production 

VALUATION:

Some simple concepts:

1.) Energy stocks doen't trade on PE's but rather proven reserves - if you don't have oil / gas in the ground you will have no future earnings - so PE's aren't as important as reserves.

2.) Companies that grow reserves or who have reserves worth more than the company's stock should go up. 

3.) Some people like me like to value energy stocks on the present value of thier current PROVEN reserves. Then assess the growth by looking at the companies PROBABLE reserves. Ideally I want to pay as little as possible for probable and possible reserves because they are not definite numbers. 

4.) My Valuation Technique

- I take a companies gross margins on a hypothetically low natural gas selling price (the marginal cost of production)  and then I figure the present value of the gross margins for the companies proven reserves and for the proven, probable, possible reserves. I look at the possible reserves to eyeball the potential upside for a stock.

 

5. AN EXAMPLE OF HOW I VALUE NAT GAS STOCKS

 

Assumptions:

- Lets also assume nat gas co TXCO will sell that gas at a minimum of $7.50 

- Lets assume TXCO has 100Bcf in proven reserves ($290M worth of gas)

- Lets assume TXCO has finding costs of  $2.50 

- Lets assume TXCO has possible reserves of 8Tcf (they claim they do!)

- Lets assume TXCO has an Enterprise Value of $495M

 

Conclusions: 

TXCO's profit per mcf is $5.00  / This is the selling price ($7.50) minus finding costs ($2.50)

 
TXCO's estimated profit on its 100Bcf reserve would be is worth $170M today.  Calculation = $5 profit x 100Bcf = $500M, which has a present value (PV-10) of $170M

TXCO's possible reserves would be worth $13.6B.   

TXCO is a high risk / VERY high reward stock.

  (see my blog for more in depth long / short ideas) 

 

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SIMPLE FORMULA FOR VALUING NAT GAS STOCKS

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As you can see from the recap above, there are several steps that you can walk through to  establish rationale valuation on a natural gas stock.  However there is a simpler formula you can use on the fly.

But I caution you to make sure that it's always worth verify the finding costs for the natural gas company you are looking at to make sure that this formula's gross margin assumption is correct. I only look at low cost natural gas producers ($2 cost per mcf or lower) so this is appropriate for most stocks I look at .

Basically  my formula assumes floor in nat gas prices at $7.50, $2 finding costs, and gross margins of $5.50. Then I do a 10 year present value on that number to come to valuation per mcf that I can apply to the entire companies reserves.

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THE BOTTOM LINE 

HOW DO I VALUE NAT GAS COMPANIES:

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I take a present value of $5.50 which = $1.93 per mcf. Some people are more generous they're using $2 or $2.25. 

* Note: you can calculate present value here

My 2 step valuation: 

1. I value ONLY the proven reserves to come up with a conservative valuation for co's reserves

2.  I value the probable reserves - but I'll only do this if I have a high degree of confidence in management and in the prospect(s) they are drilling... for example I'll want to know that they successfully drilled that prospect before and that it's an onshore project (lower cost / lower risk).

Example:

Sandridge (SD)

    - Sandridge is one of my favorite low cost nat gas producers (though I like STR better).

    - SD produces an mcf of nat gas for less than $2... but I'm assuming two for the example.

    - Enterprise Value (value of company): $7B

    - 2Tcf of proven gas - that has a present value of

    - 5.5Tcf of proven + probable reserves

 

The Value of SD's 2Tcf proven reserves are $3.8B ($1.93 X 2 billion mcfs)

The Value of SD's proven and probable reserves are $10.6B  ($1.93 X 5.5 billion mcfs)

Conclusion -

Sandridge is being valued at about 1.75x it's proven reserves

Sandridge is being discounted at 30% below it's probable reserves.

If you believe that Sandridge can prove it's probable reserves and that nat gas has a $7.50 floor then SD is undervalued. 

Fyi - SD has had over 200M of insider buying this year - so I think the insiders believe it's cheap...additionally Sandridge may have another 20-30Tcf in their big field.

14 Comments – Post Your Own

#1) On August 21, 2008 at 11:07 AM, dexion10 (28.25) wrote:

Another way to trade energy stocks is to wait for CNBC commentary to say "This is the nail in the coffin of commodities... the rally is definitely over". When you've heard that story five times in one week... just buy energy stocks!

 Then read this link here about PEAK oil.  Oil stocks with oil anywhere near $90 or $100 is a great long-term buy for anyone with a +3 year investing horizon. 

1.)  Great article on why we should be concerned about peak oi......

  - Article explains how OPEC reserves are likely overstated and production is lagging their reserve estimates

 

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#2) On August 21, 2008 at 1:14 PM, VTEngineer2001 (< 20) wrote:

D: Good insight on natty gas - a rec for this one.

I have also read several articles that discuss OPEC's 'plausilble' inflated reserves. What a shock the world would be in if the truth ever came out. The biggest tell-tale sign for me is that with all the world's new exploration and drilling of late, the world-wide production in oil has been relatively flat the past several years - around 84mbd while demand continues to edge up by about 1mbd every year. We won't know we've reached peak oil until we've past it. I for one, think we are on the cusp.

Lunch is over.

-Scott.

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#3) On August 21, 2008 at 1:14 PM, VTEngineer2001 (< 20) wrote:

D: Good insight on natty gas - a rec for this one.

I have also read several articles that discuss OPEC's 'plausilble' inflated reserves. What a shock the world would be in if the truth ever came out. The biggest tell-tale sign for me is that with all the world's new exploration and drilling of late, the world-wide production in oil has been relatively flat the past several years - around 84mbd while demand continues to edge up by about 1mbd every year. We won't know we've reached peak oil until we've past it. I for one, think we are on the cusp.

Lunch is over.

-Scott.

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#4) On August 21, 2008 at 1:29 PM, dexion10 (28.25) wrote:

VT Engineer - I hear you I think Oil is the really easy long-term call... long-term the price belongs at $100 or higher... the tough call is to try to game when the world will accept that we're running out of oil amidsts all the propoganda that says we are not.

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#5) On August 21, 2008 at 1:29 PM, dexion10 (28.25) wrote:

VT Engineer - I hear you I think Oil is the really easy long-term call... long-term the price belongs at $100 or higher... the tough call is to try to game when the world will accept that we're running out of oil amidsts all the propoganda that says we are not.

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#6) On August 21, 2008 at 1:58 PM, TMFDeej (99.46) wrote:

Echo, Echo.  All of the comments are getting repeated :).  Great post, Dex.  I just gave it a rec.  I'll have to play around with your valuation method for nat gas stocks a little when I have the time and see how some of my holdings stack up.

Deej

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#7) On August 21, 2008 at 2:14 PM, dexion10 (28.25) wrote:

thanks deej

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#8) On August 21, 2008 at 4:05 PM, VTEngineer2001 (< 20) wrote:

Well, for me long term is the only term. I don't trade short term which I define as less than 6 months (give or take). I just can't devote that much time to watching the market with a full time job (thus the "lunch is over" comment).

Frankly, I am shocked that there are people 'in the know' that still think we are not running out of oil. It is a finite resource for crying out loud. Oil is air to our way of life - has been for many decades and will still be for at least the next. I wonder what the world would do if all the trees and plants stopped producing oxygen as a by-product. O2 would be finite, right?

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#9) On August 22, 2008 at 11:47 AM, ResearchLover (< 20) wrote:

Dexion- It seems like you have valuation of companies in the nat gas sector down pat, if only the average future price of the asset could be pegged.  Then, there's the marginal production cost number contributing to the bottom possible margin.  But the future production cost may be higher than $2 if you factor in inflation--particularly for output retrieved way in the future.  Upon closer examination, though, this is a minor adjustment.

I might like to see more comparative valuation in your model, e.g. factoring in the difference between $2 production cost and $65 oil sands production cost, too.  Assuming they are interchangable in their downstream uses.  But that can get murky.  For example, when and whether it will be more valid to compare cost of nat gas vs. heating oil per therm or to compare cost of nat gas in terms of the value for its use in NG combustion engines vs. refined gasoline. (miles per therm of liquid NG) vs. miles per galon, and converting therm and gallon into future dollars.

Another example of complexity in figuring the real value of those reserves is a chemical one, which comes into play if cap and trade of CO2 emissions becomes more widespread.

As it stands, CO2 output is an externalized cost of production.  If this cost were internalized, then the difference in the amount of CO2 released per therm of NG vs. per unit of oil and other competitors also affects the comparative value of NG.

Anyway, I like the post, and it did enlighten and enrich...

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#10) On August 22, 2008 at 12:00 PM, dexion10 (28.25) wrote:

researchlover - thanks for your reply.

You raise many important and valid questions.  Personally I try to steer clear of the extrapolating future uses of nat gas.

In fact I tend to think of nat gas as serving very different end markets vs. oil. Nat gas is used to power utilities, heat homes , and as an industrial heat source (because it's much cleaner than oil) where as oil is primarily used for auto's, chemicals, and consumables.

Additionally the supply dynamics are much more bullish for oil - as a global commodity vs. U.S. nat gas which is a domestic resource in abundant supply.

So in a nut shell I try to look at each as separate markets though I acknowledge there are large overlaps at the margins.

 

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#11) On August 22, 2008 at 12:03 PM, dexion10 (28.25) wrote:

regarding cost inflation for nat gas production

- I suspect that costs will level off here. the US nat gas production is growing so rapidly that we could end up with short-term oversupply issues... when that happens E&P cos will idle the rigs their renting... and the cost of renting rigs will probably go down when the E&P co's get realistic about their aggressive growth plans.... they need to slow down the drilling in my opinion.

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#12) On August 26, 2008 at 3:36 PM, dexion10 (28.25) wrote:

HERE IS AN S&P NEWS ALERT THAT ECHOES WHAT I'VE SAID ABOUT A $7.50 FLOOR IN NAT GAS


BERNSTEIN UPGRADES NAT GAS STOCKS & EOG RESOURCES (EOG)

TO OUTPERFORM FROM MARKET PERFORM

 Analyst Benjamin Dell says while consensus is that oil has stronger backdrop than natural gas, believes reverse is true. In oil market, thinks risks to prices appear to be skewed towards further downside as demand goes negative. In contrast, says US gas market appears to have a floor around $7.50 mark, supported by economics of switching to coal in power generation, impact on E&P budgets. Adds that gas market has upside potential if winter temperatures end up being colder than expected. For EOG, says valuation, which has historically been his concern, has now come in significantly, while its strong balance sheet looks enviable given softening environment. Has $127

 

MY TAKE:

WHILE THIS ANALYST BELIEVE IN A $7.50 Floor. He cites coal costs instead of marginal production costs. That basically means that nat gas is a levered play on coal... if coal falls significantly than nat gas will as well.

It also assumes any excess nat gas will be absorbed by utility companies... this may not be true either.

 

So I go back to the fact that marginal cost of production is the only floor and if the marginal costs fall because of over production onshore in the U.S. - then gas prices COULD TEMPORARILY fall lower than $7.50 in 2009 or 2010.

So while I think that $7.50 is an ok price target right now - over the mid term it may not be and that is a REAL risk.

My bigger point is that so long as nat gas isn't expected to fall significantly below $7.50 - these stocks are buys over the mid-long term IF over-production is kept in check.

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#13) On August 26, 2008 at 3:36 PM, dexion10 (28.25) wrote:

HERE IS AN S&P NEWS ALERT THAT ECHOES WHAT I'VE SAID ABOUT A $7.50 FLOOR IN NAT GAS


BERNSTEIN UPGRADES NAT GAS STOCKS & EOG RESOURCES (EOG)

TO OUTPERFORM FROM MARKET PERFORM

 Analyst Benjamin Dell says while consensus is that oil has stronger backdrop than natural gas, believes reverse is true. In oil market, thinks risks to prices appear to be skewed towards further downside as demand goes negative. In contrast, says US gas market appears to have a floor around $7.50 mark, supported by economics of switching to coal in power generation, impact on E&P budgets. Adds that gas market has upside potential if winter temperatures end up being colder than expected. For EOG, says valuation, which has historically been his concern, has now come in significantly, while its strong balance sheet looks enviable given softening environment. Has $127

 

MY TAKE:

WHILE THIS ANALYST BELIEVE IN A $7.50 Floor. He cites coal costs instead of marginal production costs. That basically means that nat gas is a levered play on coal... if coal falls significantly than nat gas will as well.

It also assumes any excess nat gas will be absorbed by utility companies... this may not be true either.

 

So I go back to the fact that marginal cost of production is the only floor and if the marginal costs fall because of over production onshore in the U.S. - then gas prices COULD TEMPORARILY fall lower than $7.50 in 2009 or 2010.

So while I think that $7.50 is an ok price target right now - over the mid term it may not be and that is a REAL risk.

My bigger point is that so long as nat gas isn't expected to fall significantly below $7.50 - these stocks are buys over the mid-long term IF over-production is kept in check.

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#14) On January 10, 2009 at 10:47 AM, dexion10 (28.25) wrote:

UPDATE:

Where I was right -

The biggest determinant of nat gas stock prices (when they are in free fall)  is the perceived marginal cost of nat gas.

 

Where I was wrong:

 

Marginal cost expectations moved to $5.00 - and this was devistating to my buy thesis.   Additionally one can make a rational argument that marginal cost could move to $4.00 or lower over time if production shifts from the gulf to shale plays.

 

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