The KFAC physical office is closed until further notice. Click here for more information.
Nicholas Coppola, CFA
June 15, 2018
Many value investors like to talk about the concept of ‘time arbitrage’. The idea is that there’s an opportunity to earn outsized returns simply being more patient than the short-term oriented Wall Street crowd. While it’s not always perfectly clear what represents a good time-arbitrage opportunity, we are generally bullish on the long-term prospects of the currently depressed natural gas market. Like most industries, the two key drivers of revenue are price and volume. Regarding price, the US Henry Hub spot benchmark is at a low-level at ~$2.94/MMBtu, which is down a dramatic 78% since the prior peak in June 2008. Regarding volume, the natural gas industry, specifically in the Northeastern part of the United States, has been constrained by bottlenecks that are now being alleviated with the addition of new pipelines and export terminals. And going forward, we expect strong demand growth driven by a number of factors, including the displacement of coal in the utilities industry (i.e., natural gas fueled power plants are cheaper and emit less CO2 than coal), growth in residential/commercial demand as homes in emerging markets transition from burning wood to burning natural gas, and global growth in industrial/petrochemical industries that use natural gas as a feedstock. With all of this in mind, we have added a small position in Antero Resources (AR) to portfolios.
To understand the company, it’s necessary to disaggregate the pieces. Antero Resources owns ~615k net acres of oil & gas properties in the Appalachian basin. They are the largest natural gas liquids (NGL) producer and the 7th largest gas producer in the United States. The parent company is focused on the Exploration and Production (E&P) of natural gas in the Marcellus and Utica shale in West Virginia and Ohio. The company also owns 52.9% of the limited partner interest in Antero Midstream (AM), which is also publicly traded. AM focuses on the infrastructure required to get their products to market, including pipelines, compressor stations and interests in processing and fractionation plants. In our view, this controlling interest in Antero Midstream is an important strategic advantage as the company can ensure their natural resources can be processed and monetized.
The exploration and production side of the natural gas industry has seen meaningful advances in operational efficiency in recent years. We believe that Antero has been a leader in this trend. As an example, Antero last quarter completed four wells in the Utica shale with 17,400 foot laterals. To clarify, that means that the company successfully drilled horizontally underground for over 3 miles. Importantly, longer laterals translate to more gas being retrieved for a given well and drives greater efficiency and productivity. In the Marcellus, where most of Antero’s business is currently located, the company has cut their Finding & Development (F&D) costs per million cubic feet equivalent (Mcfe) roughly in half since 2014. Further improvements are expected to be driven by a number of initiatives underway, including a continued focus on longer laterals, shorter cycle times with an increase in stages per day, and putting in more wells per pad.
Meanwhile, the buildout of new pipelines and export terminals are removing bottlenecks across the industry. Energy Transfer Partner’s Mariner East 2 pipeline has been described as a ‘game changer’ and is expected to be operational in Q3’18. This new pipeline will enable transportation to the Marcus Hook terminal on the Delaware River in Pennsylvania for export overseas. It should also improve margins as this new route is lower cost than other alternatives (i.e., shipping via rail to a Texas terminal). Moving further down the supply-chain, there has been an increase in the global fleet of Very Large Gas Carriers (VLGC) that will provide shipping capacity to serve overseas markets.
Lastly, we are also encouraged to see senior management with ‘skin in the game’. After all, there is no better way to be aligned with investors than being an investor yourself. Antero CEO, Paul Rady, is the 5th largest shareholder with ~5% ownership of the company, currently valued at ~$325M. In our view, this provides more than enough incentive to maximize shareholder value. Note that in February, with the additional prodding of shareholders, management announced the formation of a ‘special committee’ to evaluate measures to enhance Antero’s valuation, which may bode well for the stock. Additionally, Mr. Rady and Glen Warren (CFO) have a long history of working together and previously sold two businesses they led, including Pennaco Energy to Marathon Oil in 2001 and a private iteration of Antero Resources to XTO in 2005. Their backgrounds prior to that also appear to be complementary, with Mr. Rady coming from geology and Mr. Warren coming from natural resources investment banking.
So where could we be wrong? Commodity prices are notoriously hard to predict, and it’s certainly possible they head lower from here. This is particularly true if the industry gets over its skis and overproduces on the heels of massive resource discovery, thereby creating too much supply (though this risk is somewhat mitigated over the next several years for Antero as the company has various hedges in place). And in regards to operational efficiencies, Antero needs to stay ahead of their competition. Warren Buffett, my favorite source of timeless investment wisdom, has an analogy in his 1985 letter to Berkshire Hathaway shareholders, referring to capital investments at their struggling textile business (which was incidentally closed that same year). If you are watching a parade and stand on your tiptoes, you will get a better view. However, if everyone in the crowd stands on their tiptoes, your efforts cancel each other out. In the context of the natural gas industry, this could look like all of the players improving efficiencies, and then proceeding to pass along their hard-earned cost savings to customers through lower prices, and thus never realizing excess profits.
That said, we continue to like the risk/reward profile of Antero Resources. Of course, valuation is an important part of the story, and the stock looks cheap as we look at both standard valuation measures, as well as several oil & gas specific ones. Most notably, AR is trading at ~15.0x next twelve months earnings, which is less expensive than the broader market. Consensus estimates call for a revenue and adjusted Earnings Per Share (EPS) compound annual growth rate of ~15% and ~40% over the next 5 years, respectively. We view the current price as attractive, particularly in light of the strong expected top and bottom line growth.
As always, please let us know if you have any questions about recent trades or your broader portfolio. Thank you for your continued trust.
Nick Coppola, CFA
Nicholas Coppola, is a Senior Portfolio Manager at Kays Financial Advisory Corporation. He can be reached at (770) 951-9001 or at email@example.com.
This report and Mr. Coppola’s comments are provided as a general market overview and should not be considered investment or tax advice or predictive of any future market performance. Any security mentioned in this report may not be suitable for all investors. No investment mentioned in this newsletter constitutes a recommendation to buy, sell or hold a particular investment. Such recommendations can only be made on an individual basis after an assessment of an individual investor’s risk tolerance and personal circumstances. Past performance of any investment mentioned is not a guarantee of future performance. Statements regarding the investment concerns and merits of any investment and fair market value computations are strictly the opinion of Kays Financial Advisory Corporation. Employees of KFAC and KFAC clients may have positions and effect transactions in the securities of the issuers mentioned here in.