After coming out of the gate strong in 1Q19, E&P stock performance took a step back in 2Q and the selloff has continued in July driven by a growing number of fears including U.S-China trade, a late cycle economy, oil price uncertainty, natural gas and NGL price weakness, and of course, capex coming in above expectations. However, a lot of this now feels embedded in the sector, with the value gap to the S&P500 reaching 6.5x on NTM EV/EBITDA, the widest level since 2001. In our view, this is providing the E&Ps an opportunity to stem the decline with a good 2Q reporting season, which is what we see on tap. A repeat will be needed in 3Q to increase investor confidence in the 2020 FCF outlooks to come, but we see the E&Ps exiting this season higher than where they come in.
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The credit markets can be telling about risks in equities and right now we’re seeing that amongst the natural gas producers. On page 3, we show how the maturities of these producers have traded since 2018 and the clear standout is GPOR’s 2023 6.625% notes that are currently yielding over 11%, up almost 80% since the start of 2018. While AR, SWN, and RRC have also seen rising yields due to weakening financial outlooks from lower natural gas and NGL prices, GPOR’s move is also reflective of an increasingly uncertain 2020 development plan combined with reduced non-core asset divestiture expectations that are slated for share count reduction. While we believe GPOR would want to take out as many shares as possible with the stock below $5/sh, the prudent move now also looks to be reducing the $2Bn debt burden, especially if activity levels and volumes will be declining next year just to generate free cash flow. We’ll look to see if there’s any change in this view on the 2Q call, but we do think improving the balance sheet now, would be long-term supportive for the stock.
Following the launch of MALESSA and the Crude Oil Predictor (COP) model, Wolfe’s QES Team continues its Energy focus by introducing DEPTH (Dynamic Exploration & Production Tactical Hedge), an E&P sector stock selection model. In combination with traditional quant factors and machine learning techniques, the model uses 150+ E&P specific factors to rank almost 70 U.S. and 60 International E&P stocks that’s designed to be crude oil and natural gas beta neutral. See full details of the QES Team’s DEPTH report here and within for our interpretation of the model.
Our E&P Index finished the week flat, underperforming the +0.8% move in the S&P500 and the big +4.7% jump in WTI. Part of the driver for the flat E&P week was a split decision amongst the sub-groups with the oil focused producers positive while the nat gas producers were down 2%, giving us a perfect intro for this weekend as we provide feedback from GasWeek and some apropos music inside.
After a brutally quiet 1Q19, 2Q brought the Energy sector back into the limelight for a few weeks as OXY fought off a bid from CVX to acquire APC for $57Bn in one of the largest E&P transactions ever. The transaction didn’t have the intended sector-wide impact we thought it would (our E&P Index underperformed the S&P500 by 20% in 1H19), but it did show that there’s good value amongst the E&Ps and we believe this will continue to come out via M&A. Within, we review the 2Q19 deals, provide updated company-by-company M&A thoughts, and focus on natural gas M&A.
Wolfe Research's Senior E&P Analyst, Josh Silverstein, hosted a webcast to discuss stock thoughts post EQT's July 10 proxy, AR bull/bear debate, what AR should do with the AM stake, and natural gas supply/demand update.
This morning (07/10/19), EQT announced that all seven of the Team Rice nominees and the five EQT nominees unopposed by Team Rice were elected to the reconstituted board. Although Team Rice had clearly been gaining support, what spoke loudly to us was the 80+% shareholder vote for each of the 12 board members. In our view, this suggests there was a big focus on driving incremental FCF out of EQT’s asset base at a time when low natural gas prices are depressing the forward outlook. The focus now moves to the implementation of the Team Rice strategy, the 100-day game planning period, and the ability to fully extract the $500MM additional FCF by mid-2021 via large scale development and improved technology. We expect the 2Q call to be Toby’s first opportunity to outline his views, with investors curious to know how the development plan may change relative to EQT’s prior 5% growth views amid declining natural gas prices and key milestones timing. Additionally, given the significant leadership turnover at EQT (Toby will be the 4th CEO in 18 months), we’ll be looking to see how cultural issues may impact the timeline as the employee base could see a fair amount of turnover. We’re reiterating our $25 PT based on the existing EQT five-year plan, but there is further upside as evidence of the $500MM/yr additional FCF starts showing up.
Ahead of tomorrow’s (7/10/2019)Annual General Meeting proxy vote, we’re reiterating our Outperform on EQT. While stock performance could swing based on the outcome, at a minimum, we believe removing the uncertainty will be positive and finally turn the focus towards improving fundamentals and the ability to generate better returns and FCF out of the asset base. Our $25 PT is based on the currently outlined 5-year base case and $2.50/mmbtu long-term natural gas, with $2+ upside from the additional FCF drivers that can be pulled.
While our long-term supply/demand outlook points to greener pastures ahead for the Northeast natural gas producers in the 2023+ period, the next 2-3 years of $2.50/mmbtu will continue to pressure this group, keeping us Market Underweight. There’s light at the end of the tunnel, but it’s too early to buy the group on the 2023 view, even after the 20% YTD underperformance vs. our E&P Index and the implied price embedded in NAVs below the forward curve.
Natural gas prices are at a 3-year low and wrestling between below average storage levels and unwavering supply growth that will limit price gains outside of weather impacts. That’s the near-term picture, but there’s also a long-term story for natural gas and it’s one of continued demand growth that will provide price support into the future. Within, we outline the key drivers of natural gas supply and demand through 2025, with our views suggesting price remains at $2.50/mmbtu through 2021 before rising in the 2023+ period.
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