Pickering drives a stake into the ground and highlights again the Chinese Wall between the bankers and the analysts.
E&P INVESTING - THE TPH MANIFESTO
· E&P Investing – The TPH Manifesto (E&P $626) – Time to focus on returns and reward companies that create value, whatever the commodity price cycle. Production growth should be the outcome – not the target. Many believe growth and commodity prices are all that matters to the E&P business…our goal is to change that mindset. With this in mind, we determined four key metrics that both drive stock performance and help us better evaluate each E&P’s ability to generate returns and create value: PV/I, ROCE, change in cash margin, and production growth per debt-adjusted share. More below. Report to come under separate email later today.
· Why a Manifesto? – E&Ps have at times overcapitalized/destroyed value, but this need not continue...every project/lease/well need not be funded. Value-creators have consistently outperformed…but not by enough. As investors/analysts, we can/should make the contrast of stock performance even more apparent. Thomas Paine said it well: “Perhaps [these] sentiments...are not yet sufficiently fashionable to procure them favor; a long habit of not thinking a thing wrong, gives a superficial appearance of being right, and raises at first a formidable outcry…But tumult soon subsides. Time makes more converts than reason.”
· Manifesto ratings changes (E&P $626) – We are downgrading 10 stocks (BEXP, BRY to Accumulate from Buy; MEG-T, PXD, SWN to Hold from Accumulate; HK to Hold from Buy; AREX, GMXR, ROSE, SGY to Trim from Hold) and upgrading two (CXO, WLL to Accumulate from Hold). Our new ratings reflect our Manifesto ranking with higher-ranked companies in general receiving better ratings than lower-ranked (top half of rank includes 5 Buys, 13 Accumulates, 1 Trim vs. bottom-half with 5 Buys, 4 Accumulates, 6 Holds, 3 Trims). More below.
E&P Investing – The TPH Manifesto (E&P $626) E&P Research Team
· The Manifesto Thesis: Collectively, we changed the upstream business, all of us – investors, company management teams, and sell-side analysts. We encouraged and paid more for growth, and subsequently, capitalism worked. Lots of smart people went in search of natural gas (now oil), applied technology, sought and received capital and ultimately, discovered a tremendous resource (natural gas and now potentially oil) that could and should transform the energy policy of the United States. Be proud of this accomplishment, but also realize that we have gone too far…the business continues to consume too much capital and many times destroys value in the pursuit of growth, capturing acreage, and most recently, chasing oil. We recommend focusing on capital efficiency (PV/I), return on capital, and margins. Growth needs to be the outcome of efficient capital allocation as opposed to the target. As investors and managers shift their focus to capital efficiency, the E&P business will become more sustainable and "investable."
· Analysis Methodology: Our thesis is that in a flattish gas and oil price environment, improving cash margins, investing in high PV/I projects, and ‘smart’ production growth = better stock performance. We believe companies that generate high returns can plowback capital beyond cash flow, but there is a limit. Our analysis is designed to show the link between operational and financial company performance measures and E&P stock performance. We found that the drivers for the business historically depended upon the cycle, but several key metrics drove the best performing stocks and are a powerful predictor of stocks that outperform and underperform. As management teams made decisions to improve those metrics, their companies created the most net asset value and those companies were (and are) the best performing stocks. Key metrics for top tier E&P stock performance:
1. A company must make money (positive net income and cash margin) at current commodity prices regardless of product mix.
2. E&P is still a price taking business, so companies and investors must focus on costs and cash flow margins. Stocks have moved as performance improves or deteriorates.
3. Invest in highest return projects (PV/I translates better than ROCE to field operations and stock performance).
4. Production and reserve growth (on a debt adjusted basis) is the outcome, not the target.
· Defining PV/I: The Value Creation Index (PV/I) is the present value of proved reserves discounted at 10% divided by trailing one-year or three-year finding and development costs. The output of an E&P company is the discounted value of the cash flow from adding production and reserves created by investing capital (finding and development costs). The investment cycle for the E&P business is 3-5 years, so we would generally use 3-year finding and development costs to measure invested capital. However as we look forward, we believe the shift in investment from the high-flying days of ’08 to more moderate spending amid a flattish commodity environment is better reflected by 1-year F&D costs…particularly as PV/I calculated with 1-year F&D shows just as strong a relationship with stock price performance.
· 2011 Outlook: Ranking our covered E&P companies on a combination of change in cash margins, PV/I, ROCE, and production growth per debt-adjusted share, the top half have consistently outperformed the bottom half as stocks. As we look forward to 2011, we ranked the companies on these metrics. For the lower ranked companies, there is always the other side of the coin and no company or investor wants to be at the bottom. Generally for these E&Ps, 2011 cash margins decline with gas price and 2011 ROCE is lower. The silver lining is improving in rank has resulted in stock price appreciation in the past and so these companies have the highest room for improvement. While the highest ranked companies have consistently outperformed lower ranked companies, that does not necessarily mean those stocks are the cheapest on net asset values or multiples. Typically the market is efficient and good companies that create value tend to be more highly valued (top half average 3% upside vs. bottom half at 23%). Some of the best opportunities exist when a company is moving up or down the ranking and either trade at a discount to our net asset values or on multiples.
o Top 5 companies: BEXP, OAS, CLR, OXY, CRZO. We tend to be agnostic regarding oil or natural gas exposure and are focused on which companies can create the most value. But with $4/mcf gas and $90/bbl oil, 2011 looks tough for the pure gas companies.
o Next 10 companies: CXO, NFX, SM, BRY, WLL, XEC, FST, NBL, APA, RRC. The next tranche of ‘best’ companies either have oil leverage or have a combination of a large gas base with the opportunity to improve via oilier projects.
o The tweeners: UPL, REXX, ROSE, PXP, CVE-T, DVN, GMXR. We believe NBL, PXP, and DVN are potentially some of the best investments for 2011 as they offer improving metrics, solid upside to our net asset value and relatively lower multiples.
o Bottom 5 companies: STP-T, SGY, XCO, GDP, CHK. Of note GDP and CHK have dramatically shifted their investment plans toward higher return oil projects, which upon success improve metrics in 2012. STP-T will commission its first oil sands project in 2011 so we would expect them all to improve on 2011 PV/I.
o Next 10 companies from the bottom: HK, AREX, COG, PXD, QEP, PXD, MEG-T, SWN, APC, SD, EOG. Some are gassy companies that suffer from lower margins/ROCE on combo of our $4 gas prediction and fewer hedges in 2011 (HK, COG, QEP, SWN). Others are oil transition stories in the works (SD, EOG, AREX) illustrating that transitioning to oil isn’t easy and requires capital.
· Applying the Thesis to Stockpicking: To pick the best E&P investments, we identified a combination of four metrics that highlight companies that generate a differentiated return on investment regardless of leverage to oil or natural gas. These companies have consistently been, and should continue to be, the best performing stocks. Our analysis necessitates changing our stock ratings methodology to reward companies that rank highly on the combination of our Value Creation Index (PV/I), return on capital employed, improving cash margins, and production growth per debt-adjusted share. The companies that rank highly on the combination of these metrics outperform those companies that rank poorly (top half outperforms the bottom half). We will delve deeper into each of these measures and why we chose them later. We continue to set our target prices on Net Asset Value (NAV) and NAV creation remains our core stock price valuation method, but we realize we cannot solely use NAV in a vacuum as it does not always accurately capture a company’s ability to create the most value per dollar invested and generate the best returns possible. Some stocks trade at significant discounts to our NAVs, which are based on $6 gas price. In today's $4-5 gas world, some of those companies are destroying value with their investment decisions (PV/I < 1 and ROCE < WACC)….our new methodology rewards and rates those companies that create more value and will not solely reward those that trade at a significant discount to NAV. To be a Buy-rated stock, the company must rank highly on our defined metrics, be improving, and/or be relatively cheap. In general, the top half-ranked of our coverage list will be Buys and Accumulates and the bottom half of the list will be Accumulates, Holds, and Trims.
· Conclusions: The upstream business has a history of overcapitalizing and sometimes destroying value, but this need not continue. E&P investors can provide the checks and balances by focusing on returns and allowing growth to be the outcome. Every project that is available, every lease that can be had, every well that can be drilled need not be funded. A company can have too much inventory as upfront leasing costs hurt near-term PV/I and ROCE and long-term capital required to develop presents a capital need overhang. As analysts, we are commodity price agnostic and just want companies to create value from their assets…as should management and investors. We do think investors have been sending the industry the signal to focus on returns as companies with higher cash margins, higher ROCE, and higher PV/I have outperformed in the past…but we can and will be louder. As investors and analysts, we can and should make the contrast of stock performance even more apparent.
Manifesto Ratings Changes (E&P $626) E&P Research Team
· Manifesto methodology impact on ratings: We are downgrading more companies than upgrading (10 downgrades vs. 2 upgrades). Our new ratings rank and reward the best performing companies (top half of our Manifesto ranking includes: 5 Buys, 13 Accumulates, 1 Trim vs. bottom-half 5 Buys, 4 Accumulates, 6 Holds, 3 Trims). Our 2011 outlook for relatively low natural gas prices and high oil prices leads us to upgrade CXO and WLL that rank in the top-half on performance. We also are downgrading 10 companies that rank in the bottom half of our performance list or have limited upside to our targets.
o Buy – APC, CRZO, DVN, FST, NBL, OXY, PXP, QEP, STP-T, XCO.
o Accumulate – APA, BEXP, BRY, CHK, CIE, CLR, COG, CXO, GDP, NFX, OAS, REXX, RRC, SD, SM, UPL, WLL, XEC.
o Hold – CVE-T, EOG, HK, MEG-T, PXD, SWN.
o Trim – AREX, GMXR, ROSE, SGY.
· Upgrades – CXO and WLL to Accumulate from Hold.
o CXO upgrade to Accumulate from Hold ($94.11 – A) – Concho ranks #6 overall in our coverage list ranking cash margins, PV/I, ROCE, and production growth per debt adjusted share. CXO ranks high on PV/I at 1.32 and with 42% production growth per debt-adjusted share the company can and will continue to create considerable shareholder value through drilling and acquisitions.
o WLL upgrade to Accumulate from Hold ($117.10 – A) – WLL’s PV/I of 1.22, 23% ROCE, and 19% production growth per debt-adjusted combine to place WLL at #10 on our list of 39 covered companies. The stock trades low multiples at 6.1x EV/EBITDA vs. peers at 8.9x, but needs to prove up Lewis and Clark potential or make an accretive acquisition with its strong balance sheet to increase our NAV.
· Downgrades – BEXP, BRY to Accumulate from Buy; MEG-T, PXD, SWN to Hold from Accumulate; HK to Hold from Buy; AREX, GMXR, ROSE, SGY to Trim from Hold.
o BEXP downgrade to Accumulate from Buy ($28.36 – A) – Brigham is the #1 ranked company in our coverage list ranking cash margins, PV/I, ROCE, and production growth per debt adjusted share. But the stock and company have been on a tear that as a result has BEXP trading at our $28 NAV and at 10x 2011 EV/EBITDA vs. peers at 8x.
o BRY downgrade to Accumulate from Buy ($46.99 – A) – Berry just surpassed our $46 NAV, which once had many doubters. The company ranks #9 on our four metrics as the combination of low gas price and high oil price places BRY #8 on improving cash margins, which combined with top half rankings on all other metrics shows the company is relatively balanced. The Permian acquisitions provide near-term primary production growth, but we are closely watching escalating costs for all newer entrants into the basin that could impact BRY’s rankings.
o MEG-T downgrade to Hold from Accumulate (C$42.65 – H) – Tough to rate MEG-T above CVE-T with the about same upside to NAV and trading at higher multiples. MEG Energy ranks #27 overall on our coverage list while CVE is #20. MEG is #1 on improving cash margins, but is hurt by 6% ROCE (#33 ranking). We expect MEG’s stock to weather through the expected early February Warburg stock sale.
o PXD downgrade to Hold from Accumulate ($93.41 – H) – Pioneer trades slightly above our $91 target and the company ranks #33 on our 38 company coverage list. The company should improve in 2011 as they accelerate their PV10 and F&D improves driven by completing more zones in the Spraberry. Given relatively high PUD booking and continued gas leverage in their existing reserve base PXD’s PV/I remains lower than oily peers.
o SWN downgrade to Hold from Accumulate ($39.38 – H) – Given our outlook for $4/mcf gas and $90/bbl oil in 2011 gassy companies have a hard time competing on cash margin improvement and ROCE. As a result, Southwestern ranks #26 in our 39 company coverage list ranking cash margins, PV/I, ROCE, and production growth per debt adjusted share. With less upside and higher multiples, SWN is a Hold. SWN trades within 4% of our $41 NAV. SWN's potential monetization of midstream could reduce future capital commitments and mark the value to market, but with SWN already trading at 9.3x 2011 EBITDA (vs. peers 7.9x) the uplift in near-term multiples is low.
o HK downgrade to Hold from Buy ($19.94 – H) – Our downgrade to Hold truly reflects how our four-metric ranking outweighs pure upside to NAV. We truly believe the top-half will outperform the bottom half-listed stocks and Petrohawk ranks #31 in our 39 company coverage list. HK ranks #29 on cash margins, #32 on PV/I (leasing hurts with no reserve adds), #27 on ROCE (at 9%), and #10 on production growth per debt-adjusted share. As HK drills more Eagle Ford, cuts back in the Haynesville, and slows leasing the company should move up the list and realize the considerable upside to our $37 target based on $6/mcf long-term gas.
o AREX to Trim from Hold ($25.29 – T) – Approach’s leverage to the emerging Wolffork Shale has driven the stock well above our $15 target and the company ranks #30 on our 39 company coverage list on the combination of rankings. Simply put the market is willing to pay more for emerging oil exploration than we are. We and the market eagerly await the company’s first set of wells to better understand how the resource potential coverts into production, cash flow, and more importantly returns.
o GMXR to Trim from Hold ($5.51 – T) – GMX Resources’ asset base is expected to grow production at 36% on a debt adjusted basis in 2011, but given low PV/I 0.38 and 7% ROCE, we cannot justify encouraging investment at current commodity prices. The company should slow spending even further, weather their upcoming bank redetermination, look for other basins with better return opportunities, and wait for higher gas prices that are needed for the stock to work.
o ROSE to Trim from Hold ($37.02 – T) – Fine line internally between a Hold and a Trim rating as Rosetta Resources ranks #18 on our coverage list, so is a “top half” company. The Eagle Ford drives a #11 ranking on production growth, but our issue is ROSE trades well above our $30 target and is being rewarded for resource potential in the emerging Alberta Bakken play before ‘any real well results’ are available. Well results in the basin continue to push further into the future.
o SGY to Trim from Hold ($23.50 – T) – Pure ranking and NAV convergence drive a Trim on SGY. Ranked #36 and trading 19% above our $19 net asset value. Stone’s Gulf Coast deep exploration, Marcellus, or Alberta Bakken/Paradox need to hit for the stock to meaningfully appreciate. We do believe the CRK ownership overhang may likely behind the company as CRK needed capital and likely sold.