This article is part of our Rising Star Portfolios series.
What with the persistence of natural gas as the commodity patch's ugly stepchild; consistent fracas over the environmental consequence of fracking; and recently (re)raised questions regarding shale gas economics -- it's hard to ignore resources giant BHP Billiton's (NYSE: BHP ) $15 billion acquisition of shale behemoth Petrohawk.
This deal -- alongside Chevron's ( NYSE: CVX) acquisition of Atlas' natural gas E&P, Exxon's (NYSE: XOM ) foray via the XTO Energy deal, and BHP's recent purchase of Chesapeake Energy's (NYSE: CHK ) Fayetteville acreage -- is one in a spate of supermajor activity in the commodity, and by any stretch, it's significant. The open question: What does it really mean for investors?
First things first
BHP was quick to tout this deal as an investment in clean-natural gas, a carbon-conscious and sustainable fuel. The markets, for their part, seemed to agree, bidding natural gas-focused independent exploration and production companies higher on the news. But the truth is, it's not entirely that: Petrohawk possesses a significant footprint in the Permian Basin and the recently hot Eagle Ford shale, two regions that wonkish types call liquids-rich. In practical terms, that means a simple thing -- besides natural gas, these areas also produce natural gas liquids (or NGLs), whose prices closely track oil and have similar applications, and oil.
So for those seeking validation of the ugly commodity's cheapness, don't celebrate. It's only a partial win: 10% of Petrohawk's 2010 year-end reserves were oily, and 30% of its "risked resource potential" (management-speak for: stuff we haven't yet proven, but might be able to). You can be sure that, whether or not it's outwardly obvious, BHP paid a premium for Petrohawk's oily revenue streams.
But for that caveat, there's still something to please natural gas acolytes. After all, Petrohawk's a heavyweight in the Haynesville, and 90% of current proved reserves are natural gas.
What it does mean
As with the Chevron and Exxon deals, an economically minded strategic buyer's taken a shine to a predominantly natural gas shale-focused small-to-mid-sized company. So what should we, the tea-leaf-reading public, infer? By these buyers' reckoning, natural gas is two things: (a) cheap and (b) a strategically important fuel.
There are buyers willing to pay -- and pay nice sums -- for the ugly child of the commodity patch. It's important because natural gas bulls have continuously argued the commodity's due for a turn up from $4 per mcf, but it's stubbornly resisted. The reasons are many in number, but the takeaway, to me, is clear: BHP, Exxon, and Chevron aren't buying on the expectation that natural gas will languish around $4 in perpetuity.
Likewise, it again raises two issues central to the natural gas debate: the viability of shale-gas economics, and fracking. For the (fortunately) uninitiated, fracking's been a political lightning bolt, with allegations that it's polluted groundwater and uses environmentally unsafe -- and at worst, unsavory -- techniques. For the lack of data, the jury's still out on that one.
The debate around the economics, alternatives (to fracking), and environmental viability turns in many directions. I won't bore you with the details. This purchase, as others, provides tentative affirmation that producers believe there is a way to extract shale gas economically, and that the technology employed in fracking -- if effectively employed -- is safe. An alternative explanation is this: Whether or not hydraulic fracking (as currently performed) remains an instrument in the shale gas E&P's toolbelt, they're willing to make sizable gambles other economic extraction methods exist, such as propane-based fracking.
That gets to the final topic of debate. A hot button issue, the life-cycle profitability of shale gas drilling has again taken center stage with a series of editorial columns from New York Times columnist Ian Urbina. The jury's still out on the actual life-cycle profitability of new, unconventional natural gas plays. The geology of shale deposits varies dramatically and some are bound to be unprofitable, or less profitable than initially anticipated. Moreover, operators' technological aptitude -- and efficacy of drilling programs -- can make for dramatically different cost curves.
But for all the hullaballoo, I don't think it matters too much in the long run. If shale gas isn't as profitable as anticipated, the market will take care of itself, and natural gas prices will move higher. And while I'm well-versed in the sundries of tulipmania, I don't think the industry's brightest, best, and penny-pinchingest are apt to risk vast sums on a phenom that's a wholesale dud. Also note, these guys aren't pitching in the dark: E&Ps have been drilling the industry's granddaddy shales, like the Barnett Shale, for six to seven years now. That means they have some idea of the life-cycle economics.
Take it full-circle, and to me, an inexorably obvious point arises: Natural gas, with its seemingly vast quantities and low-carbon footprint, make a startlingly sensible alternative to other carbon fuels, as our nation and the world seek to address their carbon addiction.
So who's next?
Is there more takeover fodder in the independent E&P space? I've taken a look at some relevant deal metrics in companies whose assets are similar in quality, cost of extraction, and size for reference.
% Developed / Undeveloped Acreage*
||22% / 78%
||44% / 56%
||70% / 30%
*At fiscal year close nearest deal date.
**At time of deal.
First, a quick sidebar: I'd call the XTO deal a sweetheart deal for Exxon, in part because it happened in a still-shaken economy. And the multiple on the proposed EXCO deal also looks a touch cheap. No surprise then that it's encountered opposition, and hasn't gone through.
Now let's have a look at the publicly traded counterparts:
EV/Proved Reserves *
% Developed / Undeveloped Acreage*
|Ultra Petroleum (NYSE: UPL )
||6% / 94%
|Range Resources (NYSE: RRC )
||48% / 52%
|EOG Resources (NYSE: EOG )
||30% / 70%
*At most recent fiscal year close; Ultra figures include recent 100,000-acre Niobrara investment.
These are but a few metrics, but on a look at the data and potential in the E&Ps mentioned above, I think it's pretty plain: These companies are pretty cheap against their prospects. And they just might become takeover bait on account of it. Keep up with the continuing natural gas story by adding any or all of these companies to your free watchlist.