Description

Summary:

As timing is everything,  I recommend Antero Resources (AR) on the day that the Wall Street Journal highlights the potential world glut of natural gas on page 1. [1]  Why?  Antero has the following attributes:

--low cost producer

--very long growth runway with minimal development risk

--strong management with ample skin in the game

--discount to NAV

--good (though not complete) protection against commodity price swings

--valuable midstream assets held by Antero Midstream (AM:  59% owned)

--a potential beneficiary of Appalachian basin consolidation

My conservative target price is $40 over the next three years, which I will detail below, or a 20% compound return.

Company Background:

CEO Paul Rady and President/CFO Glen Warren founded Antero in 2002 with Warburg Pincus as the lead investor. It then focused on the Barnett Shale in Texas; in 2005 XTO Energy (now part of Exxon) bought its assets for $685MM.  Two years later the current Antero was founded with the same group of investors.  Though initially it operated in Oklahoma and Colorado, those assets were divested and the company operates only in the Marcellus and Utica shale basins in West Virginia and Ohio.  Having started with one well in 2009 and gone public in the fall of 2013, AR is now the 2nd leading gas producer in Appalachia and the 8th largest in the US.  At present, Warburg Pincus owns 18% of AR, Rady and Warren together own 9%, and Yorktown Energy (another PE firm) 5%.  (For further background see the good VIC analysis from May, 2015.)

Business and Strategy:

The most recent company presentation is excellent and worth reviewing along with this. [2]  Antero has amassed a very large reserve position:  46.4 Tcfe 3P reserves (1/3 proved and almost all proved and probable) as of 12/31.  Even at current gas prices, the company has over 2500 attractive drilling prospects currently, or 13 years at the 2017 planned rate.  AR is currently focusing on liquids-rich wells, which account for over 70% of its undrilled locations.  Management projects that NGL output should grow to 150K bbls/day by 2020, roughly double the current rate.  Its highly rich gas wells now yield pre-tax rates of return over 50%.  Drilling costs have been declining through both efficiencies and lower service costs, which AR is locking in at current rates.  Furthermore, longer laterals and increased use of proppant are yielding higher recoveries and better well economics.  

From the outset AR has extensively hedged its gas production, which is in sharp contrast to many of its competitors and proven to be a very effective strategy.  Its projected gas production is 100% in 2017 and largely hedged in 2018.   There are significant hedges above the current strip in 2019 and 2020 as well and even modest in the money hedges for 2021 and 2022.  At 12/31 the value of the hedge book was $1.6 billion.  On the other hand, management believes there is upside in NGL realizations, which is reflected in current strip pricing, due to greater pipeline capacity, growth in US petrochemical plants and exports.  As the chart on page 10 illustrates, this leverage to NGLs should be the major driver behind AR’s cash flow growth over the next three years. 

AR has also differentiated itself by contracting for transportation capacity (FT) well in advance of its internal needs.  Though this has added to its cost structure, its realizations have been significantly greater than most of its Appalachian competitors (and greater than the incremental expense), who have been forced to sell gas into the local market at steep discounts to Henry Hub pricing.  Its FT should grow over 50% by the end of 2018 as 3 major pipelines should come into service.  In sum, highly productive acreage, efficient drilling, timely hedging and effective marketing have combined to yield cash margins well ahead of its peers.

Antero Midstream:

From the outset, Antero has invested in midstream assets complementary to its growing production of gas and liquids.  Antero Midstream (AM) came public in October, 2014, raising $1 billion; it has actually been a much better stock than the parent company  (a recent AM investor deck is appended [3].)  AR owns 59% of AM, which represents $12/share at current prices.  Earlier this year, AR announced a joint venture with MPLX, another midstream partnership controlled by Marathon Petroleum, for processing and fractionation infrastructure in the Marcellus and Utica.  If fully developed, this will add $800MM in capital projects net to AM over the next 4 years, yielding capital spending for AM of $2.7 billion in this period.  

Beyond serving AR’s production growth, this creates an interesting arbitrage:  AR can build out midstream capacity at 4-6X EBITDA and garner a much higher multiple from yield-oriented investors who also like its high growth profile.  Management has forecast a 28-30% CAGR in its distribution through 2020 off of a $1.33 base in 2017. Note that Antero Investment, a private company owned by the PE sponsors and senior management, is actually the GP of AM and that the incentive distribution rights are now in the 50/50 (highest) split range.  

Finances and Projections:

With debt at 3.3X EBITDA, AR appears quite levered at first glance.  Its ownership of AM units ($3.8 billion) along with the hedge book ($1.6 billion), however, exceed total debt.  Furthermore, in its last two quarters, cash flow from operations exceeds drilling and completed capital spending (although the company is still using cash because of the heavy midstream spending).  This should continue over the next few years; hence debt/LTM EBITDA should decline to the 2.0-2,5 range by 2020.

Closer in, EBITDA should be flattish in 2017 despite 20%+ production growth.  The reason is that 2016 EBITDA was augmented by outsize hedging gains, which added $1.89/Mcf to underlying realizations.  While gas prices in 2017 should be higher than in 2016 (recall how low gas was early in the year), the hedge book is not nearly so favorable this year as it was last, though it improves somewhat over the balance of the decade.  D&C capital should be flat in the $1.3 billion neighborhood.  

Looking out beyond the current year, EBITDA should ramp rapidly given better hedges and the leverage to NGLs described above.  2018 should see an especially dramatic year/year increase as there will not be the year/year negative comparison in hedging gains that will occur this year.

Consolidation:

At the beginning of January Chapter IV Investors, a partnership managed by Barnes Hauptfuhrer, made public a letter and presentation to the Board of Equitable Resources. [4]  In a nutshell, his thesis is that consolidation in Appalachia has great industrial logic and that Equitable should enter into discussions with both Antero and Range Resources.  There is a lot of logic in the presentation.  Hauptfuhrer, who has a banking and PE background, owns meaningful positions in all three companies and takes pains to make the point that he is friendly and constructive. His thesis is worth considering.

The PE investors led by Warburg have now been involved for a decade and own over 20% of the company.  Rady and Warren, both of whom are in their 60’s, own 10% and have sold two companies before.  Additionally, this founders’ group also control the GP of Antero Midstream, which is extremely valuable--perhaps worth over $1 billion.  With burgeoning cash flow over the next few years, it could be an interesting time to enter into a transaction.  Note that Temasek, the Singapore wealth fund, bought 6.7MM shares directly from AR in October.  

Valuation:

There are many ways to value an exploration company.  I am not a specialist in the field (probably evident by now) and will use a quick and dirty approach:  Public values for high quality E&P companies--I think Antero is certainly in this group--have ranged in recent years between 6-8X EBITDA on some measure of normalized commodity prices.  Looking out to 2020 and using the midpoint of the multiple range, I get a $40 stock price for Antero.  I think this is pretty conservative given the quality of the acreage, the predictability of the wells (AR has never had a dry hole!) the hedge book, and the embedded value of Antero Midstream.  

Risks:

 Steep decline in oil and gas prices.  Mitigants: The hedge book and the decline in industry drilling that would inevitably result.

2.  Sharp increase in natural gas prices leads to relative underperformance as PMs chase more levered gas bets.  That’s fine.  Antero will still do well.

Footnotes:

[1] Wall Street Journal, 3/15/17 http://www.wsj.com/articles/gas-glut-reverses-lucrative-2016-trade-1489492959?emailToken=JRryd/lzZXmQhdwzbMwz3UZtYa0VF6qTS03aNmvHIQ3IqXfPqP6g2ahw3YPu/yazX0926pVdsz5uGWyL0Tc7

[2] December 28, 2016 Letter and Presentation to the Board of Directors of EQT Corp.

Catalyst

Surge in 2018 cash flow even in a low gas price environment.