Description

Antero Resources is an idea that has been discussed quite thoroughly recently on VIC, we will not rehash the business model or prior thesis, but what the current bet looks like. Energy in the past six months has been an absolute trainwreck with performance across the space in some cases coming in worse than early 2016. To give an example of the carnage, from Oct. 5th till Christmas Eve the oil services ETF (OIH) was down almost 47% in less than three months, and the larger cap XLE down 31%. Given that backdrop we think Antero’s stock has become even more dislocated than the indexes due to idiosyncratic factors not fundamental to the business. For instance, Warburg Pincus the initial sponsor started selling aggressively right around a 15-year vintage, commodity fund Sailingstone (former activist) sold ~ 7.5mn shares, and sovereign wealth fund Temasek also parted ways with over 4.2mn shares in the quarter. Antero is down almost 60% from its early July 2018 peak, while most upstream stocks have similar looking charts, most of the value to AR is currently attributed to Antero Midstream (AM; 53% ownership), a much more stable midstream business, on top of this Antero has a large natural gas hedge book, fully hedged in 2019. So while seeing levered SMID cap E&Ps dropping 50-70%+ makes sense, we don’t think Antero’s business and capital structure risk is remotely similar to the peer average. With that in mind, if one has the view that the five year strip in both natural gas and oil is too low, Antero should do well (multi-bagger potential) in either uplift scenario.

Exposure to Natural Gas as well as WTI

Antero has unique optionality between natural gas and oil (NGL as a % of WTI) pricing. Antero benefits quite significantly if the long-term natural gas strip elevates, currently averaging ~ $2.72/mmbtu five years out, Antero has fully hedged out 2019 and over 55% of 2020 is hedged. Antero is currently producing slightly over 3 bcf/d equivalent, with firm transport (FT( commitments of 4.7 bcf/d. As this incremental 1.7 bcf/d fills in it helps Antero expand overall margins, under the 15% CAGR scenario management presents the FT is filled by 2022, and under the low growth 10% CAGR scenario it is approximately 70% filled in by 2022. The FT portfolio has been a concern over the past few years and one we think one that is manageable given the lower leverage profile.

With regards to oil, Antero benefits mainly from NGL pricing (~29% of production) and a small mix of oil production. Antero is also receiving an uplift from the Mariner East 2 (ME2) pipeline completion and just started shipping NGLs on the pipe in Feb. ME2 gives Antero access to the export market out of Marcus Hook, Antero currently has 50,000 barrels per day of propane and butane. Additionally Antero has expansion rights on another 50,000 barrels (C3/C4) per day when ME2 starts running at full capacity in Q3 2019. On ME2 they are receiving an uplift of approximately $2-$4 per barrel from the new pipeline, thereby increasing the percentage of WTI to around 60%+. This is likely to become even more beneficial as in-basin NGL supply is pulled out of Appalachia and overall supply comes down. Not only should ME2 benefit from in-basin pricing, but it should firm up relative to pricing at Mont Belvieu as more NGLs are exported out of Marcus Hook and less supply transported south. Management gave guidance on the most recent call that every $5 of C3+ NGL pricing equates to an additional $180mn in cash flow based on C3+ midpoint 2019 production of 100,000 barrels per day.

Given how commodities prices have come down, both WTI and natural gas (spot), we think Antero is roughly around breakeven or slightly positive on a FCF basis at these levels now that WTI has just inched above $56.

Antero Profile:

Market Cap: $2.88bn

EV: $6.7bn inclusive of $2.4bn in AM.

Consolidated leverage w/ midstream: 2.7x

Stand-alone leverage: 2.2x  

2019 production guidance: 3.15-3.25 Bcfe/d

Proved reserves: 18.0 Tcfe

Net Acres: 612,000

Core drilling locations: 3,013

Liquids: ~29%

• At least $300 million in expected cash proceeds related to the midstream simplification, which is expected to close in the first quarter of 2019 (cash amount may be increased depending on the cash election of AM public unitholders)

• Expected free cash flow generated during 4Q 2018 through 1Q 2020

• The first $125 million tranche of Antero Midstream water earn-out payments expected in early 2020

• $471mn outstanding on the buyback program.

“Hidden Value”

Antero Resources stand alone net leverage comes down to 2.2x if you make proper adjustments, and screens on a consolidated basis at 2.7x as pointed out by management on the most recent call. While most investors should pick up on this, the other benefit of the simplification transaction is it streamlines the structure and enables greater transparency for potential investors and clarifies some of the conflicts of interest with AMGP.

Antero currently owns 53% of Antero Midstream Partners LP, currently worth approximately $2.624bn or ~ 91.1% of Antero Resources Corp market capitalization. Or said another way, investors give very little credit to Antero’s core contiguous acreage in the most prolific liquids rich area within North America. Antero has a PV-10 on proved reserves of $12.6bn (up 24% y/y), and proved developed reserves of $8.4bn. Investors are currently placing a negative value on the proved undeveloped reserves. Investors also give little credit for the uplift from the new Mariner East 2 pipeline which just became effective on 12/29/2018 (February first month for Antero), meaning most of the incremental uplift will be booked in second half of Q1 ‘19, and fully booked in Q2 2019. Furthermore, in the AR simplification transaction proposed, AR would receive a minimum of $300mn cash to fund additional share repurchases or debt reduction-- AR will also have direct ownership of 31% of the new AM entity and continue to be the largest holder.

High Yield Credit: Forcing Discipline.

From early December to roughly mid-January the high yield bond market had 40 days without one new issuance. Given that energy has significant exposure to the high yield credit market, we think that this could be one of the limiting factors that forces more capital discipline within the industry. This has likely hampered investments in D&C, pipelines, and other Capex related investments to drive continued production growth in oil and gas.

We believe the combination of tighter credit markets along with weak pricing has been forcing Appalachian peers (as well as oil E&Ps) to exhibit restraint on the recent exponential growth. An example of this is the backlog of uncompleted wells has risen 35% y/y (per Bloomberg), while the number of frac crews has declined, suggesting a retreat in aggregate completions.

Natural Gas Timing Window

Antero recently released a Natural Gas Fundamentals slide deck, an unusual change in narrative for management given the historically negative view on dry gas pricing and corresponding hedge book.

We think there is a decent window where the outer year gas strip is likely to get bid up if oil prices don’t materially improve this summer. Demand is coming in aggressively from LNG export projects finishing up, and likely presents a 1-2 year window where you could see some significant dislocations in the market-- nat gas storage is already running 15% below the 5-year average. Even though the markets are significantly under supplied at the moment, the complacency of this market is notable, given the strip stayed depressed through a substantial winter spike in the spot market.

Antero management gives a few reasons why they believe the futures strip could be “oversold”.

1. “Waves of gas hedges put in place by wind project developers.”

2. “Significant gas hedges put in place by merchant power developers”

3. “Large gas hedges have been put on for gas asset acquisitions”

4. “Reduced number of financial counterparties to execute hedge transactions”

As we discussed in the earlier section with respect to credit, if credit became extremely tight again we think that could create an interesting situation given shale gas has the constant need for D&C capital every year. Antero estimates annual gas base decline rates of 27% from 2019 to 2020. If there was a “funding gap” it would clearly put pressure on maintaining current production levels let alone hitting out year growth targets. In this situation we think Antero (2.2x stand-alone) should fair well given its lower relative leverage to peers such as CHK: 4.5x, RRC: 3.7x, SWN: 2.6x.

One big counter argument to a bullish stance on natural gas is the associated production from the Permian basin, which has been a significant addition to the overall gas market in the past few years. Impressive amounts of oil and thus associated gas (price agnostic) has been hitting the market from blockbuster wells. The Permian basin currently produces over 10 bcf/d of gas, with significant amounts being flared due to capacity constraints from lack of pipes. One big risk for Antero and other Appalachian peers on the gas side is if oil prices continue to rise there will likely be significant additions to associated gas. However, given the short cycle nature of crude, if crude doesn’t rally from these levels natural gas production will stay low (assuming production cuts and less associated gas), and gas prices will rise. While Permian gas production is growing significantly off a low base, by 2023 it is still only predicted to represent 13% of total U.S. dry gas production. Additionally, there is some concern that the Permian boom is overestimated longer-term as noted by a study from Wood Mackenzie, Ltd. which states that wells in some parts of the Permian’s Wolfcamp shale were losing almost 15% of output annually five years out, this compares to 5-10% initially modeled. So some of these Permian wells are potentially declining 3x as fast as initially modeled.  

"If you were expecting a well to hit the normal 6% or 8% after five years, and you start seeing a 12% decline, this becomes more of a reserves issue than an economics issue.,”-- R.T. Dukes, Woods Mackenzie.

Summary

While the FT portfolio has been an anchor on Antero operationally over the past few years we think as this gets absorbed over time and fixed cost leverage becomes more apparent. Not only this, but the new ME2 pipeline also provides a nice uplift on NGLs and one we think is underestimated by the street. Antero is really a 3-4 year story and as we witnessed in Q4 not many investors can hold on to the position given the heightened volatility. We think there is substantial value in the industry-leading liquids exposure, along with scarcity value of the contiguous acreage blocks in the most economic areas of the Appalachian basin. So the current bet is basically, either the gas strip elevates from here or the oil strip trends higher, and we think it is highly unlikely both continue to decline from these levels. Near-term there are the soft-catalysts with the simplification strategy coming in March, the ME2 uplift throughout 2019, and the possibility of $300mn+ used in some form of debt reduction and/or share buybacks.

Catalyst

ME2 pipeline and corresponding uplift pricing

Simplification strategy

Stock buyback ($300mn+) ~ March from the realization of AMGP consolidation into AM.