| 2021 | 2022 | ||||||
| Price: | 7.65 | EPS | 0 | 0 | |||
| Shares Out. (in M): | 276 | P/E | 0 | 0 | |||
| Market Cap (in $M): | 2,075 | P/FCF | 0 | 0 | |||
| Net Debt (in $M): | 2,934 | EBIT | 0 | 0 | |||
| TEV (in $M): | 0 | TEV/EBIT | 0 | 0 | |||
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Comstock Resources (CRK) is a natural gas E&P operating primarily in the Haynesville shale in North Louisiana and East Texas and, per management, is the largest producer of natural gas in that region. The hydrocarbon mix is ~98%+ gas and <2% oil making the company a pure play on gas prices. With natural gas at current prices the stock could rise by 33%. However, should gas prices in 2023 and beyond increase only to where they are already for 2022, the stock could double from here. In taking a position, I think one goes in looking for at least the 33%, while believing the likelihood of the double is material. Some multiple expansion for the group would add further upside.
Natural gas prices are rising. Dec 21, Jan 22 and Feb 22 Henry Hub gas contracts are above $5.00 per mcf. Hurrican Ida shut-ins are a contributing factor: https://seekingalpha.com/article/4453925-natural-gas-production-remains-offline-pushing-lower-storage-estimates-yet-again. However, even the Jan 2023 contract has now traded above $4.00 per mcf. That upward price movement in winter 2023 I suspect is not entirely driven by a hurricane outage in late summer of 2021. In any case, Ida does not seem to impact crude which at least suggests that existing gas tightness is a factor.
With the idea of a tight gas market in mind, I want to first focus on the state of supply and demand in natural gas (and oil) and why the emerging state of tight supply makes North American natural gas E&Ps attractive (and maybe the oil names too).
In natural gas, I also own RRC, COG and AR along with CRK. I am not arguing that CRK is the best of the group, or the worst, but it is the one I chose to model first to learn the space because I thought it was the easiest to model. Now that the group is running I thought it time to get an idea posted in a timely manner. Because I had the model, CRK is the one I discuss. If the commodity thesis is correct, then they are all likely to be going up.
The overriding reason to buy natural gas heavy E&Ps is that the bonanza of supply that the development of shale oil and gas brought may now have peaked. Drivers of this peak include, 1) the best assets may have been found, 2) that those best assets are at the cusp of production decline and 3) that E&P investors, after destroying endless amounts of capital, are finally demanding capital discipline, are getting it, and thus there is unlikely to be a wall of new supply at least in the next few years.
To argue the bull case I provide a series of links prepared by natural resource investors Goehring & Rozencwajg. Their Q2 commentary and some recent updates regarding the tightness and shortage developing in North American natural gas provide an analytical framework that argues that the current move up in prices may be sustained over the intermediate term. View through their thesis, Hurricane Ida disruptions can be viewed as problems that exacerbate an already tight market, as opposed to the root source of it. In a tight market, next year’s hurricane and the hurricane that year after that can be viewed as events that cause reoccurring price spikes.
I can’t make their case better than they can and even if I tried I would only be paraphrasing them and others while delaying posting this:
http://gorozen.com/research/commentaries/2Q2021_Commentary
http://gorozen.com/research/commentaries
Linked below is another presentation, via video, by Eric Nuthall, a portfolio manager of an energy fund in Canada. His focus is more on oil, but it still underscores the point. His video is a marketing piece for sure, but it provides a useful helping of charts and graphs showing evidence that energy markets are growing tight and, arguably, that equities in the space are cheap. https://www.ninepoint.com/alt-thinking/audio/the-fog-of-energy-ignorance/
More on this topic from a group called Bison Interests: https://bisoninterests.com/content/f/oil-demand-is-outweighing-supply-inventory-analysis
Should these bullish arguments on energy commodities come up short for you than there is no reason to read further.
Climate change activists may provide an additional support to prices as they succeed in diverting the oil majors away from their core business and towards all manner of climate preservation initiatives. This is touched on in at least some of the above links and you have undoubtedly seen the headlines yourself:
For instance, activist fund Engine One, with apparently little in the way of assets, co-opted a majority of the Exxon shareholder base to effectively neuter their own company: https://www.reuters.com/business/little-engine-no-1-beat-exxon-with-just-125-mln-sources-2021-06-29/
Engine One is now actively plotting where next to direct its oil-major weenie snipping tool. Chevron could be next. Though from the link below it sounds like the next target is a secret only Engine One knows for now. Regardless, of which company is the next victim, I’m sure they won’t stop there and I suspect they will not be the last activist that makes such attempts: https://www.cnbc.com/2021/09/03/engine-no-1-takes-climate-fight-to-other-big-oil-companies-after-underdog-win-at-exxon.html
Shell is building out the UK EV charging station network (link “a”below) as part of their “Powering Progress” strategy to be net-zero emissions by 2050. However, Shell’s 2050 plan was deemed insufficient by Dutch courts (link “b”) and it is back to the drawing boards to construct a new plan that does more and sooner.
a) https://www.theguardian.com/business/2021/sep/01/shell-on-street-ev-charge-points-2025
b) https://www.offshore-energy.biz/shell-to-appeal-historical-dutch-court-ruling-on-emissions-cuts/
One activity few E&Ps are spending on is “x-raying” the ground for new resources. I happened across the seismic data acquisition companies IO Geophysical (IO) and Dawson Geophysical (DWSN) while sifting through oil service names and was blown away to learn business at the very front end of exploration has vanished for now. IO’s revenue peaked in 2013 at $549M. Since that year, business has been in a steady decline. IO had $123M in sales in 2020 and annualizing 2021 1H revenue would put them at $68M, a drop of 88% from the peak.
I don’t think it is hyperbole to characterize Dawson’s revenue collapse as stunning. Their revenue peaked in 2015 at $234M. In 2020 it was $86M. Annualized 1H 2021 revenue would put them at $24M for the full year. However, almost all 1H 2021 revenue was in Q1. Second quarter 2020 Dawson revenue was only $193 thousand. They effectively had no business! It doesn’t sound like much business is forthcoming either. Clearly, E&Ps, both oil and gas, are focusing on moving reserves into production and not searching out new resources for now.
On the Dawson Q2 call, the one with essentially no revenue, the CEO, when he was audible through his uncontrolled sobs, noted that the large hedge books of E&Ps are tying their hands because so much of the upside from the recent rise in oil prices is hedged away. Specifically, he noted ~$7.5B in cash has been contributed to the hedging gods:
“Exploration and production companies are continuing on their path of capital discipline, focusing on shareholder returns and keeping spending levels below cash flow. Despite recent oil price improvement into the mid-70s range and natural gas prices in the upper $3 range, capital spending levels increased only slightly as many E&P companies have portions of the production hedged well below spot prices. According to IHS market, U.S. oil hedging losses during the first half of 2021 totaled approximately $7.5 billion, adding further pressure on spending plans for companies that entered into such contracts during the downturn.”
Due to a combination of covenants which require hedging and managements trying to lock in cash flow and create some level of predictability to their business as they navigate near-death experiences, they have given away much of 2021 upside and, depending on the name, large chunks of 2022.
Both oil and gas producers have hedged but my impression – and it is only an impression – is that gas skewed E&Ps have done more hedging into 2022. If that is true, and to the extent that growth activities are hindered by hedges, there is at least one to two more years of curtailed growth activities before discipline will be more of an issue of self-control rather than a need to pay down debt. For now, E&Ps are generally seeking to roughly maintain production. I know this won’t continue forever, but it is the now.
Comstock Resources has ~70% of remaining 2021 production hedged out and about ~47% hedged out through 2022. The hedging is driven by covenants on their bank credit facility and management indicates they don’t plan to hedge beyond those requirements, at least as of the Q2 call. Maybe that could change. From the CFO on the Q2 call:
“Yes, we're currently required to hedge 50% of our proved developed producing reserves at each borrowing base redetermination. So that's twice a year. So whatever the next 12 months of -- now usually, if you look at our production outlook, 100% doesn't come from proved developed producing reserves at that time. So -- and the 40% of our expected production to no more than 45%, we do need to hedge in some form, it could be in the form of a collar in order to satisfy the credit facility as the covenant currently stands. So we're at those levels for already for 2022, if we choose not to put any more hedges in at all. So obviously been a huge run-up in prices. And I think we think we're adequately hedged for next year. And so I can't tell you if we're going to add any more or not, but I don't think we'll be hedging at a real high percentage level of 2022 right now based on how we see the outlook.”
Other gas-levered names have varying, but material hedging into 2022 as well. For instance, RRC has hedged 37% of gas and 71% of oil. CHK has 54% of oil and 32% of gas hedged thus far for 2022. SWN is at 70%. COG has little in the way of hedges, but will be gaining some from XEC should the merger be completed.
RRC is less hedged, but arguably is a little less undervalued. Also, I’m not so familiar with NGLs which are part of the RRC story and felt I should avoid it for a write up for now. As noted, COG is in the midst of a merger and I decided to avoid that for now for that reason. CRK had 98% gas exposure and was the easiest to model quickly and get an understanding of one company’s dynamics and then apply it to others.
CRK does have a 59.5% owner in the form of NFL Cowboys owner Jerry Jones. Please take that into consideration. On the recent call, management pitches that as a benefit. It actually could be a benefit if Jones is a hammer on capital discipline instead of leaving it to management. At this time I don’t have an answer to that question. I can say that the industry seems to be gravitating to formalizing their capital payouts in terms of dividends, and potentially variable dividends based on cash flows. That could very well be the kind of thing a rich controlling shareholder might push for and get. If this was to occur I believe it would be perceived as a positive for the stock price.
As further background on CRK, member “abcd1234” wrote a well-timed short writeup on the name in September, 2019 and covered in May, 2020. Not too shabby timing on both the sell and cover calls.
The write up lays out the company’s pre-pandemic foibles. The current CEO, Jay Allison, has been CEO since the 1980s and thus gets full credit for shepherding the stock price from its peak of $147 in 2014 to a low of $4.00 and diluting shareholders by increasing the share count from 9.3 back in 2014 to an amazing 276m shares today. No doubt the rolling gas price depression of the past decade is a factor in the company’s woes. Yet, management contributed to the depression by drinking similar Kool-Aid as most of the rest of the industry.
The recent history of the industry and CRK, does underscore that what today’s equity holders have going for them is a favorable supply/demand backdrop, a gas price that is beginning to respond to that dynamic, and managements, though they may not be good, are at least chastised enough to exhibit discipline for at least the time it takes to right their balance sheets. A move to predictable dividends, even if variable, might also bring back a classier and more institutional shareholder base than just the average hedgie.
At Q2, CRK had $2.9B in debt consisting of $2.2b termed out to 2029 and 2030. ($1.25b at 6.75% to 2029 and $0.97b at 5.87% to 2030) They have $244m on a 7.5% 2025 note that they plan to pay off early next year and $475m on a credit facility which they intend to continue to pay down as they generate cash.The credit facility is the driver of mandatory hedges and is redetermined twice a year. Perhaps they can get beyond the mandatory hedging in 2023. In any case, next year is hedged.
The company also has a $175M in preferred equity which pays 10% and converts at $4.00. I believe Jones owns this. With the stock at $7.50 I am assuming for this writeup that the preferred is converted to 43.75m shares and have added the shares to the share count which then totals 276.6M shares.
I assume ~70% hedges for the remainder of 2021, nearly 50% hedges for 2022, and minimal for 2023. (In my model I incorporate the hedges at the granular level provided in the latest 10Q.) Hopefully as they pay down the credit facility, they can escape the need for mandatory hedging at the current levels. I assume the 2025 debt is paid off in 2022 and is deducted from cash.
I am assuming $550m in “capex” per year, roughly in line with 2021 full year guidance. I am keeping production flat. I am including $50M/yr for exploration. I used management’s updated 2021 guidance for costs, which amount to 53c cash costs per mcfe + 6c G&A. Costs are among the lowest of peers.
The company has 5.6 Tcfe of proved reserves and which is a reserve life of over 12 years at current production. I need to better understand their assets.
BASE CASE: For my full-year 2022 and 2023 estimates I am using strip natural gas pricing, which as I write is $4.00 natural gas for 2022 and $3.20 for 2023 (average of each month price) and am plugging in $62 for WTI. In 2022, I get $1.34b in ebitdax and in 2023 about $1.1B in ebitdax (ebitda less exploration). Applying a 4.5 ev/ebitdax to the lower 2023 numbers I get a ~$10.30 stock.
In all cases, I am deducting 20c per mcf from all the natural gas price assumptions in my models to account for CRK’s hub differential. This may not be optimal and may require adjustments. I searched a year and half of transcripts to try to gain insights in how to model their differential and this was the best I could do for now. I also need to learn more here.
Continuing with my base case, but moving to diluted earnings per share I get ~$1.99 in hedge adjusted eps for 2022 and $1.44 for 2023. If I apply a seven p/e multiple to earnings I get $13.93 stock price off 2022 and $10.08 off 2023. I’ll use the lower of the two, or $10, for my base case fair value on p/e.
My base case would be 33% upside to above $10+. However, 33% upside is not the reason to get into this name. One would want to buy believing that the likelihood of 2023 gas rising to 2022 prices will deliver a stock more like $14, which would be a valuation off 2022 gas.
I am a bit unsure what multiples to apply given how unstable and risky the group is now perceived, a reputation it has for good reason. I think I am being conservative, but welcome input. I do believe if the thesis that natural gas is tight and will be tight for a while becomes the consensus view then my multiples are appropriate.
In my base scenario I get net debt to ebitdax dropping below 2.0 by the end of 2022. Management claims they are looking to pay a dividend at some point when leverage drops below 2.0.
UPSIDE: My upside case maintains 2022 gas at the current average of the strip at $4.00 and moves 2023 and out-years to $3.80. I figure WTI in at $65. In this case I get $1.34B in ebitdax in 2022 and $1.46 in 2023. If I apply a 4.5 ev/ebitdax multiple I get an $18.50 stock.
I also get $2.00 in earnings in 2022 and $2.48 in earnings in 2023. If I apply 7x p/e to $2.48 I get $17.50. That’s more than a double from here. But what if the market puts an 8 p/e on that $2.48. Now the upside approaches a triple.
A couple final thoughts. One can argue that electric vehicles will rule the world in just a few short years shuttling their owners autonomously from their Point A’s to their Point B’s. At the same time wind and solar will eliminate the need for gas fueled power plants to charge their batteries. As a counterpoint to that thesis, I point you to page 6 and beyond of the linked Q3 2020 Horizon Kinetics letter. In it I believe Murray Stahl makes an excellent argument that fossil fuels, and in particular, natural gas demand, are not going anywhere any time soon: https://seekingalpha.com/article/4384132-horizon-kinetics-commentary-q3-2020.
I have seen the argument Horizon makes made elsewhere. Essentially, it is that as renewables increase in terms of their share of energy use, it is unheard of in the history of the world that the absolute usage of the previous sources of energy they displace actually decline in terms of their absolute demand. (Fossil fuels would lose share, but still maintain their current level of use.) Moreover, natural gas may be more likely to keep growing anyway per the linked report. You’ll need to decide that for yourself. It is also not a gimmie in my view that renewables can really become the our dominant energy supply without collapsing the grid. In which case, there will be demand for gas for decades. However, whatever the outcome of solar and wind over the long term is not critical to this report’s 1 to 2-year investment horizon.
However, should consensus conclude that a dramatic reduction of natural gas usage is further out in the future than perhaps is assumed today, then multiples may expand somewhat. It doesn’t take much multiple expansion to drive material upside. Ongoing blackouts and brownouts and what seem to be looming problems and electricity price hikes in Europe potentially caused by outages driven by overreliance on renewables at the expense of base capacity could help change perception. However, once again, a changed perception and higher multiples are not part of my thesis:
Lastly, having been very fortunate to be a member of vic for 18 years, I can’t recall a time when there has been so little posting and discussion of oil E&Ps and services. There is not none. There is some. Yet, it sure seems like a lot less than in the past. Their always seemed to be a quite a bit more. This coming winter’s gas is screaming above $5.00/mcf and no one seems to care. Also, I have PM friends, many of whom use to be involved in energy more than I ever was and none of them seem to be interested in the group. We’ve all been burned. Or we aren’t up on what is happening because we’ve moved on. If my thesis is correct, it means there is plenty of money that may yet jump into the pool. Of course, I could be the one who is wrong. That is a material risk.
Here are some additional RISKS:
The increase in North American natural gas prices continues beyond winter 2021-22 and is driven by a structural shift to tighter supply and capital discipline that limits growth of new supplies. Tightness in natural gas becomes more evident, becomes the consensus view which attracts more investors, and provides some upward push on multiples.
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