Description

RRC

At near its 5-year low, RRC is a long.  Not only is RRC the lowest cost producer, but also has the highest proved-developed reserve life among its peers.  Given the turbulence in the oil and gas market, siding with the lowest cost producer seems sensible.

At a macro level, even at current prices, gas has better prospects than oil:

• On an energy-equivalent basis oil is more than two times more expensive than gas

• Unlike oil, it is virtually impossible for imported gas to compete

• Demand for US gas has much better prospects

• Growing local gas consumption (e.g. coal substitution)

• High-potential gas exports: Mexico + LNG

Expected incremental natural gas demand

Source: Simmons & Company

Among US gas producers, with very limited exceptions, the low cost producers are in the Appalachian Basin.  Not only do these producers have low capital and operating costs but also remarkably low administrative costs, in general.  Further, producers in this basin will benefit in the not-too-distant future from substantial takeaway capacity.  This will further strengthen their competitive position.

In particular, RRC will benefit, to some extent, from access to higher price markets beginning in 3q15.  The initial overall effect is relatively modest.  I estimate it could benefit differentials by up to $0.10/Mcfe.  However, going forward there are several infrastructure projects starting in 2016 and 2017 that would further benefit net pricing.  (See RRC 2q15 presentation)

Naturally, the question is: would all this incremental takeaway capacity provide Appalachia producers lower differentials or will it depress HH pricing?  My take is a little bit of both.  However, it is worth repeating that demand prospects are healthy.  Thus, it is not unreasonable to expect higher HH pricing with the advent of material increases in demand starting in 2016.

RRC is clearly among the lowest cost producers.  Like all their peers, RRC has dramatically increased productivity.  Given the amount of excess capacity among service providers, it is not too far fetched to imagine further increases in productivity going forward.  As a testament to the quality of their acreage and their operations, RRC currently is the lowest cost producer in the Marcellus:

Longest proved-developed reserves life among its peers.  RRC has almost 11 years of proved developed and another 10 years of PUD reserves (at 2015 production rate):

Proved reserve life (years)

* F&D + production + diff + taxes

Modest capex going forward.  As of 6/30/2015 RRC has spent $725m out of its $870m capex program for 2015.  At current pricing, cash flow generation for 2h15 should be neutral to slightly positive -a rarity in the industry.

Management incentives aligned with equity

Management compensation 80% equity -no re-pricing, SARs, change-in-control incentives.  (In my cash flow projections, I use the sum of cash and non-cash g+a.)  Management seems clearly motivated to create equity value.  On the negative side, 30% of their bonus target is tied to f&d costs.  While this seems sensible, the target parameters are too low.  I don’t know if this is distasteful sandbagging, or the compensation committee (and their consultants) are utterly incompetent.

Attractive acquisition candidate.  With such a relatively undemanding valuation, RRC would be highly accretive to very much any E&P company; especially those with synergy opportunities.  Absent a huge rebound in oil price, a wave of consolidation is likely.  Under this scenario, and given the macro fundamentals, cash flow positive gas names should be quite attractive.

Staying power

There are not a lot of names in E&P that have staying power under current pricing conditions.  RRC is one of the few with staying power.  It is cash flow positive.  And has been able to access capital markets under very favorable terms despite gas trading under $3.  Recently, it was able to place $750 million of 10-year paper at sub 5%.

Liquidity

$2b (1.5%) revolver due 2019; $1.14b available.

$240m cash

$864m 1.5% Revolver

$750m 4.875% Sr Notes due 2025.

$500m Sr. Sub Notes 5.75% due 2021

$600m Sr. Sub Notes 5.0% due 2022

$750m 5.0%  due 2023

Total debt $3464m

Annual interest $149m, including commitment fee ($0.29/Mcf).

No cash income taxes.

Net debt/Mcf $6.3

Revolver available/Mcf $2.2

Cash generation

Cash generation per Mcf

It is important to highlight that the above do not take into consideration several items that would increase FCF:

1. Differentials should improve starting in 3q15

2. Cash g+a is probably lower

3. Production costs and capex are on a downward trend, and are likely to be lower in 2016

Risks

Clearly, investing in E&P is not without risk.  First and foremost, there is commodity risk.  My view is gas is unlikely to go much lower.  But what do I know.  There are some mitigating factors.  As I mentioned, fundamentals seem to be on its side.  Natural gas prices have remained relatively stable while oil prices have collapsed from around to $60 to $40 over the last two months.  And most importantly, this risk can be hedged to a large extent by shorting a disadvantaged gas producer.

The debt load is heavy; although I hope I was able to show it is manageable.  I believe RRC will be able to more than manage its debt as long as: a) they are judicious with their cash, b) new takeaway capacity comes on line within a reasonable time frame, and c) continue to improve their productivity.

Another mitigant to the risk here is bankruptcy of one or more substantial producers.  This could have several potential benefits.  First, it would curtail production.  But perhaps more importantly, it could improve terms on takeaway capacity.  This could have a very significant effect on cash flow generation; and equity value...

Summary

In summary, RRC makes sense as a long in light of:

• Solid gas macro fundamentals

• Low cost producer in low cost basin

• Improving differentials (and productivity)

• Cash flow positive

• Substantial liquidity

• Management incentives to create equity value

Did I mention RRC was up today, while the markets tanked 3%+ (including some Appalachian names, let alone oil producers)

Catalyst

Improvement to differentials in 3q15

Positive/neutral cash flow 2h15

2016 guidance