Neal Dingmann: The Play's the Thing
Interview

The Energy Report: Neal, last week Chevron Corporation (NYSE:CVX) offered US$3.2 billion in cash and shares for Atlas Energy, Inc. (NASDAQ:ATLS) and agreed to assume Atlas' debt. Thus, for about US$4.2 billion Chevron gets a significant foothold in the Marcellus Shale, where most of Atlas' trillion cubic feet (tcf) of natural gas reserves are located. What messages does that deal send?

Neal Dingmann: I think there are probably two messages. First, it's pretty clear that a deal like this shows that the majors, in this case Chevron, have a long-term positive view on natural gas. Obviously, there's a lot of near-term cautiousness to outright bearishness on natural gas in the market right now. However, I don't know if you want to call it an extreme bullish view; but, clearly, Chevron is at least somewhat bullish to pay this kind of number for these assets. Secondly, I think it says that Chevron believes in the newer type of technology that will bring gas out of these shale plays. They're telling us that gas prices should be sufficient as long as the technology will work to deliver that gas.

TER: Isn't it also about companies taking the view that mergers are a better way to develop these assets than financing by diluting equity or taking out loans? For example, we've seen Exxon Mobil Corp. (NYSE:XOM) take out XTO Energy Inc. This is a similar but much smaller-scale merger.

ND: This is Chevron, along with the other large companies, telling us that in order for it to keep its recent growth profiles, it's running out of other options. Would the company rather go with some sort of domestic oil play if it could? I think absolutely. Offshore drilling is very difficult; international is becoming even more difficult. So, choices are becoming fewer and farther between.

You also have to look at the seller side of the equation. Two to three years ago, conventional wells were relatively cheap. The plays in these unconventional shale wells are still very expensive. You need good-sized capital or a bankroll to develop them. It might make sense to have economy of scale here.

TER: Did the Chevron merger catch you off guard?

ND: Not really. I think last year's Exxon/XTO deal is the one I think caught everybody off guard because gas prices were still heading down. The Chevron merger was, I believe, 10 times the size. But ever since the Exxon/XTO merger happened, I would say probably nothing is going to catch us completely off guard.

TER: In the June interview you did with Bloomberg, you said that onshore producers would outperform offshore producers for months after BP's Macondo accident. Time has passed. Is there still a performance gap?

ND: There hasn't been as much of a performance gap as expected. In the case of Energy XXI (NASDAQ:EXXI) and some other offshore stocks, the market initially hit the stocks rather hard. However, up to the moratorium being lifted, you saw a nice rebound. Then, when there was talk about issuing permits and some offshore companies actually received permits, you saw an even larger rebound.

What still makes me a bit cautious is that we haven't yet heard much from the government about the final rules and regulations about infrastructure, procurement or even about the well-liability cap. So, I'm still relatively cautious on the offshore group versus the onshore.

TER: What estimates are the regulators talking about for the liability cap?

ND: I've heard everything from a billion on up to several billion to unlimited liability. The problem with those types of numbers is that they would essentially put some of the smaller independents out of business. As someone at one small, independent public company said, 'With that kind of liability you would have to self-insure.' You're essentially putting your company at risk for each well you drill. You just couldn't afford to do that. Well-cap liability is going to be a big issue when Congress returns.

TER: Could we see some mergers on that side?

ND: I think most definitely. Having a Republican House, you might think things won't get worse. If I had to bet, I wouldn't think the well-cap liability would get too onerous. But if it did, I think it could force some acquisitions.

TER: Sticking with offshore producers, are there some you think are poised to rebound in 2011?

ND: There are a couple. Obviously, Energy XXI comes to a lot of people's minds. What makes that one interesting is its nice oil base production of around 28,000 barrels per day (bpd). It also has a pretty nice working interest—call it between 15% to 20% interest—of some McMoRan Exploration Co. (NYSE:MMR) wells, the Davy Jones and Blackbeard prospects. They are shallow water but very deep gas wells that have big potential. In addition to those big prospects, Energy XXI has some great baseline support and the kind of diversification one looks for.

Another one that's been on a run and looks interesting is W&T Offshore Inc. (NYSE:WTI). It just bought a big deepwater piece from Royal Dutch Shell Plc (NYSE:RDS.A). I believe it was for about US$450 million. Founder and CEO Tracy Krohn generally seems to develop newly acquired properties very well. The first year or so after he acquires a property, we've, historically, seen a pretty good ramp-up. This could be the case with these new properties.

TER: Looking through some of your recent research, you have quite a number of companies with buy ratings. Since the research was published, some have exceeded your targets. Let's go through some of those companies, starting with TransAtlantic Petroleum Ltd. (TSX:TNP, NYSE:TAT). It's trading at about US$3.45. You had a target of $5. What supports that?

ND: This is a company with extremely good management. It's managed by Malone Mitchell, who previously operated Riata Energy. He has several million acres in Turkey, but the real key is that he runs all his own service equipment. The company is now producing about 2,500 bpd. Next year, the potential is there to exit more than 15,000 bpd and two years later, to exit more than 25,000 bpd. TransAtlantic could see production ramp-up tenfold within a couple of years for two reasons: 1) He has the acreage to support it; and 2) He's got all the oil field services to make sure that is done correctly—that the wells are drilled properly. I like that combination.

TER: At a slightly higher price, Venoco, Inc. (NYSE:VQ) is trading at $17. Your prior price target was US$25. Why the revision?

ND: Venoco's pretty interesting. In a sense, you are really betting on its core gas position in the Sacramento Basin. It provides nice baseline cash flow because it's gas and is well hedged for the next couple of years. One would say, 'well that's not very exciting.' But the really attractive upside is Venoco's Monterey Shale play. Venoco has a couple of thousand acres there, and it's just Venoco and Occidental Petroleum Corp. (NYSE:OXY) in this play.

This Monterey Shale is a very interesting oil play on the coast of California. Estimates say there could be more than 100 million barrels in place, though the estimates could be extremely high. This play is almost like an offshore. You have a lot of upside, but you've got a lot of risk because we just don't know about the timing. The company's only going to drill four or five horizontal Monterey Shale wells this year and probably 15–20 next year; so, you're not going to see a ton of results. But as those results unfold, I think you're going to have a lot of people very excited.

TER: Northern Oil & Gas Inc. (NYSE:NOG) has already exceeded your prior target of US$20. Is there room for more, or do you have a hold on it now?

ND: I need to revisit this one, following its last conference call. In the past, I was hesitant to put a buy rating on it and I've become very positive about a non-operated strategy. But Northern has done a very good job. It kept costs down to a fraction of what the operators pay, and it has great relationships out in the Bakken. Then to cap all that off, last quarter the company's guidance was that it would ramp-up somewhere around 30%–35% on a sequential, quarterly growth basis. It actually increased by about 40%. I'm not necessarily going to automatically bump it up, but I can tell you it's sure hard to bet against these guys given their reports the last few quarters.

TER: So, you're not willing to speculate on what your revised target might be?

ND: No. I haven't had a chance to catch up with management. The part that makes me a little bit nervous is that winter is coming. Up in the Bakken, you have a little bit of an activity slowdown in the winter. But I'm still telling clients to look at the stock, and if they are going to buy to buy it on a full 2011 calendar year. Everything that I'm seeing still checks out quite positively.

TER: When you value these companies, you do a multiple of cash flow, correct?

ND: Generally, yes. For companies that are on a go-forward basis, I'll run a cash flow. With newer or brand-new companies that have little to no cash flow or don't have enough of a cash-flow history, I'll try to come up with a net asset value. I might not know how much cash flow it's going to kick off or what it might have to do behind the scenes in terms of seismic or exploration—things that are not going to boost cash flow overnight. But clearly a company's assets—that being its acreage, reserves and equipment it holds—any of that must have a value. So, a lot of times I'll look at assets.

TER: But how do you determine that multiple?

ND: I like to use a relative basis. Does Company A deserve a 20% or 30% premium to Company B if it operates in various regions? I'll break companies out by whether they are offshore or onshore. If they're onshore, where are they? Are they in Marcellus or Eagle Ford? What groups are trading at that level today? I also look from a historical basis. I think the answer is in the combination of the relative and historical. You might have a stock that deserves a premium to its peers because it's growing production 40% a year, while its peers are at 10%. But comparing it on a historical basis helps make sure it's not too far out of line regarding what's it's historically traded at.

TER: Would you be willing to rank the shale plays right now? Maybe the top-five shale plays in terms of their premiums.

ND: Clearly, you can't get any better than the Bakken. The returns are there. Everything is there. That's going to be your number-one choice. I think that with the natural gas liquids (NGLs) it has, the Eagle Ford has to be, not a close number two, but still strong nonetheless. The number three and four positions are going to be interesting because they're a little bit newer, still unfolding. I would say it would be either the Marcellus or the Niobrara. Niobrara is likely going to be much oilier and have much more liquids. But in terms of pure acreage, the pure size of the Marcellus makes it one you can't get away from. The Marcellus may be a little different because there could be dry gas. So, those two plays would be three and four.

At number five, I would put the Haynesville Shale. Haynesville is still a very good play. I would call it sort of a lower economic play because we know it's mostly going to be dry gas. The difference with the Bakken, Eagle Ford and Niobrara is that they are going to be oil or liquid, both of which clearly demand a very nice premium right now.

TER: I also want to ask you about Clayton Williams Energy Inc. (NASDAQ:CWEI). This company has the biggest market cap by far. It's trading at around US$73.07 and you had a target of US$85 on it. What's your read there?

ND: To me, Clayton is a very simple company; it's just blocking and tackling. Historically, Clayton was in the penalty box because it had a number of dry holes. That's changed in the last couple of years. It's been doing what I call 'just singles and doubles'—mostly just premium drilling and Austin Chalk drilling. These types of things have no exploration risk, in my mind.

If you look at where the stock is trading right now and go back to my old adage about a pure multiple, the stock would actually be closer to a US$80 target. The discount is there because Clayton Williams and his family own more than 60% of the shares and the stock is pretty illiquid. Without the illiquidity, I would clearly say the stock is worth more than US$85.

TER: What other companies are you following?

ND: One that I think is noteworthy is Gran Tierra Energy Inc. (NYSE:GTE; TSX:GTE). It has done a tremendous job of growing the company with virtually no debt. Right now, the company has well over US$3 million in cash and no debt. That's remarkable for a company of that size. But what's interesting is the company's core asset base, called Costayaco. Costayaco is generating +15,000 bpd. On top of that, the company's talked about two or three potential new discoveries. One is called the Moqueta, which is a new play wherein it's drilling the fourth well. Gran Tierra's also got the Taruka-1. The point is that besides the cash, lack of debt and stable base assets, Gran Tierra has some very exciting exploratory projects, which really give the stock some upside.

TER: Do you have some parting thoughts on what's going on in the oil and gas sector?

ND: Obviously, the premium of oil versus gas sticks out. The dichotomy is there when you look at oil versus gas stocks. You have oil at US$82 and gas is at US$4; that is a 42:1 multiple. That has to balance out a little. I don't mean to insinuate that we need to go back to a 6:1 multiple, but maybe we can go back to at least 15:1. Until that happens, the big premium is going to be on oil and the liquids. Albeit, you might have some periodic valuations when you have deals like the Chevron deal. Overall, as we see the next few months play out, the oil and the natural gas liquids companies will clearly get the premium value.

TER: Thank you for your time and your insights, Neal.

Neal Dingmann has more than 12 years of equity research experience, most recently at Wunderlich Securities where he covered over 30 companies in the exploration and production and oilfield services sectors. He previously held similar positions at Dahlman Rose, Pritchard Capital, RBC Capital Markets, and Banc of America Securities, where he worked on the number one-ranked Oilfield Services research team.

Neal was recognized last year by The Wall Street Journal as "Best on the Street," and as a "Home Run Hitter" by Institutional Investor magazine. He is a frequent guest on Bloomberg TV and has a large network of industry contacts. He received his Masters in business administration from the University of Minnesota and his Bachelor of Arts degree in business from the University of Arkansas.

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DISCLOSURE:
1) Brian Sylvester of The Energy Report conducted this interview. He personally and/or his family own shares of the following companies mentioned in this interview: None.
2) The following companies mentioned in the interview are sponsors of The Energy Report: Atlas, Energy XXI, Shell and TransAtlantic.
3) Neal Dingmann: I personally and/or my family own shares of the following companies mentioned in this interview: None. I personally and/or my family am paid by the following companies mentioned in this interview: None.