Neal Dingmann: Oil Explorers and Producers Hedge for Profit
Interview

The Energy Report: Why have so many oil exploration and production (E&P) companies failed to lock in prices for next year?

Neal Dingmann: I think that answer boils down to the size of the companies. A lot of the smaller companies have waited, hoping prices will rise and buoy their economics before they hedge. They are just trying to maximize their returns by locking in at the best prices possible, given many do not have easy access to outside capital.

Some of the larger E&Ps with readily available cash and better access to financial markets don't necessarily have to hedge. That means they don't have too much to fear about having to lock-in the majority of their production.

TER: So, you believe it's the smaller E&P companies that should be hedged for 2012?

ND: Yes. Companies know investors want to hear that they are going to spend within their cash flows. Companies need to have more certainty over those cash flows so that they will have a better idea of what they will be able to spend next year. The easiest way to lock this in is to hedge a fair amount of production.

TER: What are some examples of companies that should be hedged?

ND: Certain companies, like Clayton Williams Energy Inc. (CWEI:NASDAQ) or Range Resources Corp. (RRC:NYSE), hold a fair amount of leases. In order to keep these leases, they are going to have to spend a certain amount in order to drill. It would be beneficial to have a little more hedged.

TER: You must be forecasting lower energy prices for next year.

ND: We are. For 2012, we are forecasting just under $81 per barrel for West Texas Intermediate oil and $4.24 per thousand cubic feet (mcf) for natural gas for the four-quarter average.

TER: When we spoke back in March you said you thought gas was going to come back sooner than people think. Do you still feel that way?

ND: I do. I don't want to say I'm outright positive quite yet on natural gas. One thing that is very interesting to me is that one of the exporters, Cheniere Energy Inc. (LNG:NYSE.A) signed a very long-term liquefied natural gas exporting contract with BG Group Plc (BRGYY:OTCQX; BG:LSE). This is the first rather large one we have seen, and so I wonder if this is going to become a trend.

Also, right now there is a lot of pending legislation around coal emissions. If passed, the operators are going to have to cut some of their production or buy emission credits, which means that more gas production would likely take its place as it would become cheaper in comparison. So, between coal emission laws and more natural gas liquefied exports, I think you could really have the beginning of a natural gas rebound.

TER: What are your favorite companies currently?

ND: Two companies stick out, not necessarily because of their cash flows but because of the optionality they possess. One is SandRidge Energy Inc. (SD:NYSE) on the medium cap side. And, on the smaller cap side would be Magnum Hunter Resources Corp. (MHR:NYSE.A). Both have pretty substantial hedges of somewhere around 50% for next year. But, more importantly, their operational flexibility is quite high, meaning they could do some asset sales. They could drop down some assets into Master Limited Partnerships (MLPs) or form a royalty trust. There are a number of things these two companies could do, other than cash flow, to fund their capital budget for next year. So, these are really two of my favorites.

TER: SandRidge has had much higher relative strength than Magnum Hunter. Why has it held up so well under less than ideal conditions for these companies in general?

ND: Good question. I think it goes back to the size of Magnum versus SandRidge Energy, which is a little bit larger. Investors want to be shown a clear path to available cash. Until a small cap company can do that, investors are a bit cautious. So, I believe that Magnum is starting to do that a bit better. Once it has the full path laid out, I think the returns will follow.

TER: SandRidge is six times the size of Magnum Hunter in market cap. I guess you would call SandRidge a mid cap at this point.

ND: Absolutely.

TER: SandRidge is down 5% versus Magnum Hunter which is down 41% over the past three months. Could that mean that Magnum Hunter is a value?

ND: Looking at both Magnum Hunter and SandRidge on an asset basis or a potential cash flow basis for next year, I would call either one of those a value.

TER: What other companies do you like?

ND: A very interesting company on a larger scale is EQT Corp. (EQT:NYSE). It is primarily a Marcellus play. What is very interesting about it is that its midstream is probably one of the largest, if not the largest, for an upstream company. Much like Magnum, it has an enormous amount of optionality next year on deciding what it wants to do with these midstream assets, which I think could turn in a nice monetization for investors.

TER: What about some others?

ND: I am looking for economic, hot plays. One small-cap company that fits that fits the description would be Rex Energy Corp. (REXX:NASDAQ). Rex is very interesting because it is focusing primarily on the Marcellus region, which we know is one of the more economical regions because of all the liquids associated with that gas. It has potential for at least 11,000 more acres in the new hot Utica area, which obviously could be very economic for investors depending on how quickly it drills.

TER: Rex has been one of the strongest stocks in your universe over the past year. It is even up over the past 12 weeks. It has kept its head above water for a year.

ND: It has. When you look at its hedges for 2011 and 2012, Rex is nearly 70% hedged on oil and over 50% hedged on natural gas. So, for a small cap it is one of the most hedged out there—and hedged at very economical prices. It continues to spend within its cash flow. So, I would call Rex one of the more financially-responsible small cap companies as well.

Another one would be Rosetta Resources Inc. (ROSE:NASDAQ). It's interesting because its core operations are in the Eagle Ford, around San Antonio, Texas. Because of the associated liquids, this is quite an economical play. The company also has a very solid upside exploration potential and over 300,000 acres in the Alberta Bakken. It's very early in this play, but it's nice to have that exploration potential.

TER: What do you like outside of North and South America, Neal?

ND: There are two that I think are extremely interesting: One clearly has gotten hit a bit more, and that first one is TransAtlantic Petroleum Ltd. (TNP:TSX; TAT:NYSE). The stock clearly has been under a bit of pressure. Production growth has not increased as quickly as management or investors would have liked. But, clearly, by having millions of acres in Turkey, TransAtlantic has huge production upside. Secondly, the company owns nearly all its oilfield services. It has announced that it will likely monetize or sell off these oilfield services, and I think that could raise easily upward of $100 million (M). TransAtlantic is very interesting because you have a small company with a market cap of less than $300M, and I believe its oilfield services alone are worth over $100M. Its upstream is getting very little credit.

TER: Does that translate into what one might call a value play, especially considering the fact that its oil would be priced off of Brent Crude?

ND: Absolutely. Its natural gas is priced mostly against the Russian market, where prices are closer to $6/mcf, or in most cases $7/mcf, versus the $3.50–4/mcf we often see in the U.S. Clearly, realized commodity prices should be much higher than for most domestic companies.

TER: If TransAtlantic begins to divest drilling services operations, will that money be used to further E&P?

ND: It will. The company has a little bit of debt, and it will initially pay down some of that, but it will clearly have a revolver and some things that it can tap. What it wants to do is basically take the oil services money and have that available for more upstream opportunities.

TER: Would that be a potential catalyst?

ND: Absolutely. Also, there are two major oil plays in southeast Turkey. I think there is some big well potential down there. Up in the northwest part of Turkey, the Thrace Basin play is much more gas-focused. So, I think the combination of some of these larger potential oil wells in the southeast coupled with some of these natural gas wells in the northwest really gives an investor some interesting potential.

TER: Anything else outside of North and South America?

ND: You know, there is one other very interesting play that has one of the more conservatively managed foreign operations companies, and that one is Gran Tierra Energy Inc. (GTE:NYSE; GTE:TSX). What is interesting about Gran Tierra is that unlike most other E&Ps, this company has absolutely no debt and approximately $300M in cash. It has a very solid capex budget and the financials to continue to grow this.

TER: I want to go back for a minute and ask you about the hot areas that have so much exploration activity, particularly in the Marcellus. What about Endeavour International (END:NYSE.A)?

ND: I think Endeavour is a very interesting company, partly because of CEO Bill (William L.) Transier. He was at Ocean Energy (acquired by Devon Energy Corp. (NYSE:DVN)) as CFO years back. So, there is what I call very seasoned management. And, what is interesting is that the majority of Endeavor's production is coming from the North Sea. As you pointed out on other companies, it is getting Brent prices on that. So, as that production starts to ramp up, it has a large play called the Bacchus that is going to come on very late this year and will not only add production but will add very economical production, given that it's priced around Brent.

Endeavour also has Rochelle, another large North Sea play likely to come online at some point next year. So, you have this very economic North Sea play and then you couple that with what it has going on here in the States. And, most recently Endeavor bought a fairly large field in the Marcellus, which obviously has some interesting potential. The company hasn't drilled a whole lot there, but as it starts drilling that play, the combination of the North Sea with a play like the Marcellus can make for some interesting results.

TER: Does Endeavour have access to capital?

ND: It does. When the company did one of its major acquisitions in the Marcellus, it did a financing to pay for that. So, unlike other E&Ps that are over-levered or have to tap credit facility to grow production, this company is pretty set given that it did a financing around the Marcellus acquisition.

TER: What about Gastar Exploration Ltd. (GST:NYSE)?

ND: Gastar is an interesting one, another small cap with very solid potential. It is a company that has basically reinvented itself. Previously it had some Australian acreage. It got rid of that. It was focusing on areas in the U.S., mostly the Bossier play. Now the company's main focus is in the Marcellus. What is so unique about Gastar is that it was able to find a Korean partner who is paying most of the drilling costs in the Marcellus. So, unlike other small cap E&Ps that have large capital budgets this year, Gastar so far has been able to use someone else's money to drill those wells.

TER: Will we be hearing anything soon from its Eagle Ford/Woodbine play?

ND: Gastar has some interesting potential there. Late this year or early next year we could definitely hear something out of that area.

TER: Any company that has stock is for sale. Are there any of these companies that could be consolidation targets?

ND: I think so. If you look at the billion dollar-plus transactions this year, there are probably more than a half dozen. BHP Billiton Ltd. (BHP:NYSE; BHPLF:OTCPK) bought Petrohawk Energy for $12.1 billion (B) in July. Noble Energy Inc. (NBL:NYSE) recently did a deal for 50% of CONSOL Energy Inc.'s (CNX:NYSE) Marcellus play for $3.3B in October. So, what you are looking for in potential for consolidation is a company that has a large contiguous block. A couple of my companies that clearly have that would be EQT Corp. and Range Resources Corp. Both companies have very large contiguous blocks in the Marcellus, which I think would be very, very attractive to not only some of the majors here in the U.S., but potentially to a lot of foreign buyers also.

TER: Range Resources is a company that has relative strength. Over the past year, it is up almost 100%. Even over the past 12 weeks it is up 8%. Have there been murmurs about M&A activity?

ND: There have clearly been a number of whispers that different large companies have been looking at Range. That has helped hold the stock up. In addition to being very good operators, some of these rumors have been clearly helping the stock, especially given that the stock is about 74% natural gas-focused.

TER: It is an $11B market cap company. Does that make M&A more difficult or less difficult?

ND: You know a lot of foreign companies and majors have cash on hand, and want economies of scale. Especially if a foreign company is going to purchase the assets, it wants something that is of size to make that purchase economic and material. So, I think it kind of puts Range Resources right in that sweet spot. It is not terribly big, but clearly big enough to make it material enough for somebody to buy.

TER: I thank you very much for the time. It's been a pleasure.

ND: Thanks, very nice to talk to you.

Managing Director for Energy Research Neal Dingmann has more than 13 years of equity research experience, most recently at SunTrust Robinson Humphrey where he follows companies in the exploration and production and oilfield services sectors. He previously held similar positions at Wunderlich Securities, Dahlman Rose, Pritchard Capital, RBC Capital Markets and Banc of America Securities, where he worked on the number one-ranked Oilfield Services research team. In 2010 Dingmann was recognized 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. Dingmann received his Master of 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) George Mack 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: TransAtlantic Petroleum and Endeavour International.
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.