The Longleaf Way

[Sea Island]

South Eastern Asset Management is the largest shareholder of Chesapeake Energy as well as a large holder of Fairfax. In a recent interview with Morningstar, Stanely Cates commented on CHK and on Abbrey McClendon and addressed hisperspective on his pay package. The article makes mention of a "stamp collection" but I believe they are referring to Aubrey's map collection. The interview is linked below. In addition, I found the comments on Cemex(CX) of interest, especially as they are now trading around $8 and Cates' comments were when the stock was trading at $10. It looks as though CX has made a number of strides in cleaning up past mistakes and "right sizing" for the new normal in cement demnand. While debt is still a concern, they have no maturities until 2012 and significant free cash flow of $800M+. Does anybody have any additional insight on CX?

 

 

http://www.longleafpartners.com/pdfs/Morningstar_103492-OPP-ZCGP2_08.24.10.pdf

[Myth465]

I wouldnt beat on this horse. I think SD is a better way to play nat gas.

[T-bone1]

Sandridge is an oil company (70% oil and 30% gas) . . .

 

If you want natural gas exposure there is no better company than CHK in terms of valuation and upside exposure to the natural gas price (with a caveat that corporate governance leaves a lot to be desired).

 

If you want to buy an oil company with a good amount of low-cost natural gas upside as well as exploration potential, then buy SD

 

I am long both

[Munger_Disciple]

I would not touch CHK with a 10ft pole regardless of its upside. The CEO compensation is way over the top and in my opinion totally undeserved. If I recall correctly,  there were reports that the company bought "very" expensive art for the corporate office and bailed out the CEO from his margin calls.

[Sea Island]

According to South East Asset mgt. they view the compensation as inline with the industry. Nobody can defend the purchase of the maps from Aubrey, that was just silly, it was too much. Ultimately, executive compensation is not a greater indicator of long term value creation.

[Myth465]

Sandridge is an oil company (70% oil and 30% gas) . . .

 

If you want natural gas exposure there is no better company than CHK in terms of valuation and upside exposure to the natural gas price (with a caveat that corporate governance leaves a lot to be desired).

 

If you want to buy an oil company with a good amount of low-cost natural gas upside as well as exploration potential, then buy SD

 

I am long both

 

If gas was at $15 SD would have no problem turning into a Gas Company. They have both assets and can take advantage of either. CHK is stuck if gas sucks wind for a long time. CHK also has very shady Management. The short on VIC is a good write up and I wouldn't touch CHK when you can get gas for free at Loews (Highmount), for cheap at MCF, or with an oil kicker at SD. All of those will survive 5 years of crappy gas prices.

 

[T-bone1]

Sandridge is an oil company (70% oil and 30% gas) . . .

 

If you want natural gas exposure there is no better company than CHK in terms of valuation and upside exposure to the natural gas price (with a caveat that corporate governance leaves a lot to be desired).

 

If you want to buy an oil company with a good amount of low-cost natural gas upside as well as exploration potential, then buy SD

 

I am long both

 

If gas was at $15 SD would have no problem turning into a Gas Company. They have both assets and can take advantage of either. CHK is stuck if gas sucks wind for a long time. CHK also has very shady Management. The short on VIC is a good write up and I wouldn't touch CHK when you can get gas for free at Loews (Highmount), for cheap at MCF, or with an oil kicker at SD. All of those will survive 5 years of crappy gas prices.

 

 

Myth, SD could certainly ramp up their gas production, but after diluting shareholders by over 100% to buy oil assets, I don't think they can suddenly become a gas company any more than Exxon can, despite the fact that both companies have the ability to accelerate their gas production plans.

 

I like MCF, but it is nowhere near as cheap as CHK in my opinion. On an enterprise value basis (to adjust for CHK's debt and preferreds), MCF trades for $2.53 per Mcf of reserves and $8.44/daily Mcf of production. CHK trades at $1.67 per Mcf of reserves and $9.64/daily Mcf of production.  

 

While these numbers are similar, CHK has an un-drilled land position that is probably worth as much as their entire current market cap - as valued by major transactions by oil majors. For instance CHK's marcellus shale position is only 5% of their production and 3% of total reserves, but the land is worth $14 billion per recent industry transactions (multi-billion dollar purchases this year by Shell, Mitsui, and Reliance) . . . this is equivelent to CHK's entire market cap. They have similar positions in other shale plays.

 

If you want to say that the gas is free in Loews, I would argue that all of Chesapeake is also free if they just sold of the acreage they aren't currently producing from. MCF will continue to have low finding costs, but not as low as CHK when you take into account the drilling carries paid to them by BP, Statoil, Total, etc.).

 

CHK also has a major oil kicker in the form of huge land positions they have built in 12 oil shale plays. They bought a dominant position in the oil window of the Eagle Ford Shale this year for $1.2 billion dollars. They say that they will sell a stake (likely 20%) within 30 days at a valuation for the total acreage of $6-$7 billion. If this happens, I think it proves that they have a lot of oil, a lot of readily saleable assets that have no reserves or production associated with them, and that Aubrey McClendon produced about $5 Billion of value by being smarter and faster than the competition. I expect CHK to then repeat this with their Niobrara shale . . . if CHK cannot sell this acreage I will go buy a hat and take at least a few bites.

 

Aubrey McClendon had his captive board give him a $100 million dollar bonus (to be his only bonus for 5 years) to bail him out of a personal financial squeze caused by him buying his own stock on margin. He also sold the company his map collection for a few million. This is terrible corporate governance, but not all that much worse than any other company, particularly in the oil and gas industry. This was about $0.15 per share . . . annoying, but not the end of the world.

 

I would argue that McClendon and his captive board are an asset overall (while I certainly don't approve of the compensation practices). . . any other board might have prevented him from buying a big position in the Eagle Ford shale, which I think will contribute billions in value within a month (or at least the contribution will be proven and all the money spent recovered). I think the Niobrara will do the same thing, just as McClendon did with the Marcellus, Haynseville, Fayetteville, Barnett, and Woodford - in each play he spent more than others thought wise, then sold a small stake for a large enough price tag to recover the entire initial investment. He now has 12 oil shales to do this with. CHK management changes their mind a lot and compensates themselves very well, but I wouldn't call them very shady (greedy: yes). They all own a lot of stock, with the exeption of Aubrey McClendon who lost his $3 Billion stake to a margin call. and have built a lot of value - with the most still on the come.

 

I have read the VIC writeup, and I just don't think it adds up. Most of the value in CHK is in the land position and unproved reserves. One can argue that they aren't worth much - as the write-up does - but XOM, Mitsui, Relliance, Shell, Total, Statoil, BP, etc. are putting their money where their mouth is and valuing the acreage at about the same price Aubrey says it is worth.

 

Unlike MCF, CHK has a 10 year + drilling inventory, along with owning over 100 rigs and being almost entirely vertically integrated outside of buying drillpipe. CHK will see very little cost inflation in a rising price environment, while MCF will face competition to pay for new leases and rent rigs every year. I like MCF a lot, I just think that CHK is much cheaper and with more upside.

 

The analysts and investors almost universally hate this company. I think now is a great time to buy.

[Myth465]

T Bone those are tough points to argue, and I have learned quite a bit from you in the SD thread. My main issue with CHK is nat gas. I dont think its moving up, because of all the points you raise. With that said what makes you bullish on gas? Is it the fact that its below its production costs?

[T-bone1]

thanks Myth, but counter-arguments are always appreciated . . . i'd rather learn I'm wrong from someone on the board than from time/the market.

 

I like natural gas because:

 

1) it is trading below the cost of production

 

2) it is consumed every year for heating homes, power generation, making fertilizer, running factories etc . . . while it does have some exposure to the economy, it isn't dependant on expansion the way copper or iron ore is . . . even in a no-growth world we will consume roughly as much natural gas as we did before the reccession (same with steam coal, corn, oil). I think this makes it a much better bet despite no obvious near term catalyst . . . I would be more hesitant to invest in iron ore just because it is below the marginal cost of production.

 

3) unlike commodities like copper, iron ore, or even the oil sands, there are not large up-front capex costs . . . this means there is less barriers to exit.  Copper producers can have a $3 per pound breakeven cost (including their initial mine capex) but have a variable "cash cost" of only $1 per pound, so they will produce at $1.50 for years on end until demand causes the cost to rise to the point where investment in new capacity is justified.

 

4) it is very difficult to store natural gas. It is easy to store metals and slightly harder to store oil, but natural gas needs to be compressed in underground caverns (which only exist in north america) or liquified and kept well-below freezing. US storage capacity pretty much fills up every year and will not grow very much (maybe single digit % per year as long as gas remains volatile). Once storage capacity is filled for a year (or gets close enough to put the fear of god in producers), prices effectively go to zero (or $2 like in 2009). There is nowhere else for the gas to go, so weak players go BK (either flaring gas or shutting in wells) and the supply situation for the next year starts at a clean slate (or 10% above the 5-year average at the most, like it did this year).

 

5) the first year decline rates on multi-frac horizontal shale wells (what everyone is drilling) is about 70%. This means that a well completed today will have production 12 months from now that is 70% lower than today. I think this is very important and that not enough attention is paid to this point. These types of wells account for about 25% of current production (legacy production from old vertical wells loses about 10% per year). This means that as shale prodcution increases, it doesn't need to just make up for the decline in legacy production, but every year it gets harder and harder to replace the 50%+ loss in production in shale wells from the previous year.

 

Oversupply is obviously keeping current prices down, but here is what it percieved to keep them down for a while, and my responses:

 

1) Producers can make money at these prices and the horizontal gas rig count is at an all-time high, this will keep prices at sub-$5 forever. My response is that there are three factors at play here. The first is that many producers still have $8/mcf+ hedges that they put on in 2008 (many producers have a rolling 3 year hedging program). This gives then an incentive to keep drilling this year. The second is the need for producers to "drill-to-hold" their leases. A lot of land was leased in 2007 -2008 in the Haynseville, Fayetteville, Barnett and Marcellus shales . . . while producers might have overpaid, these shales have turned out well and are still very valuable. Leases have 3-5 year terms - at which point you lose any leases you haven't drilled. The industry spend around $50 billion leasing land, so it is worth drilling as much as possible until the leases run out over the next 6-18 months. I think this acts as a temporary exit-barrier - but one that will dissapear over the course of 2011. Companies (CHK included) can't afford to stop drilling, because a well that loses $3 million might preserve a $15 million lease. The third factor is that companies are allegedly making money at these prices. I have gone through company presentations and noticed that almost every company is failing to include completion costs (as expensive as drilling), or land costs (varies, but a big factor), or SG&A and interest cost. A couple of recent analyst reports have started to mention this. The only companies that are really earning their cost of capital here are UPL, CHK, SWN, RRC, and maybe ECA and HK, but I doubt it. Others like SD and MCF are definately below the marginal cost of production (probably $6.50), but it just doesn't make sense to drill right now if you don't have to (i.e. don't have rigs expiring or need to show growth to "the street") - This is why SD wisely is dissapointing analysts by not drilling for gas.

 

2) all of these arguments have been made before, if gas hasn't recovered yet it isn't going to. My response is that there is no clear catalyst, just a confluence of factors and arguments that will send gas higher. Will this be next year, three years from now, or even longer? I can't say for sure. All I know is that owning a low-cost producer of a vital commodity, that is trading well below the cost of production, is difficult to store, has low-barriers to exit for producers, has high decline rates for new wells, is straining current infrastructure, and has political and global tailwinds (shutting down coal plants and exporting LNG) is guaranteed to work out well at some point.

 

$15 natural gas is going to happen sooner or later, and I don't want to miss the 1,000% move in these stocks. Before you dismiss me as a kook, tell me how this is different from the story in oil or potash before those commodities made huge moves and the big producers became ten-baggers in under two years. No one saw that coming either, but in hindsight all the factors were in place. To paraphrase Munger (I think it was Munger), investing is simple but not easy. This is a simple story, but timing is tough. I have paid the price for being a year early to this. At some point it becomes a no-brainer, and I think the money is to be made now, before it becomes obvious. CHK is trading well below liquidation value - and I don't mean that as an abstract concept. CHK could certainly sell its assets right now for more than its enterprise value.  

 

Sorry for such a long rant and i'm sure some of this doesn't make sense or numbers are a little bit off, but I think you get the idea and I would love to hear counter-arguments!

[SharperDingaan]

 

Couple of things to consider:

 

The average depletion rate for NA gas is currently around 25%/yr. Where it’s all shale gas the average depletion rate is closer to 40-50%/yr. What is being missed is that the basic depletion rate is 6-11%/every quarter. Add winter heating demand to the declining supply, & it doesn’t take much to produce a seasonal change.

 

A new well in an existing field is dirt cheap when you don’t have to build extensive tie-in’s, & the existing collection facility has progressively less gas in it month by month. You keep your lease by having others farm in, & get an immediate cash flow return on your non-cash investment. The ‘why’ you can continue to produce at below the marginal cost of a green field well.

 

Absent the big producers & consumers, who hedge their real need on an everyday basis - & most of the gas ‘market’ is simply the speculative following of the herd.

 

SD   

 

[Myth465]

T Bone thanks for the reply. I have learned quite a bit in those few paragraphs.

 

I agree with everything you wrote, but agree with SD (I think). People are waiting to drill wells, literally waiting for a turn. So unless we get a super spike they will drill the prices right down there. What is compelling is the decline rates being 70%, but it seems that you are betting on a shortfall causing a super spike prior to other drillers ramping up.

 

I think thats an interesting bet, and might be worth some leaps, but prefer oil because its raise is sustainable. It is also a good inflation hedge and will work out well should the dollar fall. I like the long term boom in oil and like the fact that we have huge super fields declining with no offsetting increases in cheap production. Most of the new production is expensive which increases the marginal costs. We also have a world wide growth story with oil.

 

I see nat gas being a see saw. I am not sure if it will dip from boom to bust rapidly or in a more gradual $4-$6 fashion. Everywhere I look I see oversupply. We have rigs, acreage, and hungry companies looking to drill. I dont see the big draw with PDS as well. They will hit a wall when rigs are returned, and rates will crash (then I will buy). The drillers are still building more rigs. If gas touches $6 everyone will hedge and drill pushing it back down to $4.

 

Oil will hopefully stick around $70 which would make us a decent amount of money with SD. All they have to do is execute and it seems as though they are. Everyday a few more wells are drilled. You can also get leaps / shares on problem producers like ATPG in hopes that they turn things around. Oil should be money good unless demand falls off a cliff and if that happens, we will have bigger problems. The only real short term hope I see for gas, is this fracing review that is going on. Outside of that grey swan I think we will have a see saw. Now will it be violent causing a spike to $15 or gradual leading to $6 with everyone drilling to bring it back down. I dont know, and thats why I have a hard time with gas vs oil.

 

Now I want gas exposure. We get a spike SD can sell some acreage or drill some wells (after some hedging) getting us decent cash flow. But I don't want to bet the farm on gas, until I can see the horizon. You are right though, buy then it will be too late and the farm will cost quite a bit more.

 

----

 

With that said I am a sucker for cheap assets, and I know CHK is mirroring SD. Do you think they can turn on the oil as well as SD, the stock is literally hated so there may be something to look into.

 

 

----

 

One more thing. Why do you think the majors are keen on gas? I mean they cant all produce it.

 

http://www.gurufocus.com/news.php?id=107598

 

I think they are in run off and this is the only way to grow production. One interesting thing though is they can really push for a change in the gas markets by lobbying for new uses.

[biaggio]

T-bone, Myth, thanks for info above.

 

re CHK -I would be worried about its stewardship (discussed above). As well I am not sure what your thoughts of article on CNBC -posted previously-http://www.cnbc.com/id/39213463 - it seems they are spending their future for short term gain?

 

re catalyst- I am thinking that the expiration of the land leases over the next couple will be the catalyst. By that time the economy will hopefully be in better shape

 

Finally, I own pey.un on TSE. According to company their cost is $2.03/MCF.

 

http://www.peyto.com/news/Q22010PressRelease.pdf -

 

would appreciate opinion on their actual cost-the $2.03 includes operating costs of $0.38/mcfe, transportation costs of $0.13/mcfe, royalties of $0.81/mcfe, G&A

and interest costs of $0.50/mcfe Depletion, depreciation and accretion, as well as a provision for future performance based

compensation, and future income tax. Am I missing something. Is there a cost not accounted for?

 

I have been very comfortable owning + collecting 10+% yield thinking they are low cost producer

+ selling at a discount to the value of their reserves ($1.75 per MCF of proven + probable reserves) + management owns ~ 8% of company - am I missing something?

 

 

 

 

 

 

[SharperDingaan]

 

Be wary of 'long-term' oil vs gas, especially in the US.

 

Gas is very simple to synthesize from coal, portable, green, & there is far more coal than gas in the US. The price for both oil & gas will enevitably rise as shortages periodically occurr, but the gas price is essentially capped at the marginal cost of gassification. Improving technology, & rising volume will drive that marginal cost down.

 

We got the IC engine because its 'fuel' was incredibly cheap, abundant, & fairly easy to get at. Gas was just the sh1te hazardous by-product that you burnt off for safety reasons. Today gas is the cheap fuel, gassy companies are increasingly often worth than oily companies at times, & the whole world pretty much runs on it (power stations, heating, infrastructure etc).

 

Gas is a silent energy 'game changer' that is often overshadowed by its sexier & greener cousins. That said, volatility is the norm, so not for the faint of heart.

 

SD

 

 

 

 

[Myth465]

T-bone, Myth, thanks for info above.

 

re CHK -I would be worried about its stewardship (discussed above). As well I am not sure what your thoughts of article on CNBC -posted previously-http://www.cnbc.com/id/39213463 - it seems they are spending their future for short term gain?

 

re catalyst- I am thinking that the expiration of the land leases over the next couple will be the catalyst. By that time the economy will hopefully be in better shape

 

Finally, I own pey.un on TSE. According to company their cost is $2.03/MCF.

 

http://www.peyto.com/news/Q22010PressRelease.pdf -

 

would appreciate opinion on their actual cost-the $2.03 includes operating costs of $0.38/mcfe, transportation costs of $0.13/mcfe, royalties of $0.81/mcfe, G&A

and interest costs of $0.50/mcfe Depletion, depreciation and accretion, as well as a provision for future performance based

compensation, and future income tax. Am I missing something. Is there a cost not accounted for?

 

I have been very comfortable owning + collecting 10+% yield thinking they are low cost producer

+ selling at a discount to the value of their reserves ($1.75 per MCF of proven + probable reserves) + management owns ~ 8% of company - am I missing something?

 

I think you have to take into account DDA of $2.04 for a 33% margin. This would give you the all in costs. Also Canadian nat gas tends to get lower prices due to the transportation costs of getting it to the US. Finally they seem like they issue shares periodically which to me will make it difficult to keep the div.

[biaggio]

"Also Canadian nat gas tends to get lower prices due to the transportation costs of getting it to the US. Finally they seem like they issue shares periodically which to me will make it difficult to keep the div."

 

yes, thanks. I have wondered why they have issued shares,especially most recently- they claim it is to pay down debt- I am going to reevaluate my thinking.

 

Thanks again

[Myth465]

Ya I sold PWE for the same reason. The div doesnt allow them to really explore / keep production so they just keep issuing shares. Its like a giant ponzi scheme. The share issues in MLPs only work when they buy new assets that can cover the divs on the new shares. When you issues shares and cash flow is the same, you basically have less cash flow per share and it becomes tougher to support divs. I think in Oil and Gas you can have growth (SD, CHK, XEC) in production or you can have yield. Its hard to get both.

[Sea Island]

2009  18,551,296 Total Comp for Aubrey McClendon(Chesapeake Energy)

2009  4,224,058 Total Comp for Steven Meuller(Southwestern)

2009  12,713,702 Total Comp for Mark Papa(EOG Resources)

2009  9,360,011 Total Comp for Charles Davidson (Noble Energy)

2009  27,168,317 Total Comp for R.W Tillerson(ExxonMobil)

2009  31,401,356 Total Comp for Ray Irani(Occidental Petroleum)

 

 

[Stove]

In the last 10 years, CHK has gone from 10 to 20.  In the last 10 years, OXY has gone from 10 to 80.  Maybe Irani deserves a raise.

[Guest Bronco]

Stove - not that I disagree with you, but shouldn't managers be compensated on profits and company performance and not share price.

 

Options sometimes are the reward and go up as the stock goes up, but the stock price shouldn't be the measuring stick for compensation.

 

Of course, I get the gist of your comments though.

[Stove]

Bronco, yes I agree with you on that point.  CHK grew operating profit 10 fold from 2000 to 2009, while OXY just managed to double theirs.  However, along the way Aubrey (with the blessing of Wall Street) almost destroyed the company by leveraging to the hilt and going for broke on natty gas right before an 80% drop in the commodity price, all the while having knockout swaps that didn't actually protect any downside.  I don't know the OXY story that well, but I would guess they are more conservative.  :)

 

Back to the actual stock price.  What you get in CHK is what you pay for: A risky, leveraged play on Aubrey being able to out-maneuver his competition in getting into the most profitable plays early.  In this sense he has done a great job so far, buying pieces of property for X than selling 20% of them for X.  Maybe he does deserve his compensation in light of these deals, but the model he created is the reason for the share's underperformance.  Stand up in front of a room right now and ask who wants to buy a leveraged play on natural gas that may have a bit more oil in the future, and by the way they need to sell $4 billion of assets immediately to pay for drilling costs.  People will run screaming for the exits.  As for me I like to trip these people on their way out as I buy their shares.

[T-bone1]

As well I am not sure what your thoughts of article on CNBC -posted previously-http://www.cnbc.com/id/39213463 - it seems they are spending their future for short term gain?

 

The article states that CHK has sold 90,000 call options on natural gas with an average strike of $8.08/Mcf between 2013-2020.  Each contract is for 10,000 mmBTU or roughly 10,000 Mcf (Mcf= 1,000 cubic feet) . . . so they have sold calls on 900 Bcf of gas (900 billion cubic feet or 900,000,000 Mcf).

 

If we assume that this is spread evenly over the 7 years in the article, then they are selling calls on about 130 Bcf/year of production.  CHK's latest presentation projects that they will be producing 4.9 Bcf/day in 2015, 75% of which will be gas. I think its safe to assume CHK will be producing at least 4 Bcf/day of gas over the 2013-2020 timeframe (just 10% growth suggest it'll be closer to 5Bcf/day . . . or an extra 365 Bcf/year).

 

I'm not sure how these calls are weighted, maybe they are mostly in the earlier years, but just averaging them over the 7 year period suggest that CHK is selling calls on just 33 days of production per year, or less than 10% of their production. The 2015 $8 calls should trade for around $0.73 based on volatility, and further dated ones should be higher, but if we assume CHK is recieving just $0.52 per call (total of $8.60) for 10% of their gas, they will have huge returns - hardly mortgaging their future.

 

Now for the bad: CHK take this income from these call sales and adds it to the current year hedging program (i.e. they can hedge $1 billion dollars of gas next year at $5/Mcf, add on $200 million in income from selling longer-dated out-of-the-money call options, and the say they have hedged at $6/Mcf for next year). This is fully disclosed, but it is obviously non-standard, and like many aspects of this company, it is promotional.

 

I don't like them counting the income as part of the current year or next-year hedging program, but I do like that this company is creative and finds ways to create value all through the company. If they end up selling the gas at $8.60 in some of those years, they have still made a good return . .. plus the $0.52 that they recieved up front will have compounded at 20% a year or so, meaning its actually worth $1.30 in 2015, so they are effectively recieving $9.32+ for their gas.

 

Overall, I view this program as one more creative funding source and a positive for the company. The fact that they use it to improve their current operating cashflow and effective hedging price is obviously fuel for detractors and not the sort of thing a company like Fairfax would do, but it isn't dishonest, just promotional. If these hedges expire worthless this was a great idea, if not, its probably still a great idea compared to other sources of capital (debt, asset sales, VPPs, etc.). One more ugly positive for this unloved stock in my opinion.

[T-bone1]

I agree with everything you wrote, but agree with SD (I think). People are waiting to drill wells, literally waiting for a turn. So unless we get a super spike they will drill the prices right down there. What is compelling is the decline rates being 70%, but it seems that you are betting on a shortfall causing a super spike prior to other drillers ramping up.

 

I think thats an interesting bet, and might be worth some leaps, but prefer oil because its raise is sustainable. It is also a good inflation hedge and will work out well should the dollar fall. I like the long term boom in oil and like the fact that we have huge super fields declining with no offsetting increases in cheap production. Most of the new production is expensive which increases the marginal costs. We also have a world wide growth story with oil.

 

I see nat gas being a see saw. I am not sure if it will dip from boom to bust rapidly or in a more gradual $4-$6 fashion. Everywhere I look I see oversupply. We have rigs, acreage, and hungry companies looking to drill. I dont see the big draw with PDS as well. They will hit a wall when rigs are returned, and rates will crash (then I will buy). The drillers are still building more rigs. If gas touches $6 everyone will hedge and drill pushing it back down to $4.

 

 

The only real short term hope I see for gas, is this fracing review that is going on. Outside of that grey swan I think we will have a see saw. Now will it be violent causing a spike to $15 or gradual leading to $6 with everyone drilling to bring it back down. I dont know, and thats why I have a hard time with gas vs oil.

 

----

 

With that said I am a sucker for cheap assets, and I know CHK is mirroring SD. Do you think they can turn on the oil as well as SD, the stock is literally hated so there may be something to look into.

 

 

----

 

One more thing. Why do you think the majors are keen on gas? I mean they cant all produce it.

 

http://www.gurufocus.com/news.php?id=107598

 

I think they are in run off and this is the only way to grow production. One interesting thing though is they can really push for a change in the gas markets by lobbying for new uses.

 

Myth,

 

with regard to a super-spike before drillers can ramp up, a few things:

 

1) 70-80% decline rates on new wells are the norm, but SD is right, for all shale production its more like 40-50% - this is because most shale wells are older than one year. While older wells have lower production, they also have lower decline rates. You might have 50% of shale production as 6 months old declining at 70% and the other 50% of shale production is 2-6 years old and declining at 30% on average. Older wells also had less fracs, so they always had lower decline rates, but decline rates "level out" for wells in each year they age.  legacy production declines at around 10-15% (gulf of mexico is higher but is only 10% of total production now), so combined with shale the total decline rate for pre-2010 wells is around 20-25%. This number will go up each year as the percentage of total production that is shale <1 year old rises and as the decline rate of legacy production goes up as more shale is added to it.

 

2) There are only about 600-700 rigs that can drill these wells economically (top drive AC-driven modern rigs on skidpads). They are currently all being used and a larger and larger percentage each year is being used for oil shale (bakken, eagle ford, niobrara, etcc) or gas+liquids (eagle ford condensate window, granite wash, marcellus condensate window) drilling. Helmerich and Payne is only contracted to build 19 more right now, and they have 1/3 market share.  At the current rate we will probably need 600-700 more by 2015 and I don't see any way that we get there without higher gas prices (newbuilds are generally only built on contract, and without new contracts no one wants to commit to taking more rigs than they currently have).

 

3) All the frac crews (with 10-20 huge compressor trucks that wear-out after 3-5 years) are currently in use, with long wait-times in the haynesville and Marcellus. Midstream pipelines, gas treatment plants, condensate pipelines, ceramic proppant and trained personel are all current and future bottlenecks. Doubling shale production in 5 years is just not feasible at these gas prices (or $6-7 gas) in my opinion.

 

4) Companies aren't really making money at these prices, and most won't make money at $6 gas. These plays are only good in certain areas, which are still being deliniated. Once investors and companies realize where the "core" area really is they will stop drilling all the "hope and pray" wells that turn out to be uneconomic. Origionally people thought the Barnett shale would be good in 10-20 counties, now they only drill in Johnson and Tarrant county where CHK built a dominant position. The same thing will happen in other plays as the central PA marcellus and East Texas Haynesville are abandoned until $8-9 gas.

 

I think these factors make it likely that we have a large spike before drillers can ramp up . . . I don't think a real ramp up (double current shale production as is currently projected) can take place without $8+ gas . . . and there is no indication that gas is going to drift up to $8. What I think is more likely is that gas stays low for another 12-24 months as companies race to hold their leases by drilling. But decline rates combines with either bad weather, rising demand (either industrial or from the EPA shutting coal plants, or both), hurricanes, etc. can cause an immediate deficit in any given year. When this happens, prices will probably go to double digits and companies will scramble to build more rigs, hire more personel, build more frac trucks, reserve drill pipes, build midstream pipelines and treatment plants, secure water supplies, etc.  The ramp-up will not be easy and it won't happen until high prices have already arrived, which I think makes a 1-2 year spike very likely.  Companies will definately hedge at $8-10 gas, but I don't think anyone would at $6 after this year - companies just aren't making an economic return at those prices.  

 

With regard to your other question, CHK says they will be 25% liquids (mostly oil) by 2015.  CHK will change their plans like they always do, but that's what's possible - nowhere near the oil weighting of SD in the near term, but impressive for organic growth from a company that size.

 

As far as the majors and gas, you are correct . ..  its the only game in town. They can't get there hands on politically safe oil so they have to buy gas. I think the gas market is global within 5-10 years through Gas-to-liquids technology, LNG (exported from North America), and increased gas switching in the US. When this happens gas should trade between 1/6 to 1/10 the price of oil . . . $7-12/Mcf currently . . . double that if oil is at $150 when this happens.

[biaggio]

T-bone , thanks a lot for your analysis. Very interesting. Will help me out quite a bit.

[Zorrofan]

Very informative thread! As far as nat gas supply goes Bill Powers, he posts on both Powers Energy Investor & Seeking Alpha, did a write-up in January arguing that shale gas supplies were being over-estimated and depleting faster that many people realized. He did a field-by-field breakdown, showing a shortage by June 2011. I am not sure how accurate it is but it is an interesting read.

 

http://www.financialsensearchive.com/editorials/powers/2010/0106.html

 

Does anyone know off-hand how much Ward invested in SD? By this I mean his own money and not just stock he has received via stock options. I've been looking at swapping out of PWE and going into SD. I like Wards attitude - he seems focused on growing EBITADA and not just meeting production targets to keep the analysts happy.

 

cheers

Zorro

[Sea Island]

In March  2008 Forbes listed his networth at $2.8 billion, but SD was trading at $40 and CHK was at $45. Even if you take his current share position at that price it doesn't get him half way there so he must have some money else where