Power Chord

A post-merger O&G play offering a ~25%+ IRR / ~1.90x return.

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Value Situations is NOT investment advice and the author is not an investment advisor.

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In this issue of the newsletter I discuss a US-listed oil & gas equity that I believe offers a compelling and highly asymmetric return profile, if one has a constructive view on energy prices over the medium term.

I realise that now might seem an inopportune time to be highlighting an O&G stock given the current market backdrop. While geopolitical risks, specifically a potential conflict between Israel and Iran, supported oil prices earlier this year, that risk premium has faded as concerns around slowing demand in the United States and China in tandem with expected production increases from OPEC+ have caused oil prices to decline dramatically, in the last three months in particular.

The Brent and WTI oil benchmarks have now both fallen ~20% since their highs in April this year of ~ $91/bbl and ~$87/bbl respectively, and are hovering near three year lows of ~$69/bbl for Brent and ~$65 for WTI as at the time of writing:

In addition, increased production from non-OPEC+ producers such as Brazil and Guyana, booming US shale production and most recently the resumption of Libyan production has further contributed to oversupply concerns in recent weeks.

In short, the current outlook might be summarised as an expectation of an oversupplied market heading into next year as global demand slows (led by the US and China as the largest consumer nations) just as OPEC+ (and others) increase supply again.

With regard to US natural gas, prices have been on the proverbial floor this year, trading at an average of ~$2.20/MMBtu YTD, well below the long-term average price of ~$3.50/MMBtu (last 15 years), and having touched COVID-lockdown era lows of ~$1.50 in February this year:

This depressed pricing is attributable to reduced demand due to milder weather over the past two winters, combined with booming LNG production to replace Russian gas supplies following the invasion of Ukraine in 2022. These factors have resulted in abnormally high inventories, leading to a supply glut and historically low prices.

Regardless of the current outlook however, as I’ve written before the reality is that energy prices are inherently unpredictable, with supply and demand dynamics impacted by multiple macro and market factors such as geopolitical risks, OPEC+ actions, general economic conditions and weather, that can cause outlooks to reverse course in short order. As a result, I’m not inclined to place much store in near-term price predictions, as experience has taught me that much like the direction of the stock market, no one really knows where oil and gas prices will go with any great certainty.

With respect to WTI oil, what is known however is that over the long-term (last 15-20 years) it has traded at an average price of ~$72/bbl, within an (admittedly broad) range of $35 - $110/bbl excluding the outlier market moments of the 2008 spike to $145/bbl, the April 2020 plunge to -$37/bbl during the COVID / Saudi-Russian price war panic and the most recent peak of ~$120/bbl during the 2022 energy crisis:

Similarly in the case of US natural gas, as noted above it has traded at a long-term average price of ~$3.50/MMBtu, within a broad and volatile range of $1.85 - $6.25/MMBtu, again excluding extreme and short-lived outlier moments:

In the absence of any real ability to forecast energy commodity prices, I feel long-run average prices offer a reasonable guide as to future mid-cycle pricing.

On that basis I believe one can reasonably expect US oil and natural gas prices to fluctuate around ~$72/bbl and $3.50/MMBtu in the coming years, supported by broader demand and supply-side factors. On the demand-side, megatrends including energy security needs, increased urbanisation, a delayed energy transition (an increasingly acknowledged view) and an expected surge in demand for gas-powered electricity from AI computing imply a supportive outlook over the medium term at least.

On the supply-side, the global economy faces a more volatile supply environment post-COVID/Ukraine War, characterised by resource nationalism, constrained capital investment in fossil fuels, and frequent and intermittent supply chain disruptions caused by a variety factors including conflict, trade sanctions, adverse weather and supply/infrastructure bottlenecks (all factors feeding into the Precarity of Supply idea I’ve written about before).

So with energy names currently out-of-favour amid a perceived weak outlook, I think now is an interesting time to look at names that are potentially mispriced relative to their future prospects and in anticipation of energy prices stabilising in due course.

Furthermore, M&A has been a major theme in the US O&G industry this year with cash-rich energy majors opting to acquire independent exploration and production (E&P) companies rather than pursuing the type of “drill baby drill” capex spending that marked the previous shale boom of 2007 - 2014. And so I believe certain smaller-cap US E&P equities come with a potential event-driven angle as attractive takeover targets.

Within this theme, I have identified a very interesting watchlist situation. The subject stock is a post-merger, US-listed E&P name that is highly FCF generative even at lower oil prices, and currently trades at just ~3x PF EBITDA and offers a prospective 13.5% FCFE yield.

Furthermore, management have committed to a sector-leading capital return programme, with the majority of FCF to be returned to shareholders in the form of dividends and share buybacks, while it also has a best-in-class balance sheet with PF net leverage at ~0.1x. Finally, the stock is an independent producer that has grown via a series of acquisitions, and I believe it is a likely takeover target for a larger player given its fundamental attributes and consolidation activity in the US O&G sector.

For investors that can form a constructive view on energy prices, and oil in particular, I believe this is a situation that is worth tracking. The stock is…