2023-05-18 12:12:06 ET
Summary
- The natural gas outlook remains depressed currently. But that can rapidly change.
- Antero Resources Corporation's profitability is dependent upon a matrix of product pricing, whereas dry gas producers depend solely upon the pricing of natural gas.
- Many times, it can be to the advantage of an individual company to increase production when it is not to the advantage of the industry for production to rise.
- Despite the warm winter, a typical La Nina hot summer could rapidly change the current surplus to a deficit.
- Management typically receives a premium price for all its products by maintaining flexibility to send those products to the strongest markets.
There is a lot going on in the natural gas industry right now. Commodity outlooks are always changing rapidly. Natural gas companies like Antero Resources Corporation ( AR ) have at least some dependency on the weather. Despite the reputation of a La Nina for a cold winter, this winter turned out to be on the warmer side overall, despite a few cold spells. That led to a natural gas oversupply. The rising gas storage has led to calls for lower production from the market.
But it is not that simple. The same weather pattern that led to a warm winter can just as easily lead to a hot summer - which La Ninas are also known for. Then again, the summer could be cooler, which would increase the natural gas surplus. The fact is that oil and natural gas have extremely low visibility when it comes to forecasting the future. That makes overall industry production forecasting very difficult.
Many times, it is to the advantage of each individual company to increase production, even though it may be to the disadvantage of the industry to have higher production. This is one of the prime reasons that overproduction results in bringing about a cyclical downturn. Hedging will actually exacerbate the situation because the company overall makes money after hedging long after prices have begun to decline. Therefore, the hedging needs to "run out" before production responds to market forces.
When I first began to follow Antero Resources, management hedged out as much as five years while natural gas prices began a long decline as the unconventional business grew rapidly. This allowed management to rake in billions of extra sales dollars that overall did not represent the (at the time) declining price of natural gas. Additionally, it gave management time to decrease costs enough to make money when that hedging program finally came to an end.
Antero Resources Production Mix And Premium Natural Gas Pricing Compared To Basin Competitors (Antero Resources May 2023, Corporate Presentation)
Management has long made sure that the production can be sent to a variety of markets (for both liquids and natural gas). The result is that management frequently beats posted prices for both natural gas and liquids. Shown above is the current premium for natural gas.
Getting a premium price for the production has a similar effect to lowering the breakeven point with low-cost production because, at any given benchmark price, the superior pricing received ensures a larger than expected margin. Just as with low-cost production, it takes lower prices for that superior pricing to reach the breakeven point.
In an industry where extra pennies often head straight to the bottom line with only a minimal amount of deductions, that premium shown above is substantial enough to provide a large competitive cash flow advantage. Since it takes long-term transportation arrangements to achieve that advantage (with midstream companies), that competitive advantage could last a long time (and even be considered a competitive moat). Transportation arrangements with midstream companies are typically long-term with take-or-pay arrangements.
To Drill Or Not To Drill
The decision to drill is based upon well profitability (not corporate profitability). The reason is that a well can be profitable enough to add to corporate cash flow and spread-out corporate costs over more production. That results in a lower corporate breakeven point (sometimes even when the corporation is losing money).
Antero Resources Number Of Low-Cost Drilling Locations (Antero Resources May 2023, Investor Presentation)
Antero Resources, as shown above, has a lot of locations that break even at natural gas prices that are considerably below the current natural gas price. Therefore, this company is going to continue to drill wells during an industry downturn because it is to the company advantage to do that. The fact that the company reports a loss has a distant relationship as to whether or not a well should be drilled.
Furthermore, this company has a fair amount of liquids production. So, the natural gas breakeven price is dependent upon the price received for the liquids. Many still expect liquids prices to improve over the second half of the fiscal year (even though that could easily change). Should that be the case, then the natural gas price needed to breakeven will drop as the liquids prices received increases. This company could be reporting profits when dry gas producers are losing money.
Corporate Breakeven
Now, the corporate breakeven point includes things like the capital budget (which can be changed). Investors need to remember that maintenance capital is largely a function of the amount of production growth in the previous fiscal year. Because first year wells have a large decline rate in the unconventional business, then rapid growth in the previous fiscal year raises the amount of maintenance capital needed in the next fiscal year.
Antero Resources Corporate Breakeven Comparison And Liquids Uplift (Antero Resources May 2023, Corporate Presentation)
Maintenance capital is therefore a variable entity that is at least partially dependent upon the production growth of the previous fiscal year in the unconventional business. When one further considers that dry gas operators have little to no choice about product mix, the comparison above loses applicability because it is apples and oranges.
Antero Resources has a product mix that is dependent upon a matrix of prices, whereas dry gas producers like Comstock Resources, Inc. ( CRK ), for example, or EQT Corporation ( EQT ) are inevitably wedded to natural gas prices received. So, Antero Resources can have a decent year if liquids prices offset or more than offset the weakness of natural gas prices, while dry gas producers have no such option.
But also notice that the capital budgets are by and large discretionary, as are the dividend options. Management can, in an extreme case, decide to stop drilling completely and simply cash checks until a recovery makes restoring production worthwhile. A similar argument goes for dividends as well.
Key Points
Antero Resources obviously has some very low costs of production. That low-cost structure is augmented by one of the best transportation arrangements that are flexible enough to allow for considerable premium pricing compared to basin competitors.
That premium pricing has to more than offset any take or pay provisions for unused midstream capacity (or management sells that capacity periodically). The premium pricing must also offset the additional costs of a matrix of production products when compared to dry gas production. So far, a historically superior margin appears to build the case for a very successful overall strategy.
The risk of this strategy is a loss of superior pricing or a loss of cost control. So far, management appears to have navigated both risks pretty well.
Antero Resources Location Cost (Antero Resources March 2023, Corporate Presentation)
(Note: The company has taken this presentation down to post another later presentation that does not have a similar slide.)
Corporate profitability has increased by reducing the location cost of wells when compared to the competition. Management generally expands acreage holdings through the bolt-on acquisition of small hard-to-market holdings that can be put together into a far more marketable holding or added to a position such that the total is greater than the sum-of-the-parts.
This is usually far harder to tell, as managements rarely disclose the cost of locations in the breakeven calculation for investors. Furthermore, land itself does not depreciate. So, any high costs do not show on the income statement.
This has often deterred a lot of managements from putting in the extra effort to lower location costs, as shown above. Yet, location is a cost that will affect future corporate profitability. This is true even if it is not immediately obvious to shareholders.
Such an extra effort strongly implies a detail-oriented management that will be rewarding shareholders with superior future performance. This is a very volatile industry. Therefore, Antero Resources Corporation stock may be a strong buy. But only a strong buy for those investors who do not mind the low industry visibility and the above average stock price volatility that comes with a commodity investment.
For further details see:
Antero Resources: Why They Are Not Cutting Production