2023-12-08 17:57:01 ET
Summary
- Natural gas prices have fallen by roughly 30% since the end of October due to unfavorable supply and demand dynamics and the El Niño weather pattern.
- Energy experts believe that natural gas prices in the US are trading at an 80% discount to global energy prices, but this discount is likely to decline in the future.
- Range Resources is seen as a fantastic natural gas play, as it has deep reserves, low breakeven prices, efficient operations, and the ability to reward shareholders with distributions.
Introduction
I am sure it won't come as a surprise to many readers when I say that I'm a long-term oil and gas bull.
Oil has become a major part of my portfolio since 2020, when I started to bet on a scenario of long-term demand growth and new supply challenges, paving the way for a highly favorable environment for drillers focused on free cash flow.
However, I also like natural gas, although it's a much more volatile and riskier alternative to oil.
Natural gas prices have fallen from almost $10 per MMBtu in 2022 to currently less than $2.60. In fact, natural gas prices have fallen by roughly 30% since the end of October.
Generally speaking, I hate monitoring natural gas prices. They are volatile and highly sensitive to demand, supply, and geopolitical headlines. Being a short-term natural gas trader is a headache, which is why I focus on the long term.
It also needs to be said that natural gas is much more abundant than oil. Even companies like Waste Management ( WM ) and Republic Services ( RSG ) are now producing renewable natural gas from waste.
Before the pandemic, things were even worse, as the massive shale revolution was a driver behind even faster supply growth, turning natural gas into one of the worst places to be. I guess only coal was worse back then.
Despite all of this, I like natural gas. Although demand issues may persist in the mid-term due to warm weather expectations and strong supply, I believe we're seeing a fundamental supply/demand shift in the long term.
In order to benefit from that, I have my eye on two American natural gas producers. One of them is Antero Resources ( AR ), which I added to yesterday (December 7). The other is Range Resources ( RRC ) , which I haven't covered since September 27, when I wrote an article titled A Path To A >20% Distribution Yield: Why I'm So Bullish On Range Resources .
Although I own way more AR than RRC, I believe that RRC is a much safer play. The company has everything I'm looking for in a natural gas play: deep reserves, low breakeven prices, efficient operations, healthy debt levels, and the ability to use distributions to reward shareholders.
While RRC is currently in a very tough spot, I am very bullish on its future, believing that it has the power to move much higher.
So, let's dive into the details!
On a side note, as I already mentioned, RRC is highly volatile. As much as I love it, RRC may not be right for investors who usually buy lower-volatility dividend stocks. As I mainly discuss lower-risk long-term plays, I have to mention that RRC may not be right for you. It is very important to keep that in mind before reading the rest of this article.
Short-Term Headwinds - Long-Term Tailwinds
Right now, natural gas prices have come down significantly. As I briefly mentioned, natural gas prices have come down roughly 30% since the end of October.
The major driver is the realization that supply and demand dynamics may remain unfavorable for a bit longer - mainly thanks to the weather.
As reported by CME Group ( CME ), the current El Niño weather pattern is gaining strength, marked by a 1.5-degree Celsius rise in equatorial Pacific Ocean temperatures. This resurgence, absent for four years, carries significant implications for North America's winter weather.
Historically, major El Niño events, such as the 2015/16 episode, influenced natural gas and electricity prices in the U.S.
Several (related) factors contribute to the decline in natural gas prices.
- Elevated stockpiles, currently at 3.8 billion cubic feet, reflect a 5% increase from the previous year, with forecasts anticipating a 21% rise during the winter heating season.
- Record-high U.S. natural gas production. A pivotal factor influencing the market is the forecasted record-high U.S. natural gas production. The Energy Department anticipates reaching 103.72 billion cubic feet daily this year and 105.13 bcfd in 2024, surpassing the 99.60 bcfd recorded in 2022. This surge in production, if realized, could have profound implications for market dynamics.
These dynamics are bad for natural gas.
However, these developments seem to be temporary.
Energy experts Goehring & Rozencwajg believe that natural gas prices in the United States are way too cheap, according to global energy prices.
In fact, G&R believes that natural gas prices in the U.S. are trading at an 80% discount to global energy prices.
Although a discount is warranted due to America's deep natural gas reserves and cheap production methods, it is likely that this discount will decline.
The initial expectation of convergence in North American natural gas prices with international prices faced delays due to a mild winter and a fire at the Freeport LNG export terminal in 2022.
These events, along with increased U.S. inventories, led to an 80% decline in North American natural gas from the 2022 peak.
However, these challenges are deemed temporary, with excess inventories being addressed and operators planning to add six bcf/d of new LNG export capacity in 2024.
Furthermore, G&R's models now suggest that shale production is likely plateauing, and the discount to world prices will narrow, possibly disappearing.
The models predict that North American natural gas is on the verge of entering a structural deficit for the first time in 20 years, potentially prompting regulatory actions to limit exports and stabilize prices.
Based on these numbers, Henry Hub natural gas prices of at least $10/MMBtu could become the new normal.
Sure, currently, there are so many short-term headwinds, like rising output despite lower rigs and weaker demand. It also does not help that economic growth is in a bad spot.
However, on a prolonged basis, I think G&R is absolutely right when it calls for a structural shift in natural gas markets.
Hence, I'm increasingly adding to natural gas trades on weakness.
Range Resources Is A Fantastic Natural Gas Play
Despite the challenging market conditions, Range has had a successful year (so far), focusing on creating value and positioning itself for long-term value creation.
The company has reduced debt, paid dividends, and sustained production through a capital reinvestment program.
One benefit is the fact that the company has more than 30 years of core reserves in the Marcellus basin. Even better, more than 3,000 drilling locations are breakeven below $3.00 per MMBtu.
More than half of these locations are breakeven below $2.00!
Even below $1.50, the company can keep drilling in roughly 700 locations without losing money.
To add a few more numbers, this year, the company is expected to spend $0.76 per Mcfe in capital expenditures. One Mcfe is roughly 1.038 MMBtu.
Its average Appalachian peer will likely spend $1.01. The average natural gas peer in the United States will spend north of $1.30.
It also helps that a big part of the company's products go to higher-margin markets.
For example, a quarter of its natural gas is turned into LNG. Another quarter is directed to the Gulf Coast. Roughly a third is sold to the U.S. Midwest.
Based on this context, just 68% of the company's 3Q23 production was natural gas. The remaining production mainly consisted of higher-margin natural gas liquids ("NGL").
When it comes to LNG, the company expects a 700 thousand barrels per day of LPG supply shortage by 2027 caused by higher demand, including exports.
Furthermore, the company's ability to realize a premium to Mont Belvieu reflects the advantageous position of its NGL contracts and access to international markets.
In general, with incremental gas demand for power generation, industrial growth, exports to Mexico, and LNG commissioning, Range Resources anticipates gradual rebalancing in the domestic natural gas market.
With regard to my prior price normalization comments, Range Resources expects propane prices to return to pre-shale norms, which makes sense if the supply situation shifts in favor of higher prices.
With all of this in mind, Range Resources is a free cash flow machine. With free cash flow breakeven prices below $1.50 MMBtu (assuming $80 WTI), the company has the ability to generate a 20% free cash flow yield at $5.50 Henry Hub, according to its most recent presentation.
The free cash flow yield data in the chart above is based on $70 WTI and NGL price realizations at 35% of WTI. The data is as of October 20, 2023. Back then, Range Resources was trading at $34.40. Currently, RRC trades 15% lower.
In other words, based on the current stock price, investors could get a ~23% FCF yield at $5.50 Henry Hub if they were to buy current prices.
Although I am not going to make the case for $10 Henry Hub in the mid-term, the free cash flow potential is mind-blowing if natural gas prices were to remain at elevated levels on a prolonged basis.
The good news continues, as RRC is increasingly focusing on shareholder distributions.
In 2021, the company spent every penny of its free cash flow on debt reduction. Last year, it spent an almost equal amount on buybacks.
As of 3Q23, the company has just $1.6 billion in net debt, which it wants to lower to less than $1.5 billion. Analysts expect the company to achieve this target in early 2024, which would imply a sub-1x EBITDA leverage ratio.
So far, the decline in debt has significantly reduced interest expenses, lowering breakeven prices despite elevated (global) interest rates.
It would also unlock significant shareholder distributions.
After all, when incorporating production growth, the company could generate a 23% free cash flow yield at $5.50 Henry Hub. Even at $4.00, that number could be 14%.
In its third-quarter earnings call, the company reaffirmed its return of capital program, including a fixed cash dividend and opportunistic share repurchases.
The company plans to evaluate the deployment of free cash flow in 2024 with a stronger balance sheet.
The company currently pays a 1.1% dividend. Although I expect that number to increase, my guess is that the majority of shareholder returns will come from opportunistic buybacks.
Note that RRC has also hedged its production.
The company has approximately 50% of its natural gas hedged for the fourth quarter. The average floor price for this hedging stands at $3.40.
Looking ahead to 2024, Range has hedged about 50% of its natural gas at an average floor price of $3.68. This hedging strategy involves a combination of $4 swaps and collars, allowing the company to retain upside potential to approximately $5.30.
Valuation
The valuation is tricky. After all, we are dealing with a company that is dependent on the price of natural gas.
One way to value RRC is by using its free cash flow potential.
As I believe that natural gas prices will easily rise above $5.50 in the long term, we're dealing with a potential +20% free cash flow yield.
Given that I believe that a 10% free cash flow yield is a fair valuation, RRC could more than double.
When looking at current operating cash flow numbers ("OCF"), we see that RRC is trading at a blended OCF multiple of 6.5x. Its normalized valuation is 8.6x OCF.
Furthermore, based on current natural gas prices, the company is expected to see a 43% OCF decline (per share) in 2023, followed by a potential recovery of 28% and 12% in 2024 and 2025, respectively.
If the company returns to 8.6x OCF by incorporation of expected growth rates, it has a fair value of $52, which is almost 80% above the current price.
While these numbers are subject to change, I remain extremely bullish on RRC and expect the company to more than double in the years ahead.
The problem is that the mid-term is uncertain. I am unsure how far natural gas can fall.
Hence, my strategy remains to gradually add on weakness. I just added more AR shares and hope to add to RRC as well in the weeks ahead.
Please note that both stocks are part of my trading portfolio, not my dividend portfolio. Compared to my large long-term investments, their sizes are relatively small.
I do this to manage the risks tied to volatile natural gas stocks.
Takeaway
In a market dominated by short-term challenges for natural gas, Range Resources emerges as a standout player with a strategic focus on long-term value creation.
Despite current headwinds, the company's solid financials, efficient operations, and substantial reserves in the Marcellus basin make it a compelling investment.
With a diversified market approach, Range Resources anticipates not only weathering the storm but thriving in the evolving natural gas landscape.
As natural gas prices face temporary setbacks, the company's robust fundamentals position it as a potential free cash flow machine, offering investors an enticing opportunity for significant returns.
For further details see:
High Risk, High Reward - I Expect Range Resources To More Than Double In The Years Ahead