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Raising U.S. Upstream Oil and Gas Fair ValuesMorningstar's Analysis Raising U.S. Upstream Oil and Gas Fair Values Dave Meats Director Analyst Note | by Dave Meats Updated Jan 24, 2022 We have adjusted fair value estimates across our exploration and production coverage to account for a more constructive near-term outlook for commodity prices, resulting in an average uptick of about 5%. These changes also incorporate a revised view on U.S. corporate taxes, which was originally announced in December 2021. We now expect the U.S. corporate tax rate to remain at 21% for the foreseeable future, due to the stalling of the Build Back Better bill (we had previously expected an increase to 26%). Our long-term estimates for U.S. crude and natural gas are unchanged at $55/bbl and $3.30/mcf, respectively. However, in the short run we expect prices to remain significantly elevated, at least in the $70-$80/bbl range. Our 2022 estimates for West Texas Intermediate and Henry Hub are $80 and $4.03, respectively. Geopolitical uncertainty in Russia and Ukraine is one factor supporting the recent crude rally, given that the former accounts for over 10% of global supply. However, our updated estimates also reflect increasing confidence that the omicron variant of COVID-19 will not trigger widespread or persistent lockdowns, and is unlikely to significantly hinder the global demand recovery. Meanwhile, the resurgence in consumption is still outpacing the rebound in supply, and is likely to keep doing so through the first half of 2022. OPEC producers remain committed to adding only 400 mb/d per month, and the evidence thus far suggests the cartel will fall short of that moderate goal. U.S. producers are unlikely to change tack this year and deliver outsize production growth, either. Most E&P firms are content to target flat or slightly higher volumes in 2022, while using the windfall from higher prices to deleverage or increase shareholder distributions. In the upcoming round of earnings updates we expect only modest year-over-year increases in capital budgets (10%-20%) and production guidance is likely to signal no more than 5% annual growth in most cases. Business Strategy and Outlook | by Dave Meats Updated Jan 24, 2022 Range Resources is an exploration and production firm focusing on the Marcellus Shale play in southwest Pennsylvania. Natural gas composes over two thirds of its production, but a portion of its acreage also yields natural gas liquids, which gives it indirect exposure to crude prices (NGLs are substitutes for certain refined oil products). Management can easily shift capital between the liquids-rich and dry gas portions of its acreage as commodity prices fluctuate. Range was a first-mover in the Marcellus shale, which has been a major component of the U.S. natural gas supply stack since 2010. It has assembled close to half a million net acres in the Southwest Pennsylvania core of the play, giving it a huge advantage over other Appalachian producers. Our data fully supports management's oft repeated claim that it has a longer inventory life than its peers. Most will use up their best acreage in the next 5-10 years, forcing them to pivot to areas where well performance is typically weaker and supply costs are commensurately higher. Not so for Range, which could maintain its current cadence for multiple decades without having to worry about exhausting its core resources. Appalachia producers have endured a lengthy spell of mostly weak U.S. natural gas prices that dates back to 2012. This was exacerbated by periodic pipeline shortages in the region that pushed out basis differentials and further eroded revenues. But that regime looks to be over. A surge in LNG and NGL export capacity, coupled with sustainable global demand growth for Range's dry gas and liquids products, is the backbone of our more favorable macro outlook. Acreage and infrastructure constraints will chronically limit supply growth in the Haynesville and Marcellus gas plays, forcing producers to look higher on the cost curve to balance the market. Firms with ample drilling inventory and marketing agreements for flow assurance, like Range, will benefit from sustainably higher pricing. Economic Moat | by Dave Meats Updated Jan 24, 2022 The ability to generate sustainable excess returns on invested capital is a hallmark of companies with economic moats. Range has historically struggled to do so, and though it is likely to start earning its cost of capital in the near future, thanks to more disciplined capital allocation and a more favorable commodity environment, the margin of safety is still razor thin. We assign a no-moat rating. The firm's Marcellus Shale acreage does generate solid field-level returns under midcycle conditions (with WTI Henry Hub averaging $55/bbl and $2.80/mcf Henry Hub, respectively). And with over 2,000 potential drilling locations in its inventory, the firm has multiple decades of runway in the play. But after incorporating costs sunk on leasehold, acquisitions, exploration, and infrastructure, Range's capital base inflates to a level that makes high returns on capital very difficult. For Range, the most significant ESG exposure is greenhouse gas emissions (both from extraction operations and downstream consumption). Greenhouse gas emissions are unavoidable for oil and natural gas producers. Firms can clean up their operations in the field as much as possible by avoiding unnecessary flaring and using technologies like electric fracking and carbon capture to reduce CO2 volumes being released into the atmosphere during the extraction process. Range has reported statistics showing a strong improvement in this area (as have peers). For example, it lowered its overall GHG intensity by 80% between 2011 and 2020, and is targeting a further 15% reduction by 2025. And by combining this with carbon offsets (reforestation and forest management) it aims to reach net zero the same year. But because downstream emissions are beyond producers' control, there's really no such thing as a "clean" E&P company. Natural gas is primarily used for electric power generation and for commercial and residential heating. As consumers get more averse to fossil fuels, the reputational risk grows for producers and the probability of widespread substitution away from fossil fuels increases. We believe renewable energy will continue to gain share over fossil fuels in the next few years but at the expense of coal rather than natural gas (which is less carbon-intense than coal but does not have the intermittency issues that plague wind and solar generators). Nevertheless, there is still the potential for value-destructive regulatory intervention (think fracking restrictions or carbon taxes). These threats are not likely enough to be included in our base forecasts, but the impact is potentially material. Fair Value and Profit Drivers | by Dave Meats Updated Jan 24, 2022 Our primary valuation tool is our net asset value forecast. This bottom-up model projects cash flows from future drilling on a single-well basis and aggregates across the company's inventory, discounting at the corporate weighted average cost of capital. Cash flows from current (base) production are included with a hyperbolic decline rate assumption. Our valuation also includes the mark-to-market present value of the company’s hedging program. We assume oil (WTI) prices in 2022 and 2023 will average $80/bbl and $70/bbl, respectively. In the same periods, natural gas (Henry Hub) prices are expected to average $4.00 per thousand cubic feet and $3.50/mcf. Terminal prices are defined by our long-term midcycle price estimates (currently $60/bbl Brent, $55/bbl WTI, and $3.30/mcf natural gas). Based on this methodology, our fair value estimate is $30 per share. This corresponds to enterprise value/EBITDA multiples of 6.7 times and 8.0 times for 2022 and 2023, respectively. Our production forecast for 2022 is 2,334 thousand cubic feet of natural gas equivalent per day, which is consistent with guidance from management. That drives 2022 EBITDA to $2 billion, and we expect cash flow per share to reach $7.27 in the same period. Our 2023 estimates for production, EBITDA, and cash flow per share are approximately 2,633 mmcfe/d, $2 billion, and $7.33, respectively. Risk and Uncertainty | by Dave Meats Updated Jan 24, 2022 As with most E&P firms, a deteriorating outlook for oil and natural gas prices would pressure Range’s profitability, reduce cash flows, and drive up financial leverage. Other risks to keep an eye on include regulatory headwinds (most notably environmental concerns) and uncertainty about future federal tax policy. More specific to Range, the flip side of having a multidecade runway of drilling opportunities is that demand for the product could have evaporated by the firm gets around to drilling it. In this industry, greenhouse gas emissions are the most significant concern (both from extraction operations and downstream consumption) along with other emissions, effluents, and waste (primarily oil spills). In addition to the reputational threat, these issues could force climate-conscious consumers away from fossil fuels in greater numbers, resulting in long-term demand erosion. Climate concerns could also trigger regulatory interventions, such as fracking bans, and drilling permit suspensions. One example of a long-term potential impact would be a switch to renewable hydrogen using wind and solar as sources for power generation compared with hydrogen generated primarily from natural gas. Capital Allocation | by Dave Meats Updated Jan 24, 2022 We assign Range a Standard capital allocation rating. The firm has historically carried too much financial leverage, making it more vulnerable to declines in commodity prices. That was also true for peers, to an extent, but Range was slower than most to strengthen its balance sheet (and is still coping with elevated leverage ratios, although there is now a clear line of sight to improvement on this front). Capital allocation has much improved. Like peers, the firm has fully embraced capital discipline and has no intention of recklessly increasing its production. It will retain at least half of its operating cash flows in the next few years, enabling it to rapidly reduce debt (some of which was issued at exorbitant interest rates as a stop-gap). For the time being, the firm is targeting a maintenance-like capital program, with low-single-digit volume growth at the most, regardless of how high spot prices get for natural gas and NGLs. Management has hinted that it is willing to step up its activity modestly if the futures curves are attractive enough, but only after other priorities--namely deleveraging--have been taken care of. Range is a low-cost producer with a lengthy runway of attractive drilling opportunities, and it would be prudent to target modest growth down the road, as long as it can do so without meaningfully increasing its reinvestment rate or compromising its robust free cash stream. The firm cut its dividend to zero in 2019, during a challenging period of high leverage and low commodity prices. This was absolutely the right approach, as it left the firm with more flexibility for debt repayment. While other peers have beaten Range to the punch with splashy capital return initiatives, we note that Range has a comparable forward looking free cash yield and has the ability to deliver similar benefits to shareholders eventually. However, debt reduction will be the immediate priority. We would expect the firm to revisit the dividend in 2022, when its balance sheet goals have been accomplished. |
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