We have notched up our fair value estimate for Range Resources to $36 per share from $35 after taking a second look at the company's first-quarter operating and financial results. There is no major change to the 2022 outlook, as management's guidance for production and capital spending were both in line, despite strong inflationary pressure across the upstream space. Instead, we attribute the increase to the further strengthening of commodity prices since our March 21 update, especially on the natural gas side. There's no change to our long-term forecast of $3.30/thousand cubic feet for U.S. natural gas, but strong export demand has pushed up near-term prices and infrastructure constraints are preventing U.S. gas firms from delivering the requisite supply response. That sets Range up well to generate substantial free cash flows in the next couple of years, and at the current price, we don't think the firm is getting enough credit. At the last close, the shares were trading 22% below our updated fair value estimate.

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 companies 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 revenue. But that regime looks to be over. A surge in LNG and NGL export capacity, coupled with maintainable 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 maintainably higher pricing.

The ability to generate maintainable 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 West Texas Intermediate averaging $55 a barrel and Henry Hub natural gas at $3.30 per thousand cubic feet). And with over 2,000 potential drilling locations in its inventory, the firm has multiple decades of runway in the play, differentiating it from most of its gas-focused E&P peers. 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 environmental, social, and governance 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 greenhouse gas intensity by 80% between 2011 and 2020 and is targeting a further 15% reduction by 2025. 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.

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 $100/bbl and $87/bbl, respectively. In the same periods, natural gas (Henry Hub) prices are expected to average $7.30 per thousand cubic feet and $5.60/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 $36 per share. This corresponds to enterprise value/EBITDA multiples of 6.5 times and 6.6 times for 2022 and 2023, respectively. Our production forecast for 2022 is 2,116 thousand cubic feet of natural gas equivalent per day, which is consistent with guidance from management. That drives 2022 EBITDA to $3 billion, and we expect cash flow per share to reach $10.68 in the same period. Our 2023 estimates for production, EBITDA, and cash flow per share are approximately 2,254 mmcfe/d, $3 billion, and $10.74, respectively.

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.

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. Its leverage ratios finally reached a comfortable level in the back half of 2021, and further deterioration is very unlikely, given the firm's solid free cash generating profile.

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—like deleveraging and funding competitive capital returns—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 were quicker to the punch in rolling out splashy capital return initiatives, it was prudent for Range to prioritize the balance sheet. Now that the balance sheet is under control, we expect management to pivot to shareholder returns. The firm has already reinstated its base dividend with a modest yield of just over 1%.