Antares Energy: Shale we dance?

American gas producers once trumpeted technology that allowed gas to be produced from impermeable shale rocks. Now, as a glut of supply forces prices lower, fracking (see Shoptalk) and horizontal drilling are no longer solutions; they have become the problem.

As supply explodes, US gas prices are at generational lows. Gas is so cheap that it is displacing coal as a generation fuel; it has silenced calls for nuclear power, rejuvenated the chemicals business and, some say, may bring manufacturing back to America. Bulls even suggest that, with cheap energy, costs of production in America now approach those of inflation prone China.

The enthusiasm is understandable but probably misplaced. It’s true that gas prices are low but they’re unlikely to stay that way. Gas producers are bleeding cash, continuing to drill only because lease contracts prevent them from doing anything more sensible, like slowing activity. Already, new demand is hungrily devouring available supply and prices are starting to rise.

Thus the argument for US shale stocks, a contrarian play if ever there was one. We’ve had an eye on Antares Energy for some time; your analyst picked it as one of his top three stocks for three years and it was introduced briefly in a Friday Fishing article on 27 April 12. Now, we’re making the case to buy it.

Location, location

Antares is no stranger to shale gas. In 2004, the company started drilling sections of the Eagle Ford Shale in Texas where, although it found plenty of gas, falling prices resulted in low rates of return. Realising that dry gas—gas free from associated oil, condensate or other liquids—would struggle to earn a return if gas prices stayed low, the company sold the asset to industry giant Chesapeake Energy in 2010.

The asset was poor but Antares did well enough from it. After buying its tenements for US$200 an acre, it sold them for over US$8,000 an acre, collecting US$200m.

Antares bought its next asset with lessons from the Eagle Ford experience in mind. Only projects producing liquids (either oil, condensate or natural gas liquids) would do. The purchase of 30,000 net acres in the Permian Basin, also in Texas, met these strict conditions; it was undeveloped, cheap and liquids rich.

Since 1959, the Permian has produced more than a billion barrels of oil, mostly from conventional reservoirs. Today, it’s the hottest shale basin in North America. Two characteristics make it particularly attractive; shales are stacked thickly and sections are rich in oil.

Table 1 compares the thickness of shale sequences and the oil in place (OIP) per section of shale between the major shale basins. The Permian is a standout.

Thick shales stacked on top of each other mean vertical rather than horizontal wells can be drilled. That’s a crucial difference. Vertical wells cost just 20% of a typical horizontal well. The high productivity of shales also means more oil can be recovered (5%-10% of the total in place) compared with other basins (which average 3%-5%).

Without a doubt, the Permian is the best place to be hunting for oil and gas from shales. With liquids providing 90% of revenue and 70% of output, Antares is protected from low gas prices but set to profit should they rise. For investors seeking exposure to the bombed out US shale gas price, it’s ideal.

Production goes up

Best of all, Antares looks underpriced. A comparison between Permain Basin producers (see Table 2) shows that Antares is, in fact, amongst the cheapest when valued on an acreage basis.

On a reserves basis, it’s also cheap, trading on an enterprise value to proven reserves (EV/1P) of just US$9 a barrel. Including proven and probable reserves, that figure falls to about US$5 a barrel. With reserves highly reliable and likely to rise, Antares looks cheaper than it should be.

Why might the market be discounting it? To increase the value of its Permian assets, the company must drill continuously to extract oil and gas. It will drill 100 wells over the next three years to lift production from 2,000 barrels of oil equivalent per day (boepd) to over 5,000 boepd. To pay for that drilling, it will take on debt.

Macquarie Group has provided an attractively priced debt package (LIBOR 4%) of US$200m, significantly more than the company’s current market capitalisation. By our estimates, debt will peak at US$120m before subsiding. While the company will book profits, continuous drilling means that free cashflow is still several years away, assuming today’s prices.

If oil prices suddenly halved, debt repayments start to become a problem. The presence of debt means that this speculation could go to zero. That means Antares is only for members that accept the case for sustained higher oil prices (see The case for oil).

So why take the risk? Management has an excellent track record, the asset quality is high and, so far, the company has done exactly as it said it would. As production levels increase, the value of the Permian Basin assets will rise. This is a play on asset values more than cashflow.

Table 3 models our best guess scenario for how the company might look over the next three years. We’ve assumed oil prices of $90 a barrel, gas prices of US$3.50gj and natural gas liquids prices of US$45 a barrel. As drilling increases, production rates will steadily climb.

Each well drilled will cost about US$2m and, on average, pay back costs within a year. Although production levels fall away after the first 12 months, wells will continue to produce gas for years and Antares should make generous returns on each well it drills.

The plan to drill 100 wells is fully funded and production rates to date are exceeding expectations. The probability of Antares meeting its production goals is higher than the market’s valuation for the business suggests.

US gas prices don’t need to rise for Antares to be a success but if they do, it will be the icing on an oily cake. The investment case is built on the asset value of Antares’s ground increasing with production rates. It is a tale of higher asset prices rather than one of higher commodity prices.

This is a risky situation but we’re betting the market hasn’t priced the probability of success correctly. For 2% of a risk tolerant portfolio, we’re recommending Antares Energy as a SPECULATIVE BUY.