The Runts in the Natural Gas Litter

Jim Brown
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After spending the last two days profiling the six largest gas producers and their potential as takeover candidates it is time to turn our attention to the smaller producers in the sector. You would think that the smaller companies might be the more likely targets but in reality for a big oil company trying to scale into a large gas position it is better to take advantage of another companies years of acquisitions and large infrastructure rather than pick up a couple minor leaguers that are spread to thin or too localized to provide that big increase in reserves.

Small producers are not all bad. Some of the small producers have done an admirable job of accumulating some large lease holdings. The problem is that the small fry are left to squabble over the crumbs left by the majors. Like I mentioned yesterday a landowner would much rather lease to Exxon (XOM) or Chesapeake (CHK) than Joe's Water and Gas Well Drilling Company. They are much more likely to get some decent wells drilled with the bigger companies.

That does not mean that the smaller companies only win the crap leases. Some of the leases are decent properties but they may be to small for somebody like Chesapeake to trouble with or they might be off the beaten track, which means they have to build their own infrastructure. Again, that is not specifically bad if they have a killer lease deal and prospects for good production.

A small driller may only have the capability of 50-100 wells a year and a 300-400 well project can be very worthwhile. It just depends on the quality of the land and the capital behind the driller.

That makes the analysis for the big dogs in the hunt for an acquisition that much harder. These smaller companies don't necessarily have all the disclosures and open books that it will take to make a decent bid. Because they are small they tend to keep things close to the vest to keep somebody from stealing their crumbs.

The other side is also true. Some companies want to be big so badly that they trumpet every well, every test, every accomplishment in the press so often that they become their own tout sheet promoter. For them it is a big deal and they want to be accepted by their peers. They may even be hoping some big player will knock on their door offering them a buyout.

Before I start naming names I want to make perfectly clear that I am not categorizing any of these companies in any way. Some of these are great companies that we should not mind owning. I am not saying the rest are trailer trash because each has its own good points.

Cabot Oil & Gas (COG) is one of my favorite small producers. The company was founded over 100 years ago in Pennsylvania. They recently sold their Canadian assets to concentrate on their core businesses in the Marcellus and Haynesville Shales, the Rocky Mountains and Anadarko Basin. Cabot has 1.9 TCF of proven reserves with 97% of that in gas. Cabot has above average production growth and recently reported better than expected Q3 earnings. They drilled 432 wells in 2008 with a 97% success rate. Cabot has 3,200 miles of pipeline and 4 BCF of storage capacity. With a market cap of only $4 billion they are a pipsqueak in the sector but a quality company. Because they don't go around blowing their own horn the stock price appreciates at about the same rate as paint drying. Good company but no sex appeal. The spike in the stock price on the XTO news finally put them over resistance. It might be the time to buy them when a pullback appears.

Chart on Cabot

Southwestern Energy (SWN) was one of those fast growing companies several years ago that had to be everywhere and do everything. The stock was a favorite of the momentum crowd and was fairly easy to trade with occasional bouts of extreme volatility. When the oil and gas bubble burst in 2008 Southwestern went on a selling spree in a rush to deleverage and survive.

Southwestern bills itself as a "gas gathering and marketing" company but they sold their utility subsidiary in July 2008 and no longer have any gas distribution operations. They also sold wells and leases in the Permain Basin, Texas Gulf Coast and wells and gathering facilities in the Fayetteville Shale although they are still active in the Fayetteville. This drastic reduction in operations has produced additional cash and allowed them to concentrate on their core holdings.

They just announced a $2.1 billion capex program for 2010 and plans to operate 14 horizontal rigs in the Fayetteville Shale, two in east Texas and begin drilling operations in the Marcellus Shale in January. (I don't think companies get any respect unless they have operations in the Marcellus Shale. That is the hot spot today.) SWN is moving one rig there so they can say they are in the Marcellus.

Production in 2010 is expected to be in the range of 400 Bcf and is actually about 36% over 2009 levels. They are producing gas and with a market cap of $16 billion they have some breadth even after their recent restructuring. They are expecting net income in 2010 of around $650 million. The biggest problem SWN has in attracting a suitor is their corporate image. They still seem to have the stigma from their self promotion phase and it will be interesting to see if a larger company wants to take on SWN as a partner.

Chart of Southwestern Energy

Continental Resources (CLR) is an up and coming name that really did not attract much attention until a couple years ago when they listed on the NYSE in May 2007. They fell into the routine announcement trap just as the 2008 gas bubble occurred and they jumped from $20 at the beginning of 2008 to nearly $84 by July. The return to sanity was equally quick with a drop back to $12 by November 2008. This rocket ride round trip disillusioned investors and demoralized management. They are back on track now with operations in the Rockies, Mid-Continent and Gulf coast regions. 70% of its reserves are in the Rockies.

They are very active in the Bakken. Continental had a bad Q3 with profits falling -67% because of lower crude and nat gas prices. Revenue declined to only $170 million. Continental recently announced they were upgrading their capex to end 2009 with 12 active rigs compared to the prior target of six rigs.

That last sentence should be the clue. Six rigs? This is a small company that is trying to grow fast and reclaim some of the limelight they saw in 2008. It is going to be a rough road but investors seem to be warming to their efforts. After moving sideways after the dismal Q3 the stock did rally on the XTO news. I personally think they are too small despite a $7 billion market cap. Their better growth opportunity would be to merge with another small company and try to scale up through mergers than slog it out in the trenches trying to get to 12 active rigs.

Chart of Continental Resources

There are three other players in the sector that deserve mentioning but I doubt they would be targets for a Conoco, BP or Total acquisition. Those are Carrizo Oil (CRZO), Quicksilver Resources (KWK) and Newfield Exploration (NFX). Quicksilver at $3 billion in market cap is getting some investor attention with decent buying at the 100-day average over the last year. Somebody is picking up shares when the opportunity presents itself.

There are other gas producers but the ones I have profiled over the last week are the ones most likely to be targets for hungry predators. Anadarko (APC), Chesapeake and Encana (ECA) are the most likely targets because of their scale.

Jim Brown