Natural Gas Will Fuel The World For Decades To Come (Range Resources, NYSE: RRC)
This week’s article covers the oil & gas industry with an equity report on Range Resources, a natural gas producer in the Appalachia region. To skip to the equity report, please follow this link.
There’s been a lot of good news in the energy sector in recent weeks. To work our way backwards, OPEC+ on 4.2.23 announced a monster production cut of 1.16mmbbl, or roughly -1% of global production, with further pledges to reduce production by 3.66mmbbl, or -3.7%.
To provide some background on OPEC+, the Organization of Petroleum Exporting Countries is a cartel of state-run oil producers. OPEC and its 13 member states control roughly 80% of the known oil reserves and produce roughly 40% of the global supply. For reference, the US and Russia (Russia is the “+” in OPEC+) each produce around 10-12% of global production.
Another headline that came across my desk articulated that Japan is no longer honoring the pricing cap on Russian-produced oil. According to the Wall Street Journal, Japan purchased 748,000 barrels of oil from Russia over the last two months for an average price of $70/bbl, or a 16% premium over the price cap of $60/bbl. As for natural gas, Russia supplies roughly 10% of Japan’s gas (as compared to 55% of Germany’s gas supply, pre-Ukraine invasion). Though oil exports to Japan is a relatively small fraction of Russia’s total production, which has been around 9.8mmbbl/d, or just under 10% of global production, this isn’t the first occurrence of a country abandoning the price cap and may open the door for more to bypass the cap.
The last headline to mention is the approval of oil production in Alaska. ConocoPhillips (NYSE: COP) was granted approval to begin construction for the 180,000bbl/d Willow project. This project is decades in the making, with ConocoPhillips discovering and developing Alaska’s Northern Slope since 1965.
History & Economics
Oil, amongst other commodities, is priced based on the basis of supply & demand balances. When supply outpaces demand, as seen in 2021, prices will rise and vice versa. Production competition can also be fierce and highly combative, as seen in 2014 when prices went from peak to trough of $130/bbl to ~$29/bbl, or -77%, and again in 2019 when OPEC and Russia fought for market share, dropping the price per barrel by -35%.
OPEC meets at least twice each year to discuss the economics behind the supply and demand for oil. Much of the discussion covers how much oil will be produced by each country to meet a certain price range for the commodity. Unlike traditional open markets, volumes are collaboratively determined (Bertrand Model) as opposed to allowing each country to produce at their own determined volumes without knowing the competition’s targets (Cournot Model). The Bertrand Model can be beneficial in a global economy as long as everyone plays well. Setting the volumes with a price target in mind protects against price volatility, helps forecast capital budgets, and in state-own oil companies, helps budget for social programs. The detriment to this model can reveal the greedy underbelly of industry by creating disparity for buyers. Outside of OPEC+, producers rely on the Cournot Model and produce to maximize profits and, as of recent, maximize shareholder returns.
Much of the production dynamics in OECD countries (Organization of Economic Cooperation and Development) rely on the Cournot Model. Despite producers’ independent production targets, much of the economics have changed in recent years since 2020 when oil prices took a monster dive to -$30/bbl. During this time, independent producers plainly stated that they will no longer produce to take market share, but to produce to maximize shareholder value. Scott Sheffield, CEO of Pioneer Natural Resources (PXD) was one of the first to famously state this back in 2021. This inevitably led to a cascade of energy executives limiting investments to maintenance and 5% annual growth. This was a game changer. In doing this, the global oil markets were able to experience a recovery like no other and expand cash generation.
The natural gas market, on the other hand, is highly dependent on the oil market. At a high level, oil wells produce an abundance of natural gas; however, natural gas wells do not produce much oil. Wells in the Permian Basin produce something like 50/50 & 60/40 oil to natural gas. Wells in the Marcellus, a gaseous basin in the Appalachia region, produce something more in the range of 70% natural gas with NGLs and oil making up the rest.
On an equivalency basis, one barrel of oil and NGL (natural gas liquid) can be converted to roughly 6mcf (thousand cubic feet) of natural gas. To state this in pricing terms, $1 of natural gas can obtain 200,000 units of energy, assuming $5/mmBTU, compared to $1 of WTI oil producing 60,000 units of energy, assuming a spot rate of $97/bbl – CME Group.
Natural Gas Markets
Natural gas is an entirely different animal to oil. Because natural gas comes from both dry gas wells and associated gas from oil producing wells, production is much more abundant. In fact, gas has historically been so abundant that oil producers would flare excess gas to limit transportation costs. This has slowly been changing, however, due to a variety of factors, including greenhouse gas reduction and financial gain. The abundance of domestic natural gas has sparked a major shift into the development and expansion of LNG (liquified natural gas) export terminals all across the Southern Coast off the Gulf of Mexico to ship to regions with limited resources, such as Japan, China, and the EU. The chart below is per EIA. For example, Cheniere (LNG, CQP) supplies roughly 11% of the global supply of LNG, or 45MTPA (metric tons per annum). This is a big business for natural gas producers and exporters, and it’s only going to get better (more on that later).
Because of the abundance of natural gas and the reduction of flaring in major oil basins, natural gas prices have remained relatively suppressed excluding a few occurrences. One of these occurrences was in 2022 as the EU scrambled to secure natural gas to supplement lost flows coming out of Russia. Pre-Ukraine invasion, Russia supplied upwards of 55% of the EU’s natural gas. In total, the EU imports approx. 83% of natural gas from other countries.
Much of the gas imported from Russia came through the Nordstream I pipeline. Russia, in coordination with the EU, was in the process of bringing online an expansionary pipeline, Nordstream II, prior to the invasion. Contrary to popular belief amongst financial advisors, Nordstream II never came online due to a lack of certifying operations by the Dutch government. It was actually quite a funny story due to a mix-up between the German government and the Dutch government providing the certification. It seems like even big government agencies don’t have their ducks in a row (here’s some positive reinforcement for all our little screwups).
As time progressed and the Russian military operations moved from standard training to a full-blown invasion, the EU began devising a plan to tiptoe into sanction against Russia without disrupting their supply of natural gas. It’s amazing how the EU didn’t expect Russia to retaliate given how publicized these discussions around reducing Russian gas dependency were. It’s like they were actively nibbling at the hand that feeds them, hoping the hand wouldn’t notice. To the world’s surprise, Russia got the jump on the EU and cut off the gas supply due to regularly scheduled “maintenance” and never turned the gas back on.
As this event unexpectedly unfolded, the EU went into full-blown panic mode in one of the biggest attempts to secure natural gas from around the world.
This led to one of the biggest spikes in natural gas spot pricing the world has ever seen. As the EU scrambled to secure contracts to refill its natural gas storage tanks for the coming winter, adversity hit the streets. Many countries independently limited power utilization across residences and businesses in an attempt to preserve what little natural gas the bloc had for the upcoming winter.
Long-term effects on industry and growth are to be unraveled. Similar to the effects of lockdowns during C19, slowing or shutting in production during the energy crisis can and will have long-term rippling effects as new paths for sourcing materials are drawn.
Though the EU’s gas preservation tactics were a success, it came with a huge cost to not only manufacturing, but also to hitting milestones to a carbon-neutral economy (Paris Accord). Through necessity, the EU developed a series of pipelines and LNG import terminals to facilitate their new sources of natural gas, costing the bloc roughly $12b just for the infrastructure.
Since then, natural gas prices have waned back to more normalized levels, but don’t believe for a second this is all over. This is only Act I of the production. As the year goes on and as manufacturing picks back up across the EU, more natural gas will need to be sourced and utilized to bring the economy back into balance. The EIA estimates natural gas consumption in the EU to rise to 536BCM (billion cubic metres) by 2040, from the current level of 397BCM, with 90% of this gas being imported.
On the domestic front (back to the US), natural gas is continuing to expand in utilization.
The following graph outlines domestic consumption
.Natural gas is prominently utilized in industrial and power generation capacities. Natural gas generates roughly 38% of the electricity across the US. For more info, please read Earth, Wind, and Fire: Nuclear, Wind/Solar, and Natural-gas Fired Power Plants (AGX) (substack.com)
Natural gas is widely consumed in multiple fashions, not just your gas stove. Without getting into the details of fractionization, natural gas produces a variety of hydrocarbons, such as ethane, butane, propane, pentane, ethylene, propylene, and isobutylene. These chemical compounds have a variety of uses such as packaging, containers, fibers, and fuels. Much of these are used as feedstocks for making plastics, and coatings, amongst other things.
Looking forward, natural gas production and consumption are expected to trend higher through 2050. The EIA’s chart above has a dispersion between gas production and consumption, suggesting more gas will be exported to other countries as listed above.
Despite a growing demand for natural gas, there does appear to be some turbulence in the manufacturing space. The manufacturing PMI fell to 46.3 in March, down from 47.7 in February. As discussed in previous writings, a PMI reading above 50 suggests expansionary activity while a reading below 50 suggests a contraction in new business. One of the external factors that is heavily affecting manufacturing is the increasing financing costs. Higher oil prices may also have some effect on new projects given higher transportation and feedstock costs. The Eurozone also had a negative reading, dropping to 47.3 off of 48.5 for the same period. China’s reading was flat, right at 50. South Korea and Japan also experienced lower readings at 47.6 and 49.2, respectively.
Considering that new manufacturing orders and backlogs are shrinking, we can presume demand for natural gas may wane slightly as the economy churns through the recession. How much this affects natural gas pricing is at the top of mind. More importantly, how this affects volumes needs to be considered, given the oil and gas dynamics outlined earlier in this reading. Please read of the challenges faced in the shipping industry here: Driving The US Out Of A Recession (Rush Enterprises (RUSHA, RUSHB)) (substack.com)
To summarize, there will be near-term challenges in the global economy. It seems the keys are in the ignition of a stalled-out vehicle that’s slowly backing to the edge of a cliff. Though the current environment appears very dismal, there may be some bright spots to consider as we drop off deeper into recessionary territory.
Range Resources (NYSE: RRC)
Range Resources is a natural gas exploration and production company based in Fort Worth, Texas with primary operations in the Marcellus basin in Pennsylvania in the northern-region of the Appalachia. Range Resources currently has 894,000 gross acres under lease consisting of 18.1TCFe of natural gas in the gaseous region and operates 2 horizontal drilling rigs. The Marcellus basin holds roughly 60% of the known natural gas reserves in the US and consists of roughly 98% natural gas and NGLs.
Range Resources was founded in 1976 as Lomak Petroleum, in the business of exploring new high-risk territory for unconventional gas plays. Range Resources was the result of a merger between Lomak Petroleum and Domain Energy Corp. in 1998. Their original operations were more broad, spanning much of the Midwest, Texas, and New England areas in search of natural gas reserves. Through a series of transactions and asset sales, Range Resources inevitably concentrated its assets in the Marcellus basin. In fact, Range Resources was the first to pioneer the exploration and recovery of natural gas in the Marcellus basin, the largest land-based natural gas reserve in the US. At the time, predating horizontal fracking, these assets were seen as high-risk; however, this investment paid off through the improvement in drilling technologies and continues to pay off handsomely.
Range Resources today is a very investable company, though it faces some headwinds. As you’ll read in my equity research report, Range Resources faces tough FY23 comps as the natural gas strip prices for FY23 averages to ~2.72/mcf, well below FY22’s PV-10 valuation using $6.36/mcf. Overall, this is only a near-term headwinds in stock valuation and the long-term opportunity still holds. As shares are expected to revalue at a lower price of ~$21/share, I believe this will create a good buying opportunity to build a position to experience the ride up as the demand for natural gas improves. Please follow the link to the equity research report as found on SeekingAlpha.
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