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U.S. House Prices Analysis and Trend Forecast 2019 to 2021

Oil Companies with Natural Gas Assets to Mitigate Risks of Deepwater Drilling

Companies / Oil Companies Aug 11, 2010 - 01:16 AM GMT

By: The_Energy_Report


Best Financial Markets Analysis ArticleBlue Phoenix Inc.'s Chief Commodity Strategist John Licata says BP's Deepwater Horizon accident in the Gulf of Mexico has already resulted in oily names acquiring gas names. It will soon result in more joint ventures as companies try to mitigate the risk of deepwater drilling. In this exclusive interview with The Energy Report, John tells us why he's bullish on natural gas and why he sees more M&A activity ahead. He also offers some E&P and services names that could ultimately benefit from the rapidly morphing oil and gas landscape.

The Energy Report: Just before our interview you were talking about how the BP (NYSE:BP; LSE:BP) spill had fundamentally changed the energy sector. Could you talk about some of those changes?

John Licata: I think that we've learned some lessons on the heels of the Horizon spill. We could see a lot of revised capital cost estimates for these offshore drilling projects because many of these projects have never been done at these depths. We just saw how difficult it was to close this well at 5,000 ft. (below surface). When you look at Petrobras' (NYSE:PBR) Tupi field, it's 20,000 feet underwater, and you have to go through a salt formation. A lot of the cost estimates to develop these wells are quite conservative. You're going to see more joint ventures because companies don't want the full responsibility of an economic catastrophe on their hands.

I think companies will be more willing to work with other companies to share the costs and technology. Technology is going to become very, very sophisticated. It's essential to find technology that can go through some of these subsalt surfaces that, quite frankly, are very corrosive.

TER: Do you see joint ventures happening in both the oil and gas spaces, or will they happen more on one side than the other?

JL: Right now more companies are looking to diversify their portfolios and acquire more gas assets. I think Exxon Mobil Corp. (NYSE:XOM) made a bold move by acquiring XTO Energy Inc. (NYSE:XTO) and spending $40 billion. Now that that merger is complete, I think many people in the industry are seeking to boost their natural gas assets. We just saw Hess Corp. (NYSE:HES) announce that they have acquired 85,000 acres in the Bakken. A lot of that was oil, but there is gas there as well. I think other companies are going to follow suit and seek diversification. Most of it is going to be gas.

Royal Dutch Shell Plc (NYSE:RDS.A) just spent a few billion dollars to acquire a privately held natural gas company. I think many of the natural gas opportunities onshore are very attractive, whether we're talking about the Haynesville or Marcellus or Eagle Ford Shale, which has been getting a lot more interest in recent months. Many conference calls that I've been on the last couple of days have focused on the Eagle Ford, and I think that's going to help companies like Anadarko Petroleum Corp. (NYSE:APC) that have an interest in that area, as well as one of the companies I am very high on, SM Energy Co. (NYSE:SM), formerly St. Mary Land & Exploration.

TER: What were some of the unexpected results of the spill?

JL: Interestingly enough, companies like ConocoPhillips (NYSE:COP) and Exxon didn't have that much exposure to offshore asset plays in the Gulf of Mexico, but their share prices tended to be hurt as sentiment weighed down on the sector. But there are a lot of opportunities that could come out of this. After speaking to various management teams from drillers to E&P players themselves, and many of the service names, it seems that everyone is waiting to see what is going to happen in terms of new government legislation. They also want to see if the duration of this moratorium will be six months or not. I think that many companies, justly so, don't want to boost their capital expenditures in that region when they don't know the ramifications of the BP oil spill.

TER: What do you think the federal government will do?

JL: Over the last several weeks the U.S. government and Interior Secretary seem more willing to consider shelf drilling, which is obviously much closer to land. The shelf wells are typically up to 20 ft.; I have seen some up to 40 ft. That's shallow water drilling. Apache Corp. (NYSE:APA) is the leader in that space. I think the offshore drilling market is very speculative but not just because of the BP oil spill. It has been for years; it's very expensive to drill. But we've seen over the last few years so many companies look to offshore drilling as a means to expand their reserves, because it can be quite lucrative.

TER: You're basically saying the industry is in a holding pattern. How long will that last?

JL: I think that's going to depend on the moratorium. A lot of executives want to see if we are going to wait until November before we get the green light to move forward. At that point, it might be too late for some companies to reactivate their rigs by the end of 2010. I was on a Hess earnings call the other day and they said they were playing the wait-and-see game, but they were very willing to shift their rigs to Africa or other regions. Other companies would likely do the same. There's no reason to have idle assets when other things could be more attractive.

TER: You said the changing landscape was creating opportunities. Can you point to some specific ones?

JL: As you know, for the last two years natural gas prices have been very suppressed, and I think that has caused a lot of opportunities because many natural gas companies had to delay projects. That has caused the price of futures to be contained, but to the point where I think we're seeing some of that overcapacity start to reverse. Because natural gas has been cheap for a while, many of the coal-powered generation plants are looking to switch from coal to cheaper natural gas. The industry as a whole, which has been out of favor, is starting to get a little more attention. There's still a fear factor with natural gas, and that fear factor has been amplified by increased storm activity in the Gulf of Mexico. Even today, we were talking about another tropical storm that could possibly hit the region. So, natural gas, in my opinion, is a phenomenal play.

Many of the oil companies are going to look at these gas names and try to get involved in M&A. Some of the market caps of these natural gas companies have been hit hard over the last 18–24 months, and there are opportunities out there. It's cheaper to buy capacity than to create capacity.

TER: Do you have any specific companies in mind when you talk about takeover targets?

JL: I think SM, a company I mentioned earlier, is a very interesting name. They're in the Eagle Ford Shale, which is very attractive, and they have a partnership with Anadarko, which could be increased. The natural gas liquids (NGLs) from the Eagle Ford are very attractive. I have spoken with management, and it seems like they're more willing to beef up their presence in the region. I think that makes them a little more of a target for a larger player, especially given their exposure to the Granite Wash Shale.

TER: I was recently reading a report by Credit Suisse Group (NYSE:CS) on shale plays, and the Granite Wash Shale had the highest internal rate of return.

JL: One of the reasons that's true is that it is cheaper to drill in that area than it is in, say, the Haynesville area. You're talking about $3 million in the Granite Wash versus like $7 million in the Haynesville or Marcellus. That's one of the selling points: it is much more economical than a lot of other areas in the states.

TER: The NGLs are playing a role in that, too, right? It's a fairly liquid-rich play; but maybe not as much so as the Eagle Ford.

JL: The natural gas liquids are becoming much more attractive to Chinese companies as well. The fact that Anadarko was able to boost its presence in China makes me think that a company like SM could build their relationships with the Chinese. Although I have spoken with management and they seem to want to concentrate on North America, I would not rule out the opportunity that they could forge more ties with China. Obviously, a pre-existing relationship with Anadarko would make that much easier. Again, the natural gas liquids can be a big part of that.

TER: Are you more partial to the oily names or the gas names right now?

JL: I am more partial to the oily names that are becoming more diversified companies by beefing up their exposure to natural gas, as well as by other means, including solar. Some of the oil companies have relied too long on mature assets. A lot of these companies need a fresh injection of life. In today's marketplace, if you're not embracing alternative energy sources and cleaner energy—and natural gas is extremely clean—then you're probably doing yourself and your shareholders a disservice.

TER: Are there some other names you like in the Eagle Ford and Granite Wash—plays other than SM?

JL: Forest Oil Corporation (NYSE:FST) is an interesting name. That's one I've followed for a long time. The company's based in Denver, but they are very big in the Granite Wash area, especially the northern Texas Panhandle. The company has really been trying to focus on organic growth, and it's a company that I think is a takeover target. Their location is now a sexier area that is gaining enthusiasm. When you look at that Granite Wash or even Eagle Ford Shale, those two areas are becoming much more of a hot commodity because they tend to have more NGLs on a percentage basis that can be sold back into the market. People are going to take advantage of those economics. Whether you're looking at the Eagle Ford or the Granite Wash, I think you can't have a natural gas portfolio that's not exposed to either.

TER: Something else that is gaining momentum is liquefied natural gas (LNG). You have done some research on what's going on in Egypt and Apache's role in that.

JL: It's not all liquefied natural gas in Egypt. Some of the plays that Apache is involved in are just flat out gas fields that they're looking to cultivate. Apache was recently able to acquire some BP assets, which included increasing their presence in Egypt. Apache is the largest North American company that invests in Egypt, which has undergone a seismic shift from relying on oil to relying on natural gas.

Whether it's liquefied natural gas or just pure gas, I think that Egypt is a very interesting play. I have written a note called "Egypt, the Real Jewel of the Nile." I am absolutely amazed at how their strategic location could help Europeans get more gas through LNG or through a pipeline from Turkey that might get the green light by the end of this year. If that happens, then Egypt could become strategic in the natural gas world primarily because they could help the Europeans lessen their dependence on Russia for gas supplies. In recent years Russia has pretty much held many Europeans hostage in terms of gas, which has caused them to pay higher gas prices at very inopportune times like a very cold winter or a very hot summer.

If Apache can be successful in some of their new E&P projects in Egypt, I think we will be hearing more and more about Egypt. I am very excited to be at the forefront of research in that area.

TER: Are there some smaller companies that have some exposure to what is going on there?

JL: Not really. Apache is the largest North American investor in Egypt, and they've been there for years. It's a government that is in transition. That's kept out a lot of the smaller players.

TER: Some of that LNG from Egypt could go to China and India, right?

JL: Egypt is very fortunate in terms of its location. They can actually sell a lot of natural gas and transport it to Asian markets.

TER: And LNG sells at a premium there.

JL: It can fetch a very large premium because the Asians are looking for many different alternative energy sources. They're looking for gas because they realize that to move forward as leaders in the global economy, they need to get cleaner energy sources. Getting LNG from an area such as Egypt could be very, very beneficial to them, regardless of the premium that they're paying. If Apache can increase their discoveries, some of those premiums may fall a little, but it's my view that natural gas is the most attractive energy source we have, and that's globally.

TER: Do you have some price projections for gas through 2011?

JL: I haven't yet released my forecast for 2011, but I have an aggressive target of about $5.50 on natural gas for the end of this year. It's actually starting to get more into my range if you look at the back months trading on the NYMEX. I think that's very credible. As for next year, I think that's going to be very dependent on—and this relates to oil, too—the recovery of the employment picture not only in the United States but also abroad. I would like to better assess the landscape here at the end of the year before I start making definitive calls for 2011.

TER: Alright, what about oil?

JL: Yes, it's the same for oil. In January, I wrote a report that said oil was going to hit $87. Well, we hit $87, and we have come off since. Unless we get a really positive turn in the employment picture in this country or we have a storm that knocks out production, I think we've seen the highs in crude oil for this year.

don't think oil prices can be sustained above $90 this year. It doesn't seem credible, but for 2011, I would not be surprised if we see triple digits in crude oil again.

TER: Are we going to finish 2010 over $80?

JL: You know what? I think we will finish the year over $80. I am hopeful that at the end of Q3 and Q4, we're going to start to hear about better hiring trends, and that's going to help with demand. OPEC is really watching those prices but is not able to do anything in terms of their supply and production metrics. I think OPEC becomes a non-factor. If demand is going to increase, and supply is going to stay where it is, it makes me think that oil can very comfortably stay above $80. But I would be shocked if we end 2010 over $90.

TER: There are some plays at the refinery end that you have been researching. Tell us about those.

JL: I think the refinery business has been challenged in recent years because of pressures on the margins. We've seen that crack spreads have deteriorated over the last couple of years, but it's my opinion that the worst is over. Companies have done a very good job of cutting back output at strategic times. I think those that were able to capitalize on the misfortunes of others are set for brighter days.

TER: Crack spreads?

JL: The crack spread is the difference between the price for a barrel of crude oil, and what you can get by breaking that oil down into refined products like heating oil, jet fuel, diesel or countless others.

TER: You were talking about companies that are set for brighter days?

JL: One company that has done just a phenomenal job of building during this down time and that is poised for exponential growth is Holly Corp. (NYSE:HOC). Several quarters ago, Holly acquired assets from Sunoco in Tulsa, Okla. The economies of scale that could be realized with Holly's existing refinery, which is near their newly acquired asset, are going to be very interesting. The refinery can capture diesel, and right now diesel is fetching higher margins. It's important to note that 50% of the automobiles in Europe run on diesel; but only 5% of the autos in the United States run on diesel.

TER: And most of those are trucks.

JL: Yes, most of them are trucks. Holly will be poised to capture more upside in their business as the U.S. economy recovers—and many of those trucks go back on the road.

TER: Another company you like on the refining side is CVR Energy Inc. (NYSE:CVI). Tell us about that one.

JL: Yes, it's a smaller refining company. Much of the management that was brought into CVR has worked at larger companies. It's my opinion that management was assembled for bigger things. They could potentially put themselves on the selling block.

Most people don't realize that CVR has a pretty credible fertilizer business, and there's been talk that CVR could spin out the fertilizer business in an IPO. I think that fertilizer accounts for approximately 15% of their operating income. If we're talking about an improved economic environment in the U.S., then you would expect the demand for fertilizer to grow. I think that CVR has very interesting exposure to the fertilizer business.

TER: Is CVR's refinery in Kansas able to refine heavy crude?

JL: The Coffey Field Refinery in Kansas operates at about 110,000–115,000 barrels of oil per day. That's their gem. Coffey Field has made improvements that allow them to import a lot of the heavy, sour crude oil from Canada, which makes them different from other players in this space because not everybody can break down that heavier crude. Though smaller than many of its rivals, CVR is another company that I think can play with the big boys or could get acquired by one of them in the near future.

TER: You mentioned Petrobras earlier. It has the massive Tupi oil project off the coast of Brazil. Do you believe that Petrobras is a strong long-term investment, or should investors exercise caution given the extreme depth of the Tupi resource?

JL: Petrobras is a very good company; don't get me wrong. I just think that much of the upside enthusiasm for the name has been in place for north of a year. Most people don't realize that the Tupi field is extremely complex, and the cost estimates to develop that field are going to continue to rise. I am concerned about it, actually.

TER: Is that a sort of ripple effect related to the BP spill?

JL: I think the BP story has been partially to blame for that. I think this company will be challenged going forward to develop the Tupi field. I am having a difficult time; as much as I like Brazilian investments, I am getting a little short-roped to get into Petrobras.

TER: What are some other companies you like?

JL: I like Parker Drilling Co. (NYSE:PKD); I think that's a name that is off many people's radars. The market cap is around $500 million. I am enthusiastic about this name because I feel that most people overlook this company as a potential beneficiary of growth from the barge part of their business, which was obviously hurt by the BP spill. BP accounted for 20% of their revenues in 2009.

TER: What do you mean by barges?

JL: Barges are small platforms that are easily constructed and then moved. Most barges are used in shallow water. I believe they are among the top three barge players in the Gulf of Mexico. Parker not only has barges, they also have a really interesting subsidiary called Quail Tools. I think the rental business is a very unappreciated part of their business model.

TER: What companies does Parker have significant contracts with?

JL: I believe Exxon accounts for 10% of revenues. And Apache recently bought about $7 billion worth of assets from BP. Apache was already on Parker Drilling's client list. It makes me think Apache could be a dominant customer of Parker Drilling, and with Apache growing so much overseas, that could really benefit Parker because it's not just a domestic company. Parker Drilling gets over 50% of its revenues from outside the United States.

And if BP can sell more assets, including those in Alaska, Parker Drilling might come out of this with a much stronger customer base than what it had prior to the Horizon spill.

TER: Are there other service companies that you're big on?

JL: I like Weatherford International Ltd. (NYSE:WFT). Weatherford is beefing up their presence overseas. Weatherford and Schlumberger Ltd. (NYSE:SLB) are very big in the Middle East. When countries in the Middle East, like Iran and Iraq, open up the bidding (for prospective oil property) to E&P companies, it's more attractive for the oil service names. While the E&P companies will fight for those contracts and deal with the political pressure, it's the service names that will end up doing a lot of the work on those wells. Those two companies, Weatherford and Schlumberger, are going to move up very well in the next couple of quarters based on recent developments.

TER: Any final thoughts on the oil and gas sector?

JL: The companies involved in the cleaner side of the energy landscape are going to do very well moving forward. Natural gas historically trades at a discount to oil of between of 10–12 times; right now we're about 19 times below. That gap is going to narrow with natural gas prices moving higher. I think that prices could be comfortably higher a year from now.

And most people are not focusing on the congressional elections in November, but it's my belief that many of those races will be determined on stances related to cleaner energy. On the heels of the BP oil spill, I think that we're going to see a more concerted bipartisan effort to focus on cleaner energy. We have a really amazing opportunity in our lifetime to improve our domestic sources of alternative energy and lower our reliance on Middle Eastern oil. To me, that time is now.

TER: Thanks, John, for your insights.

John J. Licata is chief commodity strategist at Blue Phoenix, Inc., an energy/metals independent research and consulting firm based in New York City. He has appeared regularly in the media (CNBC, Bloomberg TV/Radio, Business News Network, Barron's, etc.) over the years for his insights and forecasts in the commodity spectrum.

After studying economics and graduating from Saint Peter's College (where he received The Wall Street Journal Award for economic excellence), Licata set his sights on Wall Street. During his more than 15-year career, John has held both trading and research positions on the NYMEX, and at Dow Jones and Smith Barney. Early in 2005, he founded Blue Phoenix, a leading independent research and consulting firm focused on energy and metals. John is also the editor of The Commodity Chronicles, the Blue Phoenix energy and metals newsletter (click here to receive a 30-day trial membership). John is currently in the EMBA program at New York University's Stern School of Business, and was recently voted "Up and Comer Natural Gas Analyst" in the 2010 Institutional Investor All-America Research Team Poll. You can follow John on Twitter and LinkedIn.

Want to read more exclusive Energy Report interviews like this? Sign up for our free e-newsletter, and you'll learn when new articles have been published. To see a list of recent interviews with industry analysts and commentators, visit our Expert Insights page.
1) Brian Sylvester and Karen Roche of The Energy Report conducted this interview. They personally and/or their families own shares of the companies mentioned in this interview: None.
2) The following companies mentioned in the interview are sponsors of The Energy Report: None.
3) Greg Gordon: See Morgan Stanley disclosure that follows.*

*The information and opinions in Morgan Stanley Research were prepared by Morgan Stanley & Co. Incorporated, and/or Morgan Stanley C.T.V.M. S.A. As used in this disclosure section, "Morgan Stanley" includes Morgan Stanley & Co. Incorporated, Morgan Stanley C.T.V.M. S.A. and their affiliates as necessary.

For important disclosures, stock price charts and equity rating histories regarding companies that are the subject of this report, please see the Morgan Stanley Research Disclosure Website at, or contact your investment representative or Morgan Stanley Research at 1585 Broadway, (Attention: Research Management), New York, NY, 10036 USA.

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