EQT: 4 Key Takeaways From The Q3 2015 Investor Call
EQT reported a tough Q3/15 but that much was expected – the important updates were given on the investor call that followed the financial updates. EQT, even in advance of presentations to its Board, was able to be granular with forward-looking expectations. I have to wonder about risk management of an EQT position at this point in time – I wonder if investors shouldn’t be managing total capital exposure. EQT (NYSE: EQT ) is out with a tough quarter. Still, much of what EQT reported was expected as the energy sector continues into what have been historically punitive pricing environments. That said, the Q3/15 reporting exemplifies perfectly the pressure that even quality E&Ps like EQT are under: Q3/15 adjusted loss of $0.33 per diluted share, representing a $0.83 per share decrease Y/Y Q3/15 adjusted operating cash flow of $156.3 million, a 46% decrease Y/Y Q3/15 adjusted operating revenues of $188.5 million, a $142.5 million reduction Y/Y Production sales volumes increased 27% compared to the third quarter of 2014 Average realized price of production of $1.21/mcfe, a 55% decrease from $2.69/mcfe Y/Y With EQT’s financials being expected as reported, this placed an extra importance on the investor call that followed the financial reporting. EQT CEO David Porges, SVP & CFO David Conti, and EVP & President of E&P Steven Schlotterbeck did well to cover a wide range of topics on the call. The team also did well to break out as much of the go-forward strategy at the E&P as possible in advance of a presentation of this information to the Board in roughly six weeks. Put simply, without having Board approval, and with being respectful to not presume Board approval, the management team tried to be as granular as possible. The following is my analysis of the key takeaways. Capital Plans and Play Deployment… “Given this potential for lower long-term gas prices, we do not think it’s prudent to invest much money in wells whose all-in after-tax returns exceed our investment hurdle rates by only a relatively small amount. As a result, we are suspending drilling in those areas such as Central Pennsylvania and Upper Devonian play that are outside that core. This decision will affect our 2016 capital plan though we are just starting to develop the specifics of the 2016 drilling program that forms the core of that plan. The focus in 2016 will be on this more narrowly-drawn notion of what the core Marcellus would be assuming the deep Utica play works… We will also pursue the deep Utica play with a goal of determining economics, size of resource that midstream needs and on lowering the cost per well to our target range. Our initial thoughts are a 10 well to 15-well deep Utica program in 2016 with flexibility to shift capital between Marcellus and Utica as warranted based on our progress… I feel uncomfortable putting numbers out there when we’re still what six weeks away from putting numbers in front of our own board. But if you’re looking for directional, it would be – clearly we’re heading less than 2015” A few things were made clear by Porges early on in the call. The first, that EQT is taking operations quite literally day by day. The second, that EQT has to do something regarding what are near-zero ( maybe even negative IRR) after-tax Core Marcellus IRRs on production (SEE: graphic below – current NYMEX is $2.29). I want to think that the returns outlined in EQT’s October investor deck are a blended core rate, but the slide is pretty clearly labeled “Core Marcellus”. If that’s the case, I’m having a hard time seeing where EQT can deploy capital that can be productive . That said, I think Porges was alluding to this as well. He and EQT aren’t willing to continue to invest in wells of this ilk and obviously that’s the only decision that makes sense. In that, EQT is looking to move into its Utica assets (which it believes are deep core) in an effort to begin averaging up IRRs at current NYMEX spot. The big takeaways here? EQT is hurting in a big way on Marcellus production and EQT is going to begin looking elsewhere for the derisking of production. This makes full-year 2016 one of the riskiest on record for the company. Stay tuned here. (click to enlarge) Capital Plans and Play Deployment PART 2: Investments into the Future… “Yeah, we look at all-in return. All-in after-tax returns is the way we tend to look at things. But that overlay that I mentioned in my prepared remarks was we just think we need to bear in mind what if the deep Utica works and what does that mean for clearing prices, et cetera, and therefore we should be particularly cautious about investing in anything but the core Marcellus which does stand up still in those environments and in the core Utica. So, it’s more of that. There’s always uncertainty about what prices are going to be. But whenever you have a new low-cost supply source in any commodity business, you’ve got to start being wearier of where one wants to invest one’s money. So, I think there’s a certain amount of caution that we’re taking that we’re talking about because of that unknown because of not knowing yet the extent to which the deep Utica will work… But our feeling that if it works the way it’s looking like it might that the core areas for Marcellus and Utica are simply going to be narrower. I mean, we’re going to be able to supply a big portion of North America’s natural gas needs from a relatively small geography.” This is hugely important and for me this is a reason to either risk off EQT, even assuming serious mean reversion to 52-week highs on oil beta and then natural gas beta, OR to manage total capital exposure (this can be done using CALL and PUT options as well). For me, Porges is alluding that the Marcellus is staring at potential disruption from the Utica. The Utica core, which EQT does have exposure to and that’s important to remember, is expected to be much, much more cost effective from a production standpoint (at least for EQT) than the non-Marcellus core production at the E&P currently. Porges believes that if the Utica core plays out how it is expected that the Marcellus core by comparison will shrink substantially. Outside of the Marcellus core, because of geographical proximity, it just wouldn’t be competitive to produce in the Marcellus . That matters in a big, big way for EQT. Again, this total uncertainty and required conservatism, which is smart, to me makes the full year one of the riskiest ever at EQT. Be careful when staring in the face of disruption. Production Estimates… “Our preliminary estimate for production volume growth in 2016 versus 2015 is 15% to 20% which we will refine when we announce our formal development plan at early December. If we turn online our fourth quarter wells in late December, as contemplated in our fourth quarter guidance, 2016 growth would likely be near the upper end of that range as those wells would contribute little if anything to volumes until early 2016. Obviously, this overall approach will result in a 2016 capital budget, absent any acquisitions that is a fair bit lower than 2015 and would result in continuing (16:28) of cash on hand as of end 2016 but we will provide specifics in December.” So this was short but meaningful. Keeping with the theme of “day by day” management, the only certainty at EQT at this point is lower CAPEX and potentially 15%-20% production increases based on 2015 activities. EQT isn’t willing, and this makes some sense being in advance of its Board presentations, to commit to any production increases from 2016 activities. At least that’s my read. My guess is, and I’ll reserve the right to be wrong about this, that EQT’s production growth doesn’t come anywhere near the top-end of this range and that its CAPEX sees not one but two big cuts into 2H/16 (the conclusion of 1H/16). I just don’t see the above-noted conservatism and overall NYMEX spot expectations as being productive to increased production. M&A… “Finally, the deep Utica potential has also affected our thoughts around acreage acquisitions. Given our view that our existing acreage sits on what is expected to be the core of the core in deep Utica, we are focusing our area of interest even more tightly on acreage that is in our core Marcellus and potentially core deep Utica area. As you can probably deduce from the lack of significant transaction announcements, the bid/ask spread continues to be wide… We are a patient company and believe that there will be acreage available at fair prices eventually. But the definition of fair has to contemplate the potential that the deep Utica works. We do not think that bodes well for that price of acreage concentrated in anything but the core Marcellus and core Utica. This narrowing focus also suggests that smaller asset deals are much more likely than larger corporate deals. However, as we have stated previously, we are comfortable maintaining our industry-leading balance sheet even as we look for opportunities to create value.” (Steven T. Schlotterbeck – Executive Vice President and President of Exploration & Production) “So, right now, it seems like there’s – people are interested in selling assets. So far, the prices have still been a bit high. But as Dave said, we plan on being patient waiting for what we would consider fair prices before we transact.” Porges’ thoughts here are basically what those following this space have been hearing dating back to November of 2014. The bid/ask spreads are too wide and continue to be too wide for increased M&A velocity. I outlined this dynamic in a recent Exxon Mobil (NYSE: XOM ) note , detailing how Exxon has used this spread to its advantage. That said, if we continue into a lower for longer (which, of course, is the expectation of this space), look for EQT to be in position to take assets at even further firesale prices as those currently marketing assets will likely have to take lower subsequent pricing as their balance sheets continue to degrade in structural integrity. That would bode well for longer-term EQT investors, as EQT might be able to “reset” its blended Utica/Marcellus IRRs by force rather than by organic development . If EQT can bid away core Utica acreage (assuming production does prove out to be more competitive in size than core Marcellus production), this would derisk its Marcellus-focused model significantly and have the E&P back on the board as one of the safest plays in this space (natural gas focused from a resource standpoint). That’s the big takeaway from this excerpt. That and EQT might be able to play a lower for longer, which is punitive to its financials in the immediate term, into securitization of seriously competitive long-term viability. It’s just as beneficial sometimes to be lucky as it is to be good. Again, stay tuned. Summary Thoughts… I’ve been an EQT bull in the past and I’m not implying anything of catastrophic risk in the immediate or the mid-term. I believe in EQT’s balance sheet, management, and operations as-is currently. But, and this is important, if the Utica usurps the Marcellus as the low cost, prolific production source in the geographic area, that’s going to matter in a big way for EQT. With EQT management being clear about that on the Q3/15 investor call, I think investors should take into consideration what that should mean to risk management. I would recommend taking a hard look at capital exposure to this name and at considering hedging that exposure via CALL or PUT options. I just view the EQT story as having significant implied risk at this point (if not real risk). I’ll closely follow this E&P for updates and provide analysis as possible. Good luck everybody.