Marcellus Shale: A million acres of paydirt?

by Dimitra DeFotis

The next big thing in US energy exploration will be the Marcellus Shale, a vast, underground layer of rock stretching from upstate New York down through Pennsylvania and into Ohio and West Virginia. By some estimates, this formation contains 50 tcf of recoverable natural gas, enough to meet two years of gas consumption for the entire US.
That kind of volume could go a long way to helping the country cut its dependence on foreign oil.

Enter Range Resources. A modest-sized Texas exploration outfit, it was smart enough to start buying up land rights in Marcellus Shale in 2004, when prices were still relatively cheap. It now controls some 900,000 acres of prime Marcellus soil, more than any other energy company operating in the region. If Range's drilling proves as successful as fans hope, the company's revenue could surge far, far beyond the current $ 1.3 bn a year.
"We are a relatively small company with a tiger by the tail," Chief Executive John Pinkerton tells Barron's. "If the tiger ends up being what everyone says it will be, our company will be 10 times bigger than it is."

All of which makes Range's stock singularly tantalizing. In the next year alone, bulls say, the stock should climb about 36 %, to 65. And it could keep rising in leaps and bounds for years.
Range, however, must first overcome some real obstacles. Most notably, Congressional Democrats are seeking to regulate the hydraulic process used to force gas out of shale. The process, which involves forcing sand, water and chemicals through a pipe, is called "fracking," and industry groups insist it is time-tested and safe. But environmentalists contend fracking threatens water quality and plant life.

Embarrassingly for Range, just as the debate was heating up recently, the company reported a Pennsylvania pipeline leak that killed flora and fauna. The industry can't afford many more incidents like that. If fracking foes gain the upper hand in Washington, Range and its rivals could well run into permit delays and, consequently, earnings shortfalls.
But the company's stock managed to hold firm as the Pennsylvania saga unfolded. And believers in the promise of the Marcellus maintain that any final action by Congress will take the form of reasonable restrictions rather than flat-out prohibitions.

"Public policy has to balance cheap, domestic energy with the potential 1 % risk that fracking is going to damage the water supply," says G. Warfield Hobbs, a Connecticut geologist and energy consultant with interests in the Marcellus.
For now, the biggest influence on Range's stock is the price of natural gas. Depressed demand in recent months has lowered the gas price to near $ 4 per mm Btu, but the futures market is projecting prices will rise to near $ 6 by December as an improving economy and curtailed drilling help reduce the current oversupply. That could sharply boost Range's earnings, and not just from the Marcellus.

While preparing to tap the region, the company has been drilling successfully in and around Texas, beating competitors with its production numbers. And thanks to relatively low costs -- the result of acquiring land and drilling smartly -- a healthy dose of Range's revenue goes straight to the bottom line.
Bernstein Research figures Range could produce earnings of $ 2.12 per share in 2010, up from an expected 78 cents this year, assuming a substantial rise in natural-gas prices to keep pace with oil. Earnings like that would be far above the Wall Street consensus of 81 cents, and would result in a price-earnings ratio of 22.5, versus the consensus' dizzying multiple of 59.

"Range has one of the best growth profiles of the peer group, with an expected 14 % compound annual growth rate over the next five years," writes Benjamin P. Dell, an analyst at Bernstein. He thinks Range shares could hit $ 62.
Range has a long track record, having gone public in 1980 as Lomak Petroleum. It listed on the New York Stock Exchange in 1996 as Range, but its growth spurt didn't begin until 2004 when it expanded into the Marcellus and later the Barnett Shale in Texas, another booming region. Range now has roughly 2.7 tcf of proved reserves, and it posted compound annual production growth of 19 % for the five years through 2008.

The company's new wells in Marcellus are yielding average daily production of 7 mm cf -- an exceptional initial rate. In Texas, meanwhile, Range claimed earlier this year to have drilled the most productive well to date in Barnett. Together, the Barnett and Marcellus operations produce a rate of return of nearly 30 % when natural gas is at $ 4 -- and that is "hunky dory," says CEO Pinkerton. He adds that Range will increase its total unproved reserves more than tenfold, to about 20 tcf, by 2015.
The Marcellus Shale, while near the heart of Eastern US coal production, had been ignored for years due to the expense of extracting gas and building infrastructure to transport it to customers. But now, with wells producing more gas than expected and pipelines getting built out, producers can sell East Coast gas to nearby customers at about a 30-cent premium to the benchmark price, because transportation costs are lower.

This year, Range is spending about 45 % of its $ 700 mm capital budget in the Marcellus. So far investors have been willing to pay for high exploration costs, and the company's balance sheet remains healthy. Range has kept its long-term debt at just over 40 % of total capital. And it still squeezes out a dividend of 16 cents per share, for a yield of 0.34 %.
In 2010, assuming $ 9 natural gas, Dell of Bernstein estimates Range could generate $ 6.27 in cash flow, and at $ 7 gas, $ 4.67 in cash flow. That means the stock is trading at either 7 times or 10 times cash flow, quite reasonable for a company with Range's large acreage and low costs.

The numbers, of course, could change quickly if Washington throws a curve ball. Pinkerton told Barron's in April that water quality "is just not an issue. There are millions of pages of data... incredible studies."
Still, the new administration -- clearly concerned about the environment and prone to increase regulation-could force energy companies to spend more money to cut risks. One private-equity investor focused on energy says regulation is likely to add costs and slow progress a bit, but adds, "The industry will realize it can treat the water and deal with it."

In addition, US natural gas is a clean-burning fuel alternative, and exploiting it on a scale like the Marcellus Shale creates jobs and tax revenue in a wobbly economy.
So, with a little help from gas prices, Range could be well on its way to helping both its shareholders and its country. Unless you happen to be a coal producer, it is hard to complain about that.