We are making several changes to our natural-gas price assumptions that will positively affect our fair value estimates for numerous companies in the natural-gas industry.
First, we are raising our midcycle price assumption for the NYMEX Henry Hub benchmark to $5.67 per thousand cubic feet (mcf) from $4. Although natural-gas prices have drifted lower recently due to an abnormally warm winter, we based our midcycle price decision on several longer-term trends. Unit costs have been on the rise over the past two years, with the higher-cost, marginal producers experiencing the most marked increases in costs. We don't see this trend changing over the next few years, as firms are paying top dollar to acquire new properties and day rates for rigs are still well above normal. Further, as LNG becomes a larger contributor to supply over the next decade, we expect that it will support our midcycle price. Although LNG could displace high-cost domestic producers, we think that it should improve the reliability of supply--helping to stabilize gas prices near our midcycle price, rather than creating a glut of low-cost gas.
Demand for natural gas has not fallen considerably despite steeper prices in recent years. Although we think industrial consumers could continue to disappear if high and volatile prices persist, the large installed base of gas-fired power plants and home heating customers should help shape a floor for gas prices over the next decade.
Second, we have reduced our long-term inflation rate for natural gas to 3.6% from 6%. The new 3.6% figure matches our inflation rate for oil and reflects our opinion that prices for oil and gas should hover more closely to energy equivalence (roughly 6,000 cubic feet of natural gas per barrel of oil) over the next 10 years than they have in the past. In fact, on an energy-equivalence basis, our new midcycle natural-gas price (adjusted for inflation) equals our oil-price assumption in the third year of our forecast (2008).
Third, we have incorporated seasonality adjustments to improve our near-term accuracy.
Between our methodology changes and new price assumptions, we now expect benchmark natural-gas prices to average near $8 per mcf in 2006, $6.80 in 2007, and $6.20 in 2008. After 2008, we assume prices will grow at our projected long-term inflation rate of 3.6%. Despite our higher assumptions, we still consider recent prices exceeding $10 per mcf extremely high and ultimately unsustainable.
Increases in our fair value estimates will vary. For firms concentrating on oil or those pursuing an integrated strategy, we expect fairly small changes. However, for smaller, independent firms focusing on North American natural-gas production, we expect more significant adjustments to our fair value estimates. Please refer to the valuation section of each company's Analyst Report to view how our fair value estimates are changing on a firm-by-firm basis.
Thesis 02-23-2006
By employing a balanced drilling program, seeking quality acquisitions, and focusing on domestic production, Houston Exploration has historically kept operating costs low. Faced with rising finding and developing costs, the firm has decided to change its strategy, and its decision to move purely onshore does not come without risk.
As some of its competitors look overseas for growth, Houston remains focused on opportunities in its own back yard. One of the drawbacks to this strategy is that domestic reserves have become harder and more expensive to find and develop. As a result, Houston operates wells that tend to carry lower remaining productive lives than the industry average. But this short reserve life also implies that Houston converts oil and gas reserves into cash more quickly than many of its peers with longer-lived assets.
Historically, Houston's strategy has enabled it to produce gas at a lower average cost than many of its peers. Over the past five years, Houston's average operating margins topped 40%. But with Houston's properties carrying shorter-than-average remaining useful lives, the company has felt pressure to replace depleting wells more rapidly than its peers. If natural-gas prices stay high and the price of gas properties remains high as well, Houston may be tempted to pony up more cash for acquisitions than it has in the past.
Traditionally, Houston offset some of its need for property acquisitions by pursuing a balance between onshore and offshore drilling. Its offshore wells tend to have better production prospects, but they also carry longer lead times, greater price tags, and steeper decline rates. By pursuing a mix of land and offshore wells, Houston tried to manage the overall risk of its drilling program. Over the past four years, however, Houston's strategy has failed to add reserves cheaply. Finding and development costs (exploration, acquisition, and development costs divided by new reserves) have averaged more than $2 per thousand cubic feet of natural gas, which is more than many of its peers recently paid to acquire reserves.
Houston recently announced its intentions to shed its offshore Gulf of Mexico operations (which account for about 40% of reserves and production), hoping to sell them by the end of the first quarter of 2006. Given the current climate for asset sales, we think the odds are good that Houston will fetch a great price. However, we're not sure how Houston will invest the proceeds, making it difficult to determine if significant value will be created, or not. If Houston chooses to use the funds to pay up for onshore properties, little, if any, value will be created, in our opinion.
Valuation
We are raising our fair value estimate for Houston Exploration to $71 per share from $64 based on our higher natural-gas price outlook. We assume benchmark natural-gas prices of $8 per thousand cubic feet in 2006, $6.80 in 2007, $6.20 in 2008, and $6.40 in 2009. Houston had a rough time in 2005, failing to boost production. When it recovers from the hurricanes, we think Houston can ramp up production quickly in 2006. We expect the firm can produce an average of 397 million cubic feet daily (including the assets to be sold). We've included the company's recent acquisition, costing about $195 million, in our valuation. Over the next few years, we expect that Houston's annual production growth will subside to about 4%.
Two key factors influencing our fair value estimate are our natural-gas price assumptions and our weighted average cost of capital assumption. If we boosted our benchmark oil and gas price assumptions 10%, our fair value estimate would jump to $97 per share, all else equal. If we reduced our benchmark oil and gas price assumptions 10%, our fair value estimate would fall to $45. We assume a weighted average cost of capital of 10.1%, which we use to discount future cash flows in our model. All else equal, if we reduce our WACC to 9.1%, we get a fair value estimate of $86. If we raise our WACC to 11.1%, we get a fair value estimate of $59.
Risk
Because Houston Exploration is an upstream producer, fluctuations in natural-gas prices flow straight to the income statement. If natural-gas prices fall, Houston could lose money, much as it did in 1998. When times are good, like they were in 2005, cash-rich independents like Houston typically overpay for acquisitions. With oil and gas prices high today, Houston's financial discipline may be tested.
Strategy
Houston focuses on domestic natural-gas exploration and production. After selling its offshore assets in early 2006, the company will seek lower-risk onshore projects. By focusing purely onshore, management hopes to produce low-cost natural gas. Houston's asset sale marks a dramatic strategic shift for the firm, which used to seek a balanced drilling program both onshore and offshore. It is still unclear how the firm plans to reinvest the proceeds raised from selling its offshore properties.
Management & Stewardship
William Hargett has been president and CEO of Houston Exploration since 2001. He has more than 30 years of industry experience. As a result of last year's deal, Hargett also assumed the chairman position from Robert Catell, the CEO and chairman of KeySpan. Management pay at Houston is average for the industry. All told, executives and board members own less than 1% of Houston's outstanding stock. KeySpan's recent stock sale removes any influence it might have had over Houston. We think this is good for Houston's shareholders. Overall, Houston's stewardship is average. A low level of executive ownership, antitakeover provisions, and the fact that the chairman and CEO are the same person, keep Houston from earning a better Stewardship Grade.
Profile
Houston Exploration engages in the exploration for and production of natural gas and oil. At the end of 2004, the company's estimated proven reserves topped 790 billion cubic feet, and daily production averaged 340 million cubic feet. Natural gas accounts for more than 90% of reserves and production. Houston Exploration operates primarily offshore in the Gulf of Mexico and onshore in Texas, Oklahoma, and Arkansas.
Growth
We estimate average production growth for Houston compared with many of its natural-gas peers. Besides production, volatile commodity prices have significant influence over the magnitude of sales growth.
Profitability
Although they averaged more than 40% during the past five years, Houston's operating margins are volatile. For example, when the natural-gas industry suffered a weak pricing environment in 1998, Houston's margin plunged to negative 85%.
Financial Health
Thanks to high oil and gas prices, Houston's financial flexibility improved in 2005. However, the company has an appetite for cash. If natural-gas prices slip and operating cash flows shrink, Houston may require greater external financing.
