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3 Natural Gas Taveover Targets with Attractive Valuations: UPL, SD, GMXR

Following Chevron’s (CVX) latest foray into natural gas properties with its $3.2 billion acquisition of Atlas Energy (ATLS), three operators look particularly attractive from a valuation standpoint.

Last December, Exxon-Mobil took a bullish stance on natural gas prices and demand with its $41 billion purchase of XTO Energy. At the time, January natural gas futures traded around 5.30 per mcfe, and reported storage inventories were nearly 20% above their 5-year moving average. Since then, China National Offshore Oil Corp. (CEO) agreed to buy a one-third interest in Chesapeake’s 600,000 net oil and gas acres in the Eagle Ford for $1.08 billion, and cover 75% of well costs on the project until a second $1.08 payment. This follows a joint venture between Talisman (TLM) and Statoil (STO) earlier this year for another $1.33 billion venture in the Eagle Ford. Further, India’s Reliance Industries took a 41% stake in Pioneer Natural’s (PXD) Eagle Ford acreage back in June.

A clearer picture of the per acre price tag is developing, however not all acreage is equally valuable. CNOOC is paying around $10,800 per acre for its play, while Statoil is paying $10,900. Reliance paid around $14,200/acre in the Pioneer deal, but only $6250 per acre for a 60% stake in Carrizo Oil and Gas (CRZO) Marcellus acreage in August. Arguably, the ideal shale play for drilling horizontally in North America is the Marcellus Shale under Pennsylvania land, consistent with comments from the August 2010 Enercom conference. However, political uncertainty and infrastructure problems continue to plague the shale play as Pennsylvania remains less hospitable to oil and gas drilling relative to Texas and its neighbors.

This brings us to three operators with significant acreage trading at significant discounts. Investors must be warned, however, that any cash-flow based valuation relies heavily on natural gas price assumptions. Since the Exxon’s XTO purchase, natural gas prices have eased towards $4 per mcfe and the sector has been described as a “disaster” in news media due to persistent the glut of gas inventory. We think the overall picture for natural gas is strong over the next several years as demand picks up and new production is pared to meet it.

Ultra Petroleum (UPL) leases over 110,000 acres in the Green River Basin of Wyoming and 480,000 over the Marcellus Shale in Pennsylvania. The Green River Basin, where UPL has significant experience producing gas and selling through the Rockies Express pipeline, is a promising multi-layer zone with deeper zones likely to add significantly to existing proven reserves. UPL has well over 100 exploratory wells in the Marcellus with a third already producing gas for sale. We think a buyout would come in around $10-11 billion including debt, or above 60 per share.

Sandridge Energy (SD) holds 650,000 acres in the West Texas Overthrust, 400,000 acres in the Kansas/Oklahoma mid-continent, and 240,000 net acres (330,000 gross with co-operators) in the Permian Basin. The company has a good history with Occidental Petroleum (OXY), which processes SD’s oil, liquid gases and other production at its Century Plant. The company reports that almost two-thirds of its Permian Basin production is crude oil, with 20% natural gas and the remainder natural gas liquids. 17 of 23 rigs are operating in the Permian, with 5 at Mid-Continent and 1 at the Overthrust (Pinon).

CEO, Tom Ward, a co-founder of Chesapeake (CHK) and its COO through 2006, sold shares recently but retains a significant stake. Further, the CFO departed following losses on derivatives contracts related to oil and gas hedging. Notably, Fairfax Financial (FFH.TO) holds a 10% stake in the company. We think a buyout would come in around $9-10 billion including debt, or over $10 per share. We think Occidental is interested in SD’s assets and it is simply a matter of price and timing.

GMX Resources (GMXR) is a smaller operator with around 42,000 net acres in the Haynesville shale in the eastern Texas counties of Harrison, Marion and Panola. Earlier this year, GMXR shifted from vertical drilling in the Cotton Valley Sands to horizontal drilling in the Haynesville Shale. As a result, the company had to remove substantial proven undeveloped reserves from its books on the Cotton Valley due to its switch to the Haynesville Shale below it, cratering the share price. We think a buyout would come in around $700 million on the low end or $12 per share given GMX acreage and infrastructure at current gas prices. Devon (DVN), legacy XTO (XOM), Apache (APA) and EOG Resources (EOG) all have acreage in East Texas and are looking for acquisitions opportunistically. GMXR acreage, with no impending lease expirations and the ability to place well heads near pipelines due to its Cotton Valley experience, is a potential target.

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