This is a follow-up to a previous article on Southwestern Energy (SWN, Financial), popularly known then and now for an ill timed acquisition, $5 billion rescue of Chesapeake’s (CHK, Financial) natural gas assets in the Marcellus. SWN initially financed the transaction with newly minted debt, then diluted shareholders at near 52-week lows. For good reason, SWN was taken to the woodshed and beaten. But the transaction doesn’t have to be win/lose, as the asset with future potential is now in more able hands.
Focusing on SWN, who is among the nation’s more prolific independent E&P’s for natural gas and oil, SWN has been on a roller coaster from $50 mid summer ’14, to multi-year lows $23 post dilution, only to recover to $28 after my February writings. Technicians might argue lower highs & lower lows to $21 in February, SWN recovered slightly but is still near its nadir closing Friday at $22.60. While peak to trough comparisons have limited use, SWN’s recent pummeling of 33% is demonstrative of its leveraged exposure to natural gas. As noted before, SWN will trade like other E&P’s and follow the commodity. See chart courtesy TOS.
Looking Ahead
Since late February, UNG struggled to find legs and fell again from $15+ to $13-, at least 15% lower. Discounting headlines, the retrenchment in rig counts continues (Energy Economist Newsletter: http://www.wtrg.com/rotaryrigs.html) and seemingly production will advance in spite of rigs disappearing. Investors should take note, year-over-year oil exploration in the U.S. is down 44% and Gas exploration is down 26%. Is the rig to production correlation broken or are investors being lulled to capitulate long positions?
A Barron’s broadcast this past Friday whipped up sentiment. Analyst Sterne Agee piled on and downgraded SWN. Reasons are all legitimate but their rationale are already priced into the SWN’s discount; the ill timed acquisition, new debt, diluted equity, lower Nat gas pricing, SWN’s small hedge portfolio (27% of ’16 production) , and SWN’s over the shoulder 3-year development costs. But all of these are based on rear view mirror data and fail to appreciate the opportunities ahead.
More Under the Hood:
The reasons SWN expanded its Marcellus operation so dramatically are lesser known and less obvious. Indeed, Nat Gas pricing can go lower (jeez, how low is low) and as shown above SWN and UNG trade hand in hand. But the realized price out of the Marcellus is far below Henry Hub pricing. See NGI’s charts on the two markets below. While they follow each other, Henry Hub is pushing $3 but Marcellus languishes below $2. The explanation for the markets’ divergences resides in transport/infrastructure bottlenecks.
Marcellus production is squarely responsible for the majority of new Gas supply, without which American demand/supply balance would be flipped completely. Specifically, Marcellus increased production 1123% over the past five years; 1.3 Bcf/d in 2010 compared to 14.6 Bcf/d in February 2015. However infrastructure hasn’t kept pace, yet. Coming on line are the following:
- Algonquin Incremental project, 342 million cubic feet per day (MMcf/d). Scheduled project completion date November 2016.
- Gulf Markets Expansion, 650 MMcf/d of increased capacity (up 7.7%) from the Marcellus and Utica basins. Scheduled project completion dates for phases one and two are November 2016 and August 2017.
- Penn East Pipeline, 100-mile pipeline, from Pennsylvania the pipeline is forecast in 2017
- Atlantic Sunrise, will add 1.7 Bcf/d of new capacity to the Transcontinental pipeline. This project links the Marcellus the Transco mainline, forecast for summer 2017
- Atlantic Coast, scheduled for 2018. The pipeline would have a capacity of 1.5 Bcf/d.
Returning to SWN, CEO Muller still plans to invest $1 billion to develop the acreage and specifically its midstream infrastructure to make sure… http://www.swn.com/operations/pages/marcellusshale.aspx . Soon the bottleneck will disappear and SWN is squarely in the sweet spot for patient (aka forward looking) investors.
I described a month ago, a quick glance reveals SWN trading sub $30, temporarily over the last 5 years, once in 2012, and again now. 2012 Historical earnings visited $1.50. But then and now are different, the now is clouded by Armageddonists and changed fundamentals out of SWN’s high growth and high production region. Past comparisons require acute analysis and understanding that markets are forward looking.
The Trade and How to Express your Opinion:
An investor could buy SWN outright. Without a dividend this is a value, capital appreciation, and energy play. Expanding energy in your portfolio, SWN should serve you well. An entry at low to mid $20’s is certainly at/near bottom. I’ll opine given infrastructure in SWN’s core area and lower rig counts nationally the setup for SWN weighs positively.
Alternative Investment:
Or use options, considering implied volatility remains higher than historical, given the outlook, make SWN an ideal case for Put writing. Following is a 12 months chart courtesy LiveVol. You’ll see 360 day options implied volatility remains higher than historical volatility. Importantly, (but not shown here) shorter term options are priced the opposite (implied lower than historical). Translation: Long dated option sales are more advantageous than similar option purchases. This corresponds well with the fundamental infrastructure timeline to be developed too.
I would AVOID option purchases (long term) because volatility favors options sales. I would also avoid short term option sales as there’s little visibility when energy prices may recover and you’ll miss out on the opportunity to write (collect) large premiums at favorable pricing.
Importantly, I look to write the longer term January 2016 Put at a strike that balances my personal risk tolerance with my thesis to profit.
With writing Leaps (long term), we can engineer significant yield and lower our cost basis. Specifically, the Jan ’16 $23 Put offers $3.35 premium (see the trade bar courtesy ThinkorSwim). The $23 Jan ’17 Put looks OK too and is priced near $4.50 – 5.00, (always use limit orders and especially here because of the wider spread). The Jan ’16 Put delivers a cost basis at $19.65 (strike less premium received). SWN hasn’t seen a price below $20 since 2007! The setup also has a margin of safety that is 15% below the current bid $22.60 (divide the If Put cost basis by the current bid).
If you are not comfortable owning SWN, or uncertain with the fundamental (slightly contrarian) thesis, watch from the sidelines. Note, however, the sideline is an investment, a bad one where cash (excess liquidity) comes with a negative real yield (interest below inflation).
Final thought: A client asked how I’ve managed the collapse in SWN pricing given I was short SWN options that were nearing expiration. I’ve rolled those out and down and have grown the contract size substantially. I’ve collected even larger premiums and grow increasingly aggressive in the future build-outs, production, demand / supply, pricing outlook.
Disclosure:
Short SWN put options. Long SWN. The foregoing is not intended to be specific investment advice, but concepts to consider when investing. Consult your Investment Adviser.
