Appalachia's Revitalized E&Ps Ready to Grow? Not Quite Yet

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Appalachia’s E&Ps have become such masters at generating free cash flow (FCF) that nearly all will be positioned to return capital to investors within 18 months -- a remarkable turnaround from dire market conditions of just two years ago. But this also begs some questions: Once gas-focused producers are back in good financial shape will expectations for fiscal discipline change? Will investors look at a rising gas strip and accept that US and international gas demand will support production growth and demand companies cast aside maintenance budgets and undergo “disciplined” growth? And how might E&Ps respond? For now, the key Appalachian pure plays -- dominated by some of the largest gas producers in the US -- are content “sticking to the capital and production discipline narrative and deploying FCF to the balance sheet,” Scotia Capital (USA) Managing Director Holly Stewart observes. And the strategy has paid off handsomely. Stewart notes at current strip pricing, all the major Appalachian players are poised to meet investors’ expectations that they bring debt into a 1-1.5x range by year-end 2022. “In the second quarter, leverage fell again by 0.15x, with average leverage for the group of 2.6x,” Stewart noted. “With most management teams targeting sub-2x before moving forward with substantial cash returns, hedge books in 2022 already at a stout plus-60% and the strip [recently] trading at $3.48 per million Btu, we expect better confidence and thus messaging, in the months ahead.” In the severe 2018-19 downturn, those same producers were hanging by a thread as capital markets all but slammed shut. Reining in growth and funding maintenance capex budgets with FCF became a matter of survival. Not so today. “Although there will always be some risk to FCF profiles (it is a commodity business), given the elevated [second half] 2021 and 2022 strips and stronger hedge positions, the path to significant FCF generation is more certain,” Stewart explained. As a result of a rising gas futures strip -- in part due to gas producers’ capital restraint -- combined with well-hedged positions, E&P’s foundering ships are being righted. And with debt under control, some, like EQT, should attain investor grade ratings. So What Now? It’s a given that any surge in gas production could be tamped down by limited egress out of the basin. RBN Energy estimates that for all the talk of constraint, producers eyeing growing LNG demand have added 1.4 billion cubic feet per day in production and outbound Appalachian pipelines are averaging 90% of capacity. This makes a summer 2022 opening of the 2 Bcf/d Mountain Valley pipeline all the more critical (related). However, pipeline constraints alone won’t brake Appalachian production. Dallas Salazar, CEO of Atlas Consulting and a longtime industry insider, tells Energy Intelligence that even if investor focus on FCF wanes as debt is retired, E&Ps would not be in a position to fully respond to any investor demands to raise production -- no matter how tempting downstream demand becomes. “I don't think they could [maintain fiscal discipline] on their own, but I think that inventory issues will act as a governor on growth into perpetuity. Most gas-weighted E&Ps simply don't have the inventory to grow aggressively,” he explained. “Sure, they could for a handful of years or so, but they'd have to publish how many years of inventory they have at that growth rate and it wouldn't be supportive of debt facilities in place, investor sentiment, etc. I really don't think anybody fully understands the inventory concern that is staring us in the face.” But there is key mitigating factor in terms of gas growth worth watching, Salazar said. US oil producers could be forced to rein in growth to thwart an Opec threat to take global prices lower by flooding the market. “If that associated gas is permanently dented, that would free up some market share for top gas E&Ps to stretch their legs a bit,” he said. Longer, Higher Strip Prices Needed Stewart agreed an inventory issue could loom in a growth world. But E&Ps are also likely to be more disciplined until they see supportive pricing beyond the next year. “I think if the strip in say 2023 and 2024 were over $3 and the companies could hedge it, you could start to see some modest growth,” she told Energy Intelligence. “Anything double digits though would not sit well with investors. But most of these gas names are now so large that the days of big double digit growth numbers are in the past.” Another problem in Appalachia is that Nymex is not the benchmark price. “You have to account for the differential and capacity is tight. Pushing growth will cause differentials to widen and hurt realizations,” she explained. “So I believe the growth when it comes back in Appalachia will be very measured due to both investor desires as well as pipeline constraints, even with MVP.” As for the Haynesville Shale, its position is a bit unique since it is still dominated by private producers who are running nearly two-thirds of the rig count, Stewart said. “And while they are trying to tell the same capital discipline, clean balance sheet and FCF story, they also need size and scale to compete and be desirable or attractive in the M&A market," she concludes. "Plus, bigger producers like Chesapeake and BP let their production decline and have now added activity back, so they are showing growth.” Tom Haywood, Houston

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