An Interesting Play in Oil and Gas

Erik Kobayashi-Solomon: Hi, I'm Erik Kobayashi-Solomon, co-editor of Morningstar OptionInvestor, and today it's my great pleasure to welcome Eric Chenoweth, who's associate director of equity research in charge of energy. Eric, thanks for coming.

Eric Chenoweth: Thanks for having me.

Kobayashi-Solomon: OK. I have to start off with kind of a simple-minded question. To me, natural gas and oil--what's the difference between natural gas and oil?

Chenoweth: Sure. Very simply, you find them, typically, in the same spots of the world when you're producing them, but the end market is where they're consumed a bit different. Oil tends to dominate the transportation market, refined products like gasoline and diesel and jet fuel that move us around. Natural gas tends to be used for heating--home heating, commercial heating, and power generation are the biggest markets there.

Kobayashi-Solomon: So, some shared drivers. Generally, if the economy is good and people are moving around and moving things around, then oil...

Chenoweth: Certainly. Both are economically sensitive. Gas has a little bit more of a weather feature to it.

Kobayashi-Solomon: Sure. OK. So I just wrote a QuickShot option idea on SandRidge Energy. It's a bullish position, more speculative than we usually do. This company seems really interesting. November of last year, they were a natural-gas E&P, a natural-gas exploration and production company. Now they look a lot different. Can you just kind of walk us through how they've changed over the past few months?

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Chenoweth: Sure. This is a company that was well-known for a big natural-gas field they discovered in West Texas, called the Pinion Field in the West Texas Overthrust. Through a series of transactions they've done, they've made big strides toward becoming more of an oil company.

Late last year, they announced they're going to acquire some oil properties from Forest Oil, another company we cover.

Kobayashi-Solomon: That was $800 million, something like that.

Chenoweth: Yes, $800-million deal, got them more acreage in the Permian Basin, which is just north of where their gas properties are in West Texas. Then, just this weekend, they announced that they're going to acquire more Permian Basin assets from a company called Arena Resources.

Kobayashi-Solomon: Right. So, they've gone from being, really, a pure-play natural-gas company to, now, about 85% is oil?

Chenoweth: Yes. So the way I'd look at it is, almost all their value and all their production, for the most part, came from gas last year. There was a little bit of oil, but not a whole lot. And now they've moved to about 35% of their production will be oil, but about 85% of the value will be oil.

Kobayashi-Solomon: From a strategic perspective, why do you think these managers would want more exposure to oil right now?

Chenoweth: I think there's a couple things. First, they've come out and said, as a management team, they're very bullish on oil. This is something that we've seen echoed across the investment world as well, not necessarily at all companies. There's definitely been a shift, though, across various companies, to favor oil to gas.

If you look at the two commodities right now, oil is priced much more favorably than gas, on an energy-equivalence basis, so you can see the allure toward oil. You're getting a greater value for the unit of oil you produce versus the gas equivalent.

Kobayashi-Solomon: Yes, right.

Chenoweth: But there's a couple of other things, too. I think people see that oil supply is a bit more constrained than gas. There is a lot of fear out there that a lot has been discovered on the gas side, especially in the U.S., and this abundance is going to keep gas markets suppressed.

Kobayashi-Solomon: Natural gas, it seems like there's a lot of discoveries being made, a lot of production. These guys wanted to get more exposure to a relatively, let's say, rarer or dearer commodity.

Chenoweth: Yeah. Also, it does give them a bit of a diversification angle. So if you think, from a safety standpoint, from a strategic standpoint, they aren't going to be completely exposed to gas.

If gas prices are weak, now they've got the oil. When they go to their bankers, they might be able to borrow against the oil assets, where if gas was weak, they could have their borrowing dry up.

Kobayashi-Solomon: So they've got some of that upside...

Chenoweth: More financially sound...

Kobayashi-Solomon: I've heard you talk about your investment thesis for natural gas and oil just recently. I think you're making a very convincing case that right now natural gas prices are depressed but that it won't always be this way.

Chenoweth: We think that it's hard to imagine gas prices staying below $5, and we're well below $5 now. And although we understand the abundance argument that people are making, we say it's abundance at a price. This gas is abundant, but it's not going to produce itself. There's going to be a lot of cost involved with that, but we think that cost is probably 50% higher than where you see current gas prices.

I also think it's a really interesting time to think about gas versus oil, because we're in a very seasonal, kind of transitional period. It happens every year. This is the period when gas is really weak because your winter home heating demand is drying up. You're kind of in limbo, on the demand side, for gas. But with oil, all the refineries are out there bidding up oil now...

Kobayashi-Solomon: On the other hand, you've got summer driving...

Chenoweth: You've got summer driving season...

Kobayashi-Solomon: Right.

Chenoweth: So now's the time when you really see the commodities diverge. And so, if you're thinking about finding some extra value in gas relative to oil, now's the time to, I think, look at that, and possibly benefit from some of these longer-term theses we have and we see from a cost side with gas.

Kobayashi-Solomon: So we may actually see some natural gas companies getting cheaper right now, as that kind of seasonality influences...

Chenoweth: Absolutely.

Kobayashi-Solomon: Well, this SandRidge idea is a really interesting one. Thanks very much for turning me on to it.

Chenoweth: Sure. Thanks for having me.

Kobayashi-Solomon: Thanks very much for joining us. Please stop by the OptionInvestor site, where you'll find many more great option ideas based on Morningstar's fundamental research.