Range Resources: Conservative Valuation & Huge Potential

Originally posted in March 2018

Selected History of Natural Gas

America's first major gas discovery occurred on Turtle Creek, in Westmoreland County, Pennsylvania at a site where a maple syrup cooker was using a convenient natural gas leak to boil his sap. The Haymaker brothers began drilling the site and in 1878 hit pay dirt at a depth of over 1,300 feet. After an accidental ignition, a glorious flame rose 100 feet above the well and produced endless day for miles around. The flaming well drew plenty of attention from curious travelers, but the brothers found difficulty finding the money to cap and eventually commercialize the well. Eventually, financing was secured from a wealthy uncle, the well was capped, and the Haymaker became the largest commercial gas well in the world, producing an estimated 33 million cubic feet of gas per day. Pipelines were built across the 18 miles to Pittsburgh, and in 1884, the Penn Fuel Company became the first corporation to transport gas into a major metropolitan area for domestic and commercial use.

As production technology and transmission infrastructure advanced, the market for natural gas grew. During the 20th century, gas production mostly came from conventional gas deposits geologically similar to the Haymaker/Murrysville field. These gas reservoirs were found just below layers of impermeable rock. With modern drill bits and well-capping methods, they were easy to commercialize. Natural gas quickly became an affordable fuel used to power homes and cities.

However, in 1954, a Supreme Court ruling in the Phillips Oil Co. v. Wisconsin case meant that inter-state natural gas market would be regulated with price controls. The controls lowered the price of gas and forced producers to find ways to produce their gas more cheaply. Mostly, this meant cutting exploration expenditure and only producing from the lowest cost deposits. As a result of the below market equilibrium transfer price, demand for inter-state gas was very high and supply was very low; shortages in consumer states became so severe that schools were shutting down. So, the government responded with the Natural Gas Policy Act of 1978, bringing market forces back to the inter-state natural gas trade.

For the last 40 years, market forces have allowed natural gas production and consumption to flourish. New technologies expanded the use of natural gas by allowing more efficient gathering and transportation to far away commercial sites. Today, natural gas is the cheapest way to heat the majority of residential properties. It is the most commonly used fuel for cooking. And, because of its low cost and low emissions, natural gas is quickly becoming the preferred feedstock for large industrial facilities and power plants. With the ability to cheaply extract large amounts of gas from conventional deposits and transport it many miles to residential, commercial, and industrial areas, natural gas has become a critical driver of many people's quality of life.

As the US natural gas market grew, easy-to-access conventional deposits were mostly used up and producers looked for new sources and better extraction techniques. Hydrocarbons were found in large quantities within shale formations scattered across the country. Perhaps as a way to repair the dampening effect of federal pricing controls on gas exploration, the Department of Energy instituted the Eastern Gas Shales Project in 1978 which proved that shale formations in the Appalachian Basin were rich in gas and also developed an early nitrogen fracking foam. Early on, the federal government also provided tax credits to unconventional drillers, allowing Mitchell Energy, in 1997, to prove that fracking and horizontal drilling in the Barnett Shale formation near Dallas/Ft. Worth was profitable. Word of Mitchell Energy's success quickly spread, and with the support of higher energy prices, oil & gas companies rushed to lease land in the Barnett and other US shale formations. Unconventional techniques were proven to be profitable, and the US shale revolution had begun.

Unconventional Drilling Techniques

Unconventional drilling techniques allow economical extraction of hydrocarbons from within deep shale rock formations. Companies like Range Resources use advanced drill bits to cut through layers of hard rock beneath conventional oil and gas reservoirs and into deep layers of shale. Once inside the gas-rich shale formation, the advanced drill bit turns sideways and goes horizontal for as many as 20,000 feet. Electric charges then set off small explosions to fracture the gas-rich rock, and a sand or ceramic proppant holds the fractures open, releasing the gas from the porous rock to flow up and out of the well. This complicated-sounding process has become routine and extremely profitable for certain shale gas producers.

With advanced drilling techniques, shale producers have many advantages over conventional drillers. Unconventional drillers have access to many more resource plays and greater resource potential. With the ability to extract resources from rock formations up to 10,000 feet deep, producers have access to virgin deposits. Exploration costs are also lower because the size and location of these major geological formations is more easily known. More wells are drilled into a single, known geological formation. Unit cash costs and unit costs plus DD&A greatly decrease. The pattern continues as lateral drilling lengths increase. High technologies like microseismic imaging, big data, and supercomputers also help drillers to optimize the well-completion process.

US Shale in Global Energy Markets

Shale gas production techniques were born in the US, but the rest of the world is ready to join the game. The US leads the shale gas revolution, with shale oil and gas already contributing over 50% of US daily BOE (barrel of oil equivalent) production. Production from shale has reversed the rapid decline in US hydrocarbon production and made the US the world's number one energy producer eight years running. The US produces almost 50 billion cubic feet of shale gas per day and leads all other nations in shale production by a very wide margin. But, Canada too has significant shale production, and China plans to offset its energy dependency and pollution problems with generational investments in shale gas production. Russia's gas production still comes from conventional wells, but massive shale fields have been discovered throughout that country. While the US and the world's larger economies forge ahead with large scale shale production, the rest of the world will benefit as consumers of a more eco-friendly fuel at much lower prices.

The cheap, low-pollution energy provided by shale gas presents vast opportunities for the world's economies. Shale gas is one of the most inexpensive energy sources on the planet. Henry Hub Natural Gas pricing has hovered around $3 per million BTU (British Thermal Units) for the last year. Compare this to Brent Crude oil, a barrel of which produces about 6 million BTU and costs close to $13 per MMBTU. At current prices, natural gas is more than four times cheaper than oil on a per BTU basis. In the US, the only energy feedstocks cheaper than Appalachian gas are Appalachian coal and Powder River Basin coal.

The Russian natural gas giant, Gazprom, claims to produce its gas for less than $2/MMBTU, but then sells into European and global markets for $8 or more per MMBTU. Gazprom also reports that burning natural gas as opposed to oil produces only one half to one third the carbon emissions. As China confronts its pollution problem and moves away from coal, global demand for natural gas will increase. Unfortunately, the majority of Range Resources' production comes from the region with the cheapest energy prices in the world. High capital costs of building gas pipelines and LNG facilities keeps much of Appalachia's abundant hydrocarbons within the region, but soon, long-awaited export infrastructure will cheaply transport Appalachian fuel to global markets where significantly higher prices can be fetched.

Range Resources Corporation: The Company

Founded in 1976 as Lomak Petroleum, Range Resources originally drilled wells in eastern Ohio. By the early 2000's, a series of joint ventures and acquisitions gave Range Resources a portfolio of oil and gas assets that included properties in the Permian Basin, the Texas Barnett Shale, and the Appalachian Basin. Range Resources took the unconventional drilling methods already in use in the Barnett formation and began applying them in the Appalachian Basin. In October 2004, Range Resources drilled a successful discovery well into the Marcellus Shale formation at a depth of 8,000 feet. According to RRC CEO Jeffrey Ventura, "it worked on the first try," and by late 2004, Range Resources was the first company to produce gas from the Marcellus.

Range Resources owns a fantastic portfolio of resource rights consisting of stacked pay acreage in two of the best hydrocarbon plays in the world. Due to first mover advantage, RRC was able to acquire 500,000 core stacked pay acres in the Appalachian Basin at an average cost of $1,000 per acre. The average cost for other producers later to the game was around $13,000 per acre. In the last ten years, RRC's proven reserves have grown at a CAGR of over 20%. In 2016, the company closed a $4.2B all-stock acquisition of Memorial Resources and now owns 140,000 core stacked pay acres in Louisiana's Lower Cotton Valley. The Cotton Valley is a 1,400 foot thick grouping of conventional sandstone deposits with shale layers in between. The stacked pay nature of both of these assets means Range can use the same well pads and operating infrastructure to drill into resource deposits at varying depths. For instance, Range owns 400,000 core acres in the highly promising Utica shale formation, which sits 3,000 feet below the Marcellus. Initial well results in the Utica have been fantastic and RRC will be able to use many of the same Marcellus assets when capitalizing on their Utica resource rights in the future.

The company's five year operational plan focuses on capturing the benefits of its prime position in the Marcellus, which is currently the lowest cost and most prolific natural gas play in the world. While putting 85% of 2018 capital spend towards increasing Marcellus production, the company waits to develop its stacked pay positions in the Upper Devonian, Utica, and Lower Cotton Valley deposits. Range's other acreage position, located in Northern Louisiana's Lower Cotton Valley, will produce solid returns in 2018 with an IRR at recent 10-year strip pricing of 27% or an IRR of 33% at $3/mcf. The Marcellus region, however, will (according to 10-year strip pricing dated 12/29/17 with average prices of $53.45/bbl and $2.94/mcf) average a 58.2% marginal rate of return in 2018. At $3.00/mcf and $60/bbl, the IRR of these new Marcellus wells becomes 68.7%. Range's production in the Lower Cotton Valley is expected to remain flat over the next five years as the company focuses on increasing production in the Marcellus. Production growth in the Marcellus is expected to take Range's total hydrocarbon production from 2 billion cubic feet equivalent per day in 2017 to an estimated 3.5 Bcfe per day in 2023.

Cost optimization will allow Range's margins to grow as production increases. Range's five year plan lays out most of their performance expectations through the year 2022. According to the five year outlook, total production will grow at a debt-adjusted per share CAGR of 13%. Over this time, the cash costs per mcf will drop from $2.00 in 2018 to $1.50 in 2022. Some of these cost reductions are due to optimization of the takeaway and processing infrastructure and some comes from the increasing lateral lengths of the drilled wells. The company has found that increasing lateral lengths does not diminish wellhead pressure and is a less capital intensive, but effective, way to exploit more rock. Range's average lateral length is now 10,000 feet. In Q1 2018, Range set a record for drilling an 18,100 foot lateral in the Marcellus, and the company plans to surpass the 20,000 foot mark in the coming years. The Memorial Resources acquisition should also allow Range to avoid pipeline bottlenecks in the Northeast and achieve higher realized prices on its Marcellus production through Memorial Resource's pipeline contracts to Gulf Coast export facilities.

Range Resource's financial position is strong and will improve as the company capitalizes on its Marcellus investments. With $4B in net debt and $1.1B in LTM EBITDA, RRC trades around 3.7x Net Debt to EBITDA. The company's five year plan includes reducing net debt/EBITDAX below 2.0x by the end of 2022. The <2.0x EBITDAX leverage by 2022 goal can be accomplished through operating cash flows alone and may be accelerated by assets divestitures. The company has close to $3B in Senior Notes at an average interest rate ~5%, none of which comes due before 2021. The company still has plenty of financial flexibility with its $4 billion dollar 3.4% revolving credit facility. Additionally, all planned production growth is to be funded through cash flow from operations with no need for external financing. Considering the current debt load and the expected future cash flows of the company, the company carries a small amount of balance sheet risk.

The cash flow outlook suggests that Range Resource's investors will be richly rewarded in the coming years. After 2023, Range estimates it could produce 3.5Bcfe per day for only $600 million in yearly maintenance capital, which at recent strip pricing would generate $1.3B in Annual Free Cash Flow. In the same scenario based on 10-year strip pricing, the company's free cash flow yield will be ~38% in 2022. If WTI prices are $60/bbl or NG is at $3/mcf, the 2023 forecasted FCF yield will be 40%.

The Bottom Line

With an $8.1B Present Value (r=10%) of Proved Reserves and a $7.6B Enterprise Value, Range Resources appears to be fairly valued. The market values Range's 15.3Tcfe of Proved Reserves at $0.50 per mcfe. However, this valuation excludes the Marcellus resource potential of 58 Trillion Cubic Feet of Gas Equivalent, which breaks down into 40 Tcf of natural gas, 3 billion barrels of NGL's, and 149 million barrels condensate. Also excluded is the entire stacked pay potential of the Upper Devonian, the North Louisiana shale, and the Deep Utica. As Range Resources capitalizes on the stacked pay potential of its resource rights, capital costs will be lower. This unique economy of scale within prime acreage positions in the world's best hydrocarbon deposits will give RRC a competitively dominant position in global energy markets that is not currently reflected in the market's valuation of this company.

Potential increases in energy prices, especially Appalachian Basin gas and gas liquids prices, gives Range Resources huge upside potential. Better global gas transmission infrastructure should lead to a narrowing of the spread between crude oil and natural gas prices. Further carbon emission regulations could force demand for natural gas ahead, especially with the mass adoption of EV's powered by the natural gas-fueled energy grid. Power plants, industrial facilities like ethane crackers, and even NGV's present sources of long term demand growth. Altogether, Range Resources may be the best positioned company in perhaps the most promising industry in the world, and it would not be ridiculous to say that the company's stock trades today for 20 cents on the dollar or one fifth of intrinsic value.

Environmental Concerns

Environmental concerns have followed Range Resources and many other hydraulic fracturing companies. The 2010 documentary Gasland depicts residents living near a fracking site lighting the water from their kitchen sink on fire as well as farmers and their livestock becoming mysteriously sick. Claims of contaminated soil and groundwater around drilling sites are alarming, but shale fracturing occurs thousands of feet below groundwater reservoirs separated by many layers of impermeable rock. In theory, the only way the surface environment could be contaminated is through equipment failure or negligence near the surface. Often in cases involving RRC, authorities like the Pennsylvania Department of Environmental Protection conducts scientific tests, usually proving a natural cause for chemical contaminations and exonerating RRC. There are, however, multiple instances where Range Resources was ordered to pay fines for environmental damage.