Energy analysts at Susquehanna Financial Group (SFG) last week reduced their one-year target for domestic exploration and production (E&P) companies because of lower assumed commodity price decks for natural gas.

"We've cut the gas price that we think equities will discount in a year," wrote SFG senior analyst Duane Grubert. "Reflecting weak gas markets, our targets now reflect $4.50 gas (was $5) and $70 oil (unchanged). Our targets have been reduced by an average of 1% to 8% due to the price change."

Because of weaker gas prices, Grubert said "investors are more reluctant to pay for undeveloped reserves before they are actually developed. That said, in our view, if the average value of those undrilled medium-term projects is improving, for example from a tactical shift from gas toward oil, current share prices can understate both the average value and the volume of upside reserves, and create an opportunity for patient investors."

Full storage, gas development drilling subsidized by natural gas liquids content, and drilling done to hold acreage "continues to put pressure on gas prices," said Grubert. "Gas storage is trending toward a very full 3,650 Bcf by Nov. 1, more than adequate to serve even extreme winter weather loads."

E&P investors, he said, "constantly battle a tug of war" because of two things:

"We rarely see equities priced below the value of proved reserves alone, using a price deck near ongoing prices...Nor do we often see an equity paying for more than around two-thirds of its enterprise value supported by undeveloped reserves, no matter how much more physical volume can credibly be identified as upside." However, there are big swings in E&P stock prices now, noted the analyst. For example, EOG Resources Inc., which SFG covers, traded above $140/share in 2008 and as low as $45/share in 2009.

SFG launched its E&P coverage in April based on the thesis that the "second gas bubble" had forced producers to pursue more liquids-weighted production and that gas producers would pursue oil acquisitions from a position of weakness. Gas-weighted producers now are gaining liquids exposure by pursuing "wet" gas, which is methane plus some natural gas liquids (NGL).

NGL prices have fallen, but even when they are at around 40% of West Texas Intermediate (WTI) pricing, "NGLs juice the economics of gas drilling," said the analyst. "Operators targeting wet gas have effectively subsidized dry gas production, prolonging weak gas pricing, as well as muting NGL prices. With NGLs now around 40% of WTI oil prices, $75 oil now supports around $5 gas."

Because of the economics of wet gas plays, Grubert expects to see the robust dealmaking to grab more NGL-rich reserves to continue and "for oil-levered names to see value support from industry transactions."

Unlike "the heady energy markets of 2008, markets are now hesitating to pay ahead for operating improvement results, now with more of a 'pay as you go' than leap of faith behavior. This should set up buying opportunities where correctly predicting changes for the better is undervalued in the stocks. Production results aren't here yet, but in particular are very likely, in our view," as producers make the shift from gas to oil.

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