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This Month's Tiny Gems - December 2013
Antero Resources Corp. (AR)
CF Industries (CF)
Opko Health, Inc. (OPK)
Mississippian: Sandridge Energy’s (SD)
Antero Resources Corp. (AR)
Founded in 2004 by its Chairman and CEO Paul Rady and President and CFO Glen Warren, Antero Resources Corp. (AR) is an independent oil and gas exploration and development company. It has a market cap of just over $14 billion and engages in the acquisition, exploration, and development of onshore, unconventional resources in Appalachia and Ohio regions.
Antero holds some of the highest returning assets in U.S. Shale. The company’s asset base is comprised of 329,000 net acres in the southwestern Marcellus Shale in liquids-rich window of West Virginia and 102,000 net acres in the emerging Utica Shale of Ohio. AR has an estimated total 3P reserves of 27.7 Tcfe (86% gas), including 6.3 Tcfe of proved reserves (23% developed, 91% gas), which represent a 28% increase over 2012.
AR has built an enviable position in the key area of the Marcellus shale play, which provides 15 years of drilling inventory at the current pace of development with RORs ranging from 40% up to 100%. AR’s large inventory of liquids-rich, low-cost drilling opportunities provide strong long-term growth opportunities. The company has identified more than 4,500 potential drilling locations, including 2,941 in the Marcellus shale and 720 in the Utica shale, and in the next two years production is expected to grow by 76% and 47%, respectively.
Moving from delineation and holding acreage to development, outperformers in the E&P space will have scale and capital efficiency which Antero has captured in two of the highest return resource plays in the U.S. The contiguous nature of Antero’s acreage lends itself to longer laterals, faster cycle times between pads, and effective use of field infrastructure and facilities. Moreover, significant infrastructure investments by Antero’s wholly-owned subsidiary Antero Midstream along with third-party agreements support Antero’s long-term development plans. The infrastructure including water handling systems and gathering pipelines allow for a high allocation of the capital budget to drilling and completion and reduces risks to growth.
Leading Growth Story
Among its peers, AR offers investors one of the strongest growth profiles. Production is expected to grow by 76% in 2014 and 47% in 2015. With 15 rigs currently drilling in the Marcellus, Antero is currently the most active operator in the play. In addition to that, third-party processing and pipeline infrastructure is now available in Ohio, allowing the prolific Utica shale to contribute to a full year of growth from next year with 4 drilling rigs currently active. AR’s acreage in the core liquids windows of both plays not only provides higher initial production and EURs to support growth, but a pricing uplift from the liquids content.
Low Costs Adding to Attractive Operating Margins
AR’s low cost structure together with liquids exposure supports strong operating margins. In the past two years (2010-2012), the company had a finding and development cost of $1.14 per Mcfe, and going forward the company expects development costs to drop further to $0.90 per Mcfe for its proved undeveloped reserves. In addition, AR’s reserve replacement costs over the past three years have been the lowest among its peers in the Marcellus Shale.
The company has also mitigated a big portion of its natural gas risk using fixed price swaps. As of September 30, 2013, AR has hedged a total of 1,104 Bcf and 1.5 MMBbl through 2019 at an average price of $4.71 per MMBtu and $98.50 per Bbl, respectively. Antero’s valuable natural gas hedges provide a buffer to cash flows, through the medium term.
Conclusion
AR has built an enviable position in the two of the key shale plays in North America and is well-positioned to deliver peer-leading production growth from the Marcellus and Utica shales for many years to come. While Marcellus shale should allow the company to post industry leading returns and production growth for many years, AR’s liquids-rich Utica shale assets should allow it to grow production and the liquids mix over time. AR also benefits from an experienced management team; both Paul Rady and Glen Warren have more than 30 years of experience in the oil and gas sector and prior to AR have successfully built and sold two companies.
AR trades at a premium to its peers but the company’s strong production growth profile, high quality asset base, long reserve life, strong and experienced management team, and exposure to potentially growing resource in Marcellus and Utica justify the premium.
CF Industries (CF)
CF Industries (CF) is the largest and the most flexible producer of nitrogen fertilizers in North America. Nitrogen is the most important nutrient in support of crop yields, and CF’s main market, the United States, remains structurally short. As a result, the domestic prices of nitrogen remain high and the country also continues to attract a large amount of imports.
Corn, the world’s largest cash crop, has significant fertilizer requirements with a particular reliance on nitrogen. Although the crops prices have rebounded from last year’s drought and have come down notably since then, economics still favor crop planting and it is believed that the upcoming spring season should see a steady demand.
Low-Cost Producer
As a North American producer CF has another advantage, the company benefits from a long-term trend of low North American energy costs. Natural gas is the main raw material in nitrogen production and there is an ample supply of it in North America. The low energy costs benefit CF as a low-cost producer in a price-advantaged market. This advantaged situation results in highly attractive margins for the company. Moreover, the margins have remained robust even in a down cycle.
Capital Return and Expansion Plans
Going forward, the company’s ability to conduct substantial capital returns and execute on its expansion plans should also attract investors’ attention. CF has continued its buyback program in the 4Q13 and has bought back 665,000 shares for $114.2 million so far. The company is still left with $1.7 billion in its current buyback program. CF anticipates that it could finish its $3.0 billion buyback program by early 2015, which is earlier than market expectations. At the same time the company is also executing on its capacity expansion plans. After the company executes on both the buyback program and volumes expansion, its free cash flow profile should improve substantially.
CF’s expansion projects are moving forward on schedule and on budget. In the longer-term, the company through its $3.8 billion nitrogen capacity expansion should be able to further leverage its cost advantage. It is important to note here that other producers have also sought to build new facilities but are faced with cost and permitting challenges. However, the Deerfield, Illinois based company remains committed to complete these projects, which has helped to crowd out other producers. The more important thing to note here is that even after funding its expansion projects and completing the current share repurchase program, the company believes it is likely to have the financial flexibility to return even more capital to shareholders.
Optimizing Capital Structure
CF disclosed in a recently filed 8-K document that it may return more cash to shareholders and is examining a more lightly taxed financial structure. The company is planning to issue $1.5 billion in new long-term debt next year. Moreover, in comparison to the previous target of 1.0-1.5 times, the company is now targeting 2.0-2.5 times debt-to-EBITDA leverage ratio as an optimal balance over the cycle. Along with other financing options, CF is also in discussions to evaluate MLP and MLP-like structures.
CF’s move to more transparently optimize its capital structure is positive and should be received favorably by the market. Following the new activist investor Dan Loeb’s Third Point LLC hedge fund investment, the company has taken a number of investor friendly decisions. It recently increased its dividend by 150% and optimized its portfolio by selling its phosphate business to Mosaic (MOS). CF also witnessed a change at the top management recently and there is a visible change in the company’s communication with investors, implying greater flexibility on methods of capital returns. The market next expects the company to deliver on its intentions to create value for shareholders via greater repurchase, higher dividends, and/or creation of an MLP and CF promises to deliver on all fronts.
CF is also trading at very attractive valuations and at a discount compared to its industry peers. It has a price/earnings ratio of 8.8, lower than the industry average of 14.1 and CF’s own 5 year average of 11.1. The company has a forward P/E of 8.3. CF has a price/book ratio of 2.6 vs. the industry average of 2.9. It has a price/sales ratio of 2.5, slightly above the industry average of 2.4.
Going forward, I expect as CF demonstrates earnings stability through the cycle, investors will be willing to support a valuation for the stock more in line with the rest of the industry.
Conclusion
I think CF is a stock to watch for in the agriculture sector and will likely outperform in 2014. The company is an advantaged nitrogen producer. It not only benefits from strong fertilizer demand in the domestic market but is also a beneficiary of a long-term trend for low North American energy costs. CF’s recent capital allocation actions, including its sale of phosphate business to MOS, are evidence that the company is positioning itself as a pure play nitrogen producer, which should help the company attract more of a traditional long-term shareholder base.
CF’s capital structure transformation is also taking shape. Although the MLP process is still in the early stages and the company has given no timeline as to when and which assets would be part of an MLP, the important thing is the company no longer regards these actions as too complex or difficult to execute as has been the case in the past.
The company continues to actively engage shareholders and explore all options of value creation and its commitment to more transparently optimize its capital structure should reduce its historical share price volatility and improve its valuation. Potential MLP and/or other alternative financing structures introduce further upside potential. CF’s increased capital allocation visibility, more simplistic business model, and improved yield should also attract incremental shareholders over time.
Opko Health, Inc. (OPK)
Opko Health, Inc. (OPK) is working on its proprietary 4Kscore test that can predict the probability of prostate cancer prior to prostate biopsy. In November, Opko announced the clinical validation study for its 4Kscore test. The company has begun enrolling patients across 13 sites in the U.S, and it is planning to enroll more than 1,200 patients referred for a prostate biopsy over the coming months.
A PSA test, which costs between $60 and $80, is used to detect prostate cancer and check cancer recurrence among men diagnosed with prostate cancer. The PSA test measures the level of PSA in blood. A doctor will recommend a prostate biopsy if the PSA level is above 4 nanogram per mL or ng/mL. Higher PSA levels can be a sign of prostate cancer, but it may not be fully reliable to prove its existence.
The 4Kscore is a blood test that measures serum levels of prostate-derived kallikrein proteins including total PSA, free PSA, intact PSA, and hK2 in the blood. The test measures the probability of prostate cancer using its algorithm, kallikrein protein levels in blood, patient’s age, and digital rectal examination (known as DRE). It is known that free PSA levels decrease in men having prostate cancer compared to those with benign conditions. The hK2 levels can also be a differentiator between benign conditions and prostate cancer. A study found that 56% of men with a free/total PSA ratio less than 0.10 had prostate cancer whereas only 8% of men with free/total PSA greater than 0.25 had prostate cancer. These kallikrein protein levels are also useful in predicting prostate cancer in men with elevated PSA levels.
Opko sublicensed with IHT to conduct a study in the UK, Ireland, Sweden, and Denmark, to predict the probability of biopsies in men suspected of having prostate cancer using its 4Kscore test. The study indicated that kallikrein protein levels used in the 4Kscore test could lead to a possible 50%+ reduction of unnecessary prostate biopsies. The probability of delaying diagnosis for late stage prostate cancer was found to be 0.6%.
Every year more than 70 million PSA tests are conducted worldwide, which represents an annual market size of $4.2 billion (assuming $60 per PSA test). It is expected that peak annual sales of the 4Kscore will be $300 million (assuming $300 per test). This translates to about 1 million 4Kscore tests annually, which is only 1.42% of the PSA tests conducted and represents a niche market. A traditional PSA test will only look for PSA levels in blood whereas 4Kscore involves more measures to confirm prostate cancer. This will help it to overcome some of its cost disadvantage against traditional PSA tests.
CKD effects and its treatment
Opko announced the completion of patient recruitment in the first phase 3 trial of Rayaldy in November. Each of the two phase 3 trials will enroll 210 patients being recruited at 40 sites in the U.S. These trials will be followed by an open-label extension study, known as an OLE, in which patients have the option to be treated with Rayaldy for another 6 months. As of now, 129 patients have enrolled in this OLE study.
Rayaldy, also known as Replidea, was found to be effective in its phase 2b clinical trial to treat Secondary Hyperparathyroidism, or SHPT, and vitamin D insufficiency in pre-dialysis patients. Rayaldy reduces the parathyroid hormone, or PTH, levels, which isn’t available in existing vitamin D supplements. Once approved, Rayaldy can be used to solve health problems faced by moderate CKD (stage 3 or 4) patients, along with those suffering from SHPT and vitamin D insufficiency. CKD affects over 26 million people in the U.S., including over 8 million patients with moderate CKD and severe CKD. This provides huge market potential for this drug, and Rayaldy is expected to gain a significant share in the $12 billion moderate CKD drug market.
Moves by other players
In November, Keryx Biopharmaceuticals (KERX) provided updates on its drug “Zerenex” regarding a safety extension study for the treatment of hyperphosphatemia in patients with CKD. Those patients who had participated and completed the 58-week phase 3 study were eligible for this 48-week OLE study, which represented exposure to Zerenex for 2 years. It was observed that serum phosphorus could be controlled in patients with a normal range of 3.5 to 5.5 mg/dL. Zerenex has been observed to be safe in this study up to now with a discontinuation rate of 17% in this study.
The company’s New Drug Application, or NDA, for the treatment of hyperphosphatemia in CKD patients on dialysis, is currently under review by the FDA and has a PDUFA date of June 7, 2014. The end-stage renal disease market potential is significant and could possibly reach a patient population of 7.85 million by 2020. The peak sales for Zerenex in the U.S. are estimated to reach $300 million. Zerenex has the potential to be launched ahead of its competitor’s drug, Alpharen, which will begin the next stage of its phase 3 trial in the second half of 2014.
On the other hand, Amgen’s (AMGN) CKD drug, “Sensipar,” was ranked 59th based on the total expenditures and number of prescriptions. Sensipar, used for the treatment of SHPT in CKD patients, contributed about $259 million or 5.45% of Amgen’s revenue in the third quarter of fiscal year 2013. Sensipar’s U.S. and global revenue grew 6% and 7%, respectively, compared to the third quarter of fiscal year 2012. Amgen will continue to benefit from this CKD drug, as its patent doesn’t expire until 2018.
Conclusion
Opko’s 4Kscore provides an opportunity for the company to create a niche market in the overall prostate cancer detection market. On the other hand, its CKD drug Rayaldy has started Phase 3 trials, and looking at its phase 2 efficacy results, it can be expected that the company will also post positive phase 3 results.
Sandridge Energy’s (SD)
Sandridge Energy’s (SD) is a major player in the Mississippian Lime, where it has a lease of around 1.85 million acres. The company’s major operations are targeted to the “focus areas”, which consist of six counties: Comanche, Barber, Harper, Woods, Alfalfa, and Grant. During the third quarter, the company operated around 22 rigs in the region, and it plans to operate 23 rigs in the coming quarter. In the focus area, Sandridge drilled around 211 wells as of the start of November this year, and it has identified 3,000 development locations. During the third quarter of this year the company was able to increase production by 59% year over year to around 47,900 barrels of oil equivalent per day, or boepd, which is around 53% of the company’s total production. With the number of potential development locations, the company will be able to increase production from the Mississippian.
In the Mississippian play Sandridge has a cost of around $2.95 million per well. In general, at well cost of around $3 million, a driller in the Mississippian Lime play needs to generate around $4,110 per day to achieve break-even in two years. This means that a company has to produce around 41 barrels of oil per day at a price of around $100 per barrel of oil for break-even. Sandridge’s wells have a 30-day initial production rate of around 140 barrels of oil per day and an initial decline rate of 76%. The company estimates a payback period of two years for its wells. With these production rates, the company has a certain degree of flexibility if the oil prices vary between $90 and $100 per barrel. The WTI prices are expected to be around $97 per barrel through the end of this year and an average of around $95 per barrel during the next year. At these price levels and the well production levels, Sandridge is likely to cover the cost of its well comfortably in the coming quarters.
Sandridge is not the only player in the Oklahoma shale formations; it has competition from Apache Corporation (APA). The company operates in what it calls the Central Region, which constitutes western Oklahoma and the Texas panhandle, totaling an area of 2 million gross acres. During the third quarter the company produced around 94,773 boepd, a 4% quarter over quarter production rise. In the region, Apache is currently operating more than 300 wells in different shale plays like the Cleveland, Canyon Wash, Granite Wash, Sweetwater, Cottage Grove, and others. Apache plans to increase production to more than 160,000 boepd from the region by 2016, and it has good traction as it has exceeded its projected value with the rate of growth in drilling. The potential for exploration and exploitation of multiple shale formations in the Central region provide Apache the opportunity to grow its production in the coming quarters.
More from the Mississippian stack pay
The total oil and condensate recoverable from the Mississippian play is around 1.3 billion barrels through 2035. The Mississippian has three stacked layers known as the Upper, Middle, and Lower Mississippian. Sandridge is developing the Upper and the Lower Mississippian in Harper County and Grant County respectively to increase the productivity of its acreage. In Harper County the company is testing two stacked laterals, one in the Upper and the other in the Lower Mississippian. Stacked laterals are horizontal wells drilled one above the other. The data from these two wells showed 30-day initial production, or IP, of around 456 boepd from the Lower Mississippian and 391 boepd from the Upper Mississippian. In Grant County, Sandridge tested multi-well in the Upper and the Lower Mississippian, and these wells delivered more than 400 boepd. Sandridge’s year to date average 30-day IP is 339 boepd. This shows that the new wells in the Upper and Lower Mississippian currently have 30 day IP rates that are currently above or in line with the company’s average for the year.
Sandridge also started the appraisal of the Woodford Shale, which lies below the Mississippian Lime and is around 80 feet thick. The Woodford shale is expected to contain oil and natural gas in equal proportion. Sandridge is carrying out the appraisal program in five counties within its acreage and has completed three wells. Among the three wells, two wells produced hydrocarbons at the rate of 68 bpd and 37 bpd, while the third yielded only water. We believe the activity in the Woodford shale formation is gaining momentum and will continue into the coming quarters. The combined number of rigs in the Woodford formation as of November 15, 2013 is around 50, while it was around 41 during same time last year.
Continental Resources (CLR) is a major player in the Woodford shale formation. The company operates in the Anadarko Woodford and Cana Woodford, which is located in Oklahoma. These two plays are located in the area the company calls South Central Oklahoma Oil Province, or SCOOP. In the SCOOP region the company has leasehold of 320,000 net acres, and it currently operates around 12 rigs in the region with plans to increase the number of rigs to 18 by the middle of next year. Continental’s plans to increase the number of rigs are supported by the increase in production from this region. The company was able to produce around 20,100 boepd during the third quarter of this year, which was a 293% increase year over year. The SCOOP region has a thickness of 122 meters and around 70 billion barrels of oil in place. With this amount of oil in place and the company’s robust plan, it will be able to increase the oil production from the region.
Goose that lays the golden eggs
While exploring the Mississippian Lime play to increase its productivity, Sandridge has the advantage of it being a stack pay. With its long history of operations in the Mississippian Lime, the company has a better understanding of the play. One of the high potential regions of the Mississippian stack pay could be the Woodford formation in which the company is currently investing. Currently Sandridge’s stock trades at a price-to-book, or P/B, of around 1.50. The company’s further development of the Mississippian Lime is expected to decrease its P/B value in the coming quarters.