EQT: The Low-Cost Gas Producer Is A Buy - Seeking Alpha

EQT: The Low-Cost Gas Producer Is A Buy | Seeking Alpha

Robert Nickelsberg/Getty Images News

I’ve written about several US natural gas focused exploration and production (E&P) companies on Seeking Alpha in recent months including a bearish piece on Comstock Resources ( CRK) back on January 22 and a bullish article on Southwestern Energy ( SWN) in early December.

My approach to evaluating E&Ps is straightforward.

First, I construct a production, cost and free cash flow model based on historic results and management’s latest guidance. This model estimates the level of gas prices a producer requires to cover all its costs and generate excess cash flow – basically a cash flow breakeven.

I then estimate a particular producer’s ability to generate cash over time based on current futures market pricing.

Third, I estimate longer-term free cash flow potential and derive a discounted cash flow (DCF) target for the stock.

This is the most exciting time of the year for E&P investors because most firms update their guidance and strategy outlook for the year ahead when they release their fourth quarter earnings results. After the market close on Tuesday, February 13, EQT Corp. (NYSE: EQT) did just that and management’s latest guidance serves to underline the company’s status as a low-cost US producer.

Let’s start with this:

Production and Cash Flow Model

EQT Corporation is the largest independent natural gas producer in the US and represents a pure-play on the Marcellus Shale natural gas field in Appalachia.

Specifically, the company controls around 200,000 acres in northeast Pennsylvania, around 70,000 acres in eastern Ohio, 460,000 acres in southwest Pennsylvania and 370,000 acres in West Virginia.

Here’s a look at historic results for EQT in the fourth quarter of 2023 as well as management’s guidance for Q4 released at the time of its Q3 call back in late October.
EQT's Q4 Guidance and Actual Results (EQT Q3 and Q4 2023 Earnings Releases)

This model can be divided into four distinct parts.

First up, the top section of my table shows EQT’s production in Q4 2023. The column furthest to the right are the actual numbers released as part of the company’s Q4 release earlier this week. The column just to the left of that represents the mid-point of EQT’s guidance presented during their Q3 call back on October 25.

In the company’s Q4 2023 release, EQT reported natural gas represented just under 95% of total production volume. In addition, the company does produce some oil and natural gas liquids (NGLs) like ethane, propane, and butane each quarter.

Given the dominance of gas in EQT’s production mix, I do not separately model the company’s oil and NGLs output. That does not mean we’re ignoring these volumes. As I’ll explain later in this article, consistent with management’s guidance, we’ll account for oil and NGLs volumes by adjusting the company’s realized gas prices higher by roughly 6% to reflect the value uplift EQT receives from selling oil and NGLs.

Also, note that I have labeled gas production as billion cubic feet equivalent (Bcfe) rather than simply Bcf. Oil and NGLs volumes are converted to gas equivalent volumes at the industry standard conversion rate of 6:1 – one barrel of oil or NGLs is equivalent to 6,000 cubic feet of natural gas equivalent.

As you can see, the mid-point of management guidance for production in Q4 2023 was 550 billion cubic feet equivalent (Bcfe) and the company reported it produced 564 in Q4 2023. In other words, EQT’s gas production was higher than the company expected and management’s guidance.

The second section of my table pertains to EQT’s costs.

The biggest single cost is Capital Spending (CAPEX), which I report both in absolute terms as well as in terms of $/mcfe – dollars per thousand cubic feet of gas equivalent production. In keeping with industry practice, I’m using the Roman numeral “m” to denote 1,000 and “mm” to denote millions.

CAPEX is primarily money spent to drill and complete (fracture and put into production) new wells on EQT’s existing acreage.

Sometimes you will hear analysts make a distinction between what’s called maintenance CAPEX and growth CAPEX. Simply put, over time production from existing shale wells declines rapidly, so a producer like EQT must drill some wells just to offset natural production declines from existing wells. That’s known as maintenance CAPEX – the approximate amount of capital EQT needs to spend to maintain its production.

As you may have already gathered, growth CAPEX is capital spent to increase production.

I do not model maintenance and growth CAPEX separately, because I want to assess free cash flow or cash flow outspend based on management’s current spending plans rather than some theoretical minimum level of capital required to maintain production. However, I will offer some additional granularity of EQT’s planned growth CAPEX spend in 2024 a little later in this article.

Lease operating expenses (LOE) represent costs associated with maintaining production from existing wells – these are wells EQT drilled and completed in prior quarters.

Gathering pipelines are small diameter pipes that connect individual gas wells to processing plants and larger diameter pipelines – so gathering costs would include all costs associated with handling and transporting production from individual wells. Processing refers to the cost of removing natural gas liquids like ethane, propane, and butane from the raw natural gas stream.

Transport costs generally represent the tariffs paid to move natural gas to market over longer interstate pipelines. Generally, Marcellus producers enjoy among the lowest production costs in the US, but also have significant transportation costs.

That’s because regional gas demand in Appalachia is low relative to the amount of gas produced in this play, so most producers need to ship their production to distant markets where gas demand and prices are higher. For example, many Marcellus producers including EQT use long-haul pipelines to move their production to the US Gulf Coast where it’s used in industrial applications like oil refining and chemical production or sent to liquefied natural gas (LNG) liquefaction plants for export.

In addition, significant gas from the Marcellus finds its way down the East Coast to states like Florida where it’s used to generate electricity.

Production and property taxes are taxes levied by individual states based on the value of gas produced from wells.

Most of the other expense line items should be familiar to investors and are common in other industries – that list includes general and administrative (G&A), and interest expenses.

Note that sometimes you will hear producers talk about “production expenses.” Usually, this metric includes costs related to existing wells like LOE and G&A but does NOT include CAPEX spent on drilling and completing new wells. Be careful when comparing two producers on production cost metrics alone; as I mentioned earlier, this ignores the single most important expense for most shale producers, namely CAPEX.

I report all these costs in terms of $/Mcfe of production rather than as a raw dollar amount – this allows us to derive a breakeven cash cost of production. Simply put, that’s the price a producer needs to receive to cover all their expenses including CAPEX; at prices above the breakeven, the producer in question can generate free cash flow while below that level they’d need to take on debt or draw down cash reserves to cover basic operating expenses.

Take a quick glance at the cost line items in the final column of my table and compare those to the company’s prior Q4 guidance. As you can see, EQT outperformed expectations in Q4 on this basis. In particular, note that the company’s actual CAPEX of $538.5 million in Q4 was well below the midpoint of management’s guidance at $550 million. Even better, the company produced more natural gas than expected while spending less than expected – this is a good thing, because it means EQT is spending capital efficiently.

As you can see, EQT spent $0.95 in CAPEX per mcfe produced in Q4 compared to the $1.00 mid-point of management’s guidance – that’s a significant savings and, as I’ll outline in a moment, increased EQT’s free cash flow relative to the level implied by prior guidance.

The third section of my table provides realized commodity prices for EQT. Since this is a presentation of historical results for EQT, not an estimate, I am simply using the commodity prices outlined in EQT’s Q4 2023 report, which include the benefit received from the company’s natural gas hedging activities.

And that brings me to the final row on my table – free cash flow. To calculate this, I start by adding up all the costs items on my table on a $/mcfe basis. The mid-point of management’s Q4 guidance was for all-in costs including CAPEX of $2.43/Mcfe and the company exceeded that guidance in Q4 reporting all-in costs of just $2.35/Mcfe.

As I noted earlier, the $0.05/mcfe in CAPEX savings is the largest component of this though the company’s lease operating expenses (LOE) and G&A costs were also below the midpoint of guidance.

To calculate free cash flow, I subtract this total costs per Mcfe line from the realized price of natural gas received in the quarter and multiply that $/Mcfe profit margin by total gas production in the quarter.

As you can see, based on the midpoint of management’s guidance, we could have expected the company to generate around $176 million in free cash flow in Q4 2023. However, because costs were lower than anticipated and production higher than expected, the cash cost model I’ve constructed points to over $225 million in free cash flow for Q4.

Note that EQT reported actual free cash flow of just over $236 million in Q4, so the model estimate at $225 million is close to the actual number though a bit on the low side.

That’s mainly because my model seeks to capture free cash flow generation from EQT’s core business of producing and selling natural gas and related volumes of oil and NGLs. The company earns additional cash flow through activities like providing midstream and marketing services to third-party producers. These ancillary revenues won’t be captured by a pure production model such as I’ve just outlined, but they're small enough it doesn't impact the utility of the model.

2024: A Look Ahead

So, let’s step the analysis forward and construct a similar model for EQT’s potential production, costs and free cash flow for 2024 based on management’s updated guidance:
2024 Free Cash Flow Model Based on Management Guidance (EQT Q4 2023 Earnings Results)

In this table, I’m following the same format as for the Q4 2023 numbers I presented earlier.

The midpoint of EQT’s production guidance for 2024 is 2,250 bcfe of production and CAPEX of $2.25 billion. The other expenses are all taken directly from management’s guidance table included in its earnings release.

The one exception is the interest expense. To calculate this, I took EQT’s total annual interest expense from 2023 and subtracted $10 million. That’s because management reported that it issued a $750 million bond in January and used the proceeds to pay down a term loan at a higher interest rate, resulting in annual interest savings of $10 million.

As you can see, the sum of all these costs, labeled “Total Costs per Mcfe” is $2.55/Mcfe, which is up from $2.35 in Q4 2023 as I presented earlier. This is a key point and I’ll have more to say about that in a moment.

To estimate the realized gas price for EQT, I used the average price of gas so far in 2024 as well as the average quarterly calendar strip price for the remainder of this year and 2025:
NYMEX Natural Gas Calendar Strip Curve (Bloomberg)

The blue line on this chart shows the current price of natural gas for delivery in each month of the year out through early 2026. The orange line shows the quarterly average – for example, for Q2 2024 the average is $1.80/MMBtu (by convention equivalent to $1.80/mcf). This is the average price of NYMEX natural gas for delivery in the months of April, May and June 2024.

For Q1 2025 – the average of January, February and March 2025 futures – the average is $3.37/mcf.

I made two additional adjustments to calculate estimated realized pricing for EQT. First, I added about 6% to EQT’s realized pricing to reflect the benefit of volumes of crude oil and natural gas liquids EQT produces. This is in-line with management’s guidance presented on the Q4 call.

Second, EQT sells its gas at a discount to NYMEX futures pricing. Much of that is the result of regional basis differentials. Simply put, NYMEX gas futures are priced for delivery at Henry Hub on the Gulf Coast while gas in other regions of the country, such as the Leidy Hub in Pennsylvania, trades at a discount.

Specifically, in its Q4 2023 earnings presentation, EQT reported that it sells around 32% of its production to local markets in Appalachia, 26% to East Coast markets, 19% into the Midwest and 23% to the Gulf. EQT hedges some of its exposure to regional gas price discounts via what’s known as basis hedges, but it still has some uncovered exposure to discounted regional pricing.

At any rate, management’s guidance for 2024 is that it will sell its gas production at an average price discount of $0.60/mcf to Henry Hub/NYMEX futures pricing.

The end result of all this is that the company’s all-in production costs are around $2.55/Mcfe and my estimate of 2024 realized pricing is just $1.84/mcfe for an eye-popping free cash flow outspend of almost $1.6 billion.

The good news is EQT also has significant hedges in place, summarized in this table:
Table of EQT's Natural Gas Hedges (EQT Q4 2023 Earnings Results)

As you can see, EQT has hedges covering more than half of Q1 2024 production and more than 40% of production in Q2 2024 and Q3 2024; hedge coverage drops to less than 25% in Q4 2024.

Hedges consist of both puts and swaps based on the NYMEX gas futures contract and the average prices for these hedges are listed in my table above. To calculate the value of these hedges for each quarter of 2024, I simply compared the prices locked in under these hedges to the calendar strips for the NYMEX futures curve each quarter.

These numbers are significant – the potential for $696 million in upside from swap hedging through all three quarters of this year and $480 million from put option hedges. So, I plugged these numbers into my cash flow model above and the result comes to $421 million in negative free cash flow for EQT in 2024 – that’s cash flow outspend.

Per Bloomberg, the Wall Street consensus is for positive free cash flow of around $800 million in 2024, so my estimate is far worse than the consensus on Wall Street. Look a bit deeper, however, and you’ll see many of these estimates are “stale”, dating from mid-January, when US natural gas futures prices were much higher.

For example, here’s the natural gas futures curve as of January 12, 2024, compared to the current curve:
Gas Futures Curve in Mid-January and Today (Bloomberg)

As you can see, the blue curve, representing gas futures prices through mid-2025 on January 12, 2024, is significantly higher than the red curve (the current curve).

For example, if I average futures prices for delivery in Q2 2024 today, it’s about $1.80/mcf compared to $2.66/mcf back on January 12. The 2024 calendar strip on January 12 was almost $3/mcf compared to around $2.28/mcf today.

This makes a huge difference to the free cash flow estimate. If I re-run my model above using the January 12 curve pricing, the pre-hedge free cash flow outspend jumps from almost negative $1.6 billion to around $50 million in positive free cash flow.

So, the most likely reason for my more bearish estimate for free cash flow is simply that I’m using a lower estimate for 2024 pricing based on more recent, much lower futures curve.

Free Cash Flow Outspend

Of course, cash flow outspend on that scale in 2024 is not ideal.

In my January 22, 2024 article covering Comstock Resources on Seeking Alpha, a key leg of my “sell” thesis was the company’s projected $500 million cash flow outspend for 2024 based on a similar production model.

However, there are three key reasons I’m not overly worried about EQT’s cash flow outspend in 2024.

First and foremost, EQT has a strong balance sheet and can afford to outspend its operating cash flow for a period without experiencing significant financial distress:
Yield on EQT Bonds of 2030 (Bloomberg)

EQT’s 7% Coupon Bonds of February 2030 currently yield less than 5.9% and the yield has fallen over the past few months (the price of the bond has rallied) despite the collapse in US natural gas prices. EQT has an investment grade credit rating and, as I highlighted earlier, issued $750 million in new debt early this year that matures in 2034 and has a coupon rate of just 5.75%.

In contrast, according to Bloomberg, CRK’s 5.78% bonds of January 15, 2030 currently yield almost 8.8% -- EQT’s cost of debt capital is far superior, so it’s better able to fund a near-term cash flow outspend.

Second, EQT offered additional details about its 2024 CAPEX plans as part of its Q4 2023 earnings call and guidance. Specifically, management estimates that it requires around $2 billion in maintenance CAPEX -- money it needs to spend to maintain production – out of its total 2024 CAPEX budget of around $2.25 billion as I explained earlier.

In its earnings presentation, management outlined a plan to spend $200 to $300 million in additional “growth” CAPEX this year, including $50 to $70 million on midstream infrastructure, $70 to $90 million for water infrastructure and $80 to $140 million for in-fill leasing.

If we exclude this growth CAPEX from our model above, more than half of that $421 million in cash flow outspend disappears.

In this case, I believe management has outlined a strong case for spending this capital. The company has a strategy of leasehold replenishment, basically leasing new acreage to replace some of the acreage it develops over time and extend reserve life.

In addition, leasing new acreage adjacent to existing acreage allows EQT to drill longer laterals (horizontal well segments), which increases efficiency and reduces cost on a $/Mcfe basis. In-fill leasing is the largest component of the company’s growth CAPEX.

Building out infrastructure such as gathering pipelines and water recycling systems also reduce long-term costs. Water is crucial to the hydraulic fracturing process used to produce shale gas (and oil) wells and recycling water can dramatically reduce the cost of supply.

In the company’s earnings call, management indicated it plans to spend $115 million on three midstream infrastructure projects this year. Once fully operational, EQT believes these projects will produce $50 million in annual free cash flow uplift.

As EQT deploys growth CAPEX to drive lower costs, it sees its overall maintenance CAPEX needs declining from around $2 billion in 2024 to around $1.85 billion on average from 2025-28. So, a bit of extra CAPEX in 2024 translates to far lower spending needs longer term.

Third, management indicated it has flexibility to adjust its spending depending on near term commodity price conditions. Just consider, if we use the low end of management's 2024 CAPEX and gas production guidance rather than the midpoint, that would decrease the cash flow outspend by about $80 million in 2024.

An ancillary point is that EQT has a history of conservative guidance. For example, as I outlined earlier, EQT exceeded production guidance in Q4 2023 even as CAPEX was also below estimates. Even a modest increase in CAPEX efficiency and/or better-than-expected production could add up to a significant improvement in free cash flow estimates anticipated by my model.

Target and Risks

To derive a target price for EQT, let’s focus on a discounted cash flow model.

I’ve summarized my projections in this table:
Discounted Cash Flow Valuation (Bloomberg, Author's Estimates)

The negative $420 million free cash flow estimate for 2024 is based on the production, commodity strip and cost model I outlined earlier.

For 2025, I’m using the 2025 calendar strip price for natural gas of $3.30/mcf and applying the same $0.60/mcf pricing discount I used for 2024. I’m also holding all costs the same as this year, while reducing CAPEX by $150 million to reflect declining CAPEX as I outlined earlier.

For years beyond 2024 I’m using a flat $2 billion annual CAPEX assumption, flat costs and I’m reducing the NYMEX pricing discount for EQT to $0.50/mcf from $0.60/mcf. Over time, I’d expect EQT’s pricing to improve as the new Mountain Valley Pipeline (MVP) comes onstream starting later this year.

MVP is designed to move natural gas from near the West Virginia/Pennsylvania border to southern Virginia where existing pipelines can move gas further south to the Gulf Coast or gas-hungry southeastern markets. EQT has booked capacity on MVP under long-term deals and has signed contracts with investment-grade utilities to supply gas via MVP as the new pipe comes onstream.

In its Q4 presentation, management noted that by late 2027 management expects EQT’s pricing differentials to NYMEX to improve by $0.15 to $0.20/Mcf.

For 2025 and beyond I’m using a flat $4.00/mcf NYMEX gas price to estimate EQT’s annual cash flows.

All told, based on these estimates I see EQT’s free cash flow improving to over $1 billion in 2025 and $3 billion per year thereafter. I’m using a discount factor of 9% to calculate the net present value of EQT’s cash flows.

Bloomberg’s model for weighted average cost of capital (WACC) shows EQT’s WACC at 7.9%. This is based on the actual cost of debt and an estimate for the company’s equity cost of capital based on a standard equity cost of capital for US companies adjusted to reflect EQT’s volatility relative to that of the S&P 500.

So, I’m using a higher discount factor than implied by this model just to keep my estimates on the more conservative side.

Subtracting the company’s net debt outstanding and dividing it by the current share count yields a discounted cash flow target of just over $50 per share for EQT, roughly a 45% premium to the current quote.

I see this as a conservative target for the stock. After all, EQT has a history of outperforming guidance on both costs and production and, over time, management’s efforts to sell more gas into markets like the Gulf Coast should reduce its realized pricing discounts to NYMEX by a larger amount than I’ve modeled.

The biggest downside risk to my estimate is commodity prices.

Near-term natural gas futures prices are near multi-year lows. However, as I illustrated earlier, gas futures for delivery in 2025 and beyond trade at higher prices. The main reason for that is the expected lift to demand from new liquefied natural gas export facilities expected to come onstream starting early next year.

The Golden Pass export facility under construction in Texas should add over 2 bcf/day of US LNG export capacity according to the EIA. Initially, this capacity was expected to come onstream starting in the second half of 2024; however, Exxon Mobil, the company that’s building Golden Pass, recently pushed back that timetable by around six months to early 2025.

In short, the exact timing of new LNG capacity could impact the calendar strip for natural gas through 2025. If there are additional delays, you could see a lower strip and, therefore, lower free cash flow than I’ve modeled for EQT in 2025 and 2026.

The Biden Administration’s widely publicized pause on new LNG export capacity approvals will have no impact on plants currently under construction or those that have already received permits. That would include most of the LNG export capacity that’s slated to come online between 2024 and late 2028. However, delays to new export capacity beyond 2028 could have an impact on the US natural gas market late this decade, impacting my longer-term cash flow estimates.

I believe my cash flow model has factored in conservative assumptions for EQT’s costs and cash flows that offset these risks; however, forecasting longer-term free cash flow is always subject to some error and risk.

Bottom line: EQT looks like a good buy at current levels with a target of around $50.