Significant Upside Potential, As Range Resources Could Turn Into A Buyback Machine (RRC)

Introduction

In my dividend growth portfolio, I own three energy stocks:

• Texas Pacific Land Corporation (TPL): This is a landowner in the Texas Permian. It benefits from oil and gas royalties, water royalties, and from every activity related to drilling, pipelines, and renewables on its land. It’s sensitive to oil prices like an oil driller, yet much more efficient, as it does not produce any oil or gas itself.
• Canadian Natural Resources (CNQ): This Canadian giant has more than 40 years’ worth of inventory, very low breakeven prices, and a policy to return 100% of its free cash flow to shareholders.
• Antero Midstream (AM): This company owns the midstream assets of Antero Resources (AR), making it my natural gas play without direct pricing exposure.

Although I am bullish on both oil and gas, I prefer to own companies with less exposure to natural gas prices – like midstream companies that own pipelines.

That is mainly based on my expectation that future demand will remain very strong, which requires a lot of natural gas production. However, because natural gas production is so strong, prices are very low right now.

As we can see below, WTI has broken out, trading at $85 per barrel. Meanwhile, Henry Hub Natural Gas trades below $2.0 per MMBtu.

Midstream companies transport natural gas through their pipelines. They make money based on fees. Hence, in this environment, they perform quite well, as volumes are more important than prices.

While I will continue to prefer midstream in the natural gas space, I like a few producers, including Range Resources (NYSE:RRC), which I consider to be one of the top three producers in North America.

My most recent article was written on December 8, when I went with the very bullish title “High Risk, High Reward – Why I Expect Range Resources To More Than Double In The Years Ahead.”

Since then, RRC has returned 24%, beating the S&P 500 by roughly 960 basis points – despite the decline in natural gas prices!

In this article, I’ll update my thesis, discuss natural gas prices, and explain what makes RRC so special.

So, let’s get to it!

Natural Gas May Not Be Cheap For Long

I’m glad I’m a long-term investor. If I had to watch natural gas prices on a daily basis, I would probably need therapy.

Natural gas is very volatile and often headline-driven.

While oil is in a strong uptrend, natural gas is currently being pressured by two major issues:

• Natural gas production is very strong. This is caused by “normal” natural gas production and associated gas production, as the quality of major shale plays is declining. This means more natural gas as a byproduct is being produced.

Going into this year, the U.S. produced roughly 80 billion cubic feet of natural gas per day. Most of it comes from the Marcellus Basin in Appalachia. However, the oil-focused Permian is seeing rapid growth, mainly because of associated gas production.

• Demand has been weak. Although the fact that Russian gas flows to Europe have been imploded since the start of the war, unusual weather for more than two straight years has reduced demand. This kept storage high. As natural gas cannot easily be stored, it immediately pressured prices.

The good news is that there’s light at the end of the tunnel.

For example, bargain buyers are returning. Asian LNG (liquified natural gas) imports have hit a new record, as nations are using low prices to boost inventories.

Ample supply and mild winter weather have kept Asian LNG prices near the lowest level in three years, making it cost competitive with alternative fossil fuels. Swing buyers in emerging nations rushed to procure cargoes after months of limited activity. – Bloomberg

With that in mind, Goehring & Rozencwajg agree with me that the outlook is quite good (emphasis added):

Despite the mild weather, growing inventories, and falling prices, we remain incredibly bullish. Analysts underestimate the impact of slowing shale growth ahead of the looming wave of new LNG export capacity arriving later this year. Despite pervasive bearishness, we believe 2024 will be the year Henry Hub converges with international prices, which are currently nearly six times higher. – Goehring & Rozencwajg

The core of this thesis makes sense, as the U.S. will see a rapid increase in exports. This increases demand and allows Henry Hub to converge with international prices, which tend to be much higher.

For example, Dutch TTF, which is the benchmark for European natural gas prices, is trading at EUR 26 per 1MW. This is roughly $8.30 per MMBtu (more than 4x Henry Hub!).

When adding that weather normalization is likely and long-term natural gas demand remains strong, I’m very bullish on the future of natural gas prices.

On top of that, an unexpected demand driver is artificial intelligence (“AI”), which is expected to significantly boost electricity demand.

In 2022, AI accounted for 2.5% of total electricity consumption (126 TWh). That number could rise to 390 TWh by 2030 (7.5% of total).

If all 390 TWH were to come from natural gas another 36 BCF/D would be required. For reference according to the most recent EIA-914 the U.S. is producing about 125 BCF/D with YoY growth of about 6-BCF/D. When you add the 11 BCF/D coming from LNG exports that RBN Energy projects in the next couple of years to current needs for summer cooling demand, the ends of these two pieces of string do not meet in the middle. By a long shot. – OilPrice.com

That’s where Range Resources comes in.

What Makes Range Resources So Special

Range Resources is one of America’s top 10 producers of natural gas and natural gas liquids (NGLs). NGLs are a fascinating topic, as this segment includes a wide variety of hydrocarbons that are not natural gas or oil.

As we can see below, they come with a number of uses. They also have higher margins than natural gas, which makes natural gas producers with significant NGL exposure very attractive.

Last year, the company produced 538.1 billion cubic feet of natural gas, 37.9 million barrels of NGLs, and 2.5 million barrels of crude oil and condensate.

This translates to roughly 69% natural gas production and 31% non-natural gas production.

Not only does the company’s production with a large part of higher-margin products but it also is backed by deep reserves in ultra-low-cost regions.

The company, which produces in the Marcellus, has more than 30 years of low-cost inventory. In fact, 97% of its undrilled inventory is breakeven below $2.50 Henry Hub.

It also has very efficient operations, with peer-leading reinvestment rates.

As we can see below, the company has an expected reinvestment rate of 56% of its cash flow in 2024. That’s well below the averages of its peers.

[…] the real value proposition over the long run is underpinned by ranges low sustaining capital requirements. Our low capital intensity is the result of Range’s class-leading drilling and completion costs, shallow base decline, large blocky core inventory and talented team. – RRC 4Q23 Earnings Call

The company also benefits from favorable markets where it sells its gas.

For example, half of its natural gas goes to the Gulf Coast. Half of that is turned into LNG. Roughly one-third of its gas goes to the Midwest.

This is a huge advantage for the company, as some of its peers do not have the “luxury” of selling so much gas to attractive markets.

This also explains why the company has such a favorable breakeven price.

Looking at the data below, we see that the company has a free cash flow breakeven price of roughly $1.50 per MMBtu (Henry Hub). This number includes hedges and is based on $75 WTI.

Currently, the company has hedged 55% of its 2024 production with an average floor of $3.70. It has also hedged 25% of its 2025 production with an average floor of $4.11.

Especially in the current market, these hedges provide the company with stability.

Even better, as we can see above, at $4.00 Henry Hub (we’re still way off at the moment), it has an implied free cash flow yield of 11-12%, which bodes very well for shareholders.

After all, because of its healthy balance sheet, a lot of it will end up in shareholders’ pockets.

In 2017, the company had $4.1 billion in net debt. This year, it could achieve its target of less than $1.5 billion in net debt.

This opens up possibilities for accelerated shareholder distributions.

Right now, RRC pays $0.08 in quarterly dividends. This translates to a yield of 0.9%. That’s nothing to write home about.

Going forward, I doubt the dividend will get juicy, as the company has a clear emphasis on buybacks.

So we have optionality, and we’ll lean in and be opportunistic in those share repurchases. We certainly have latitude to make those decisions. We do favor the share repurchases, given the disconnect in intrinsic value we see between the underlying asset and share price right now, versus a more heavily weighted dividend-type program though a modest base dividend makes sense to us as well. – RRC 4Q23 Earnings Call

As the quote above shows, the company believes that its attractive valuation supports buybacks over dividends. I agree with that.

After all, even at $2.00 Henry Hub, the company has a 3.5% free cash flow yield. Once the balance sheet has reached its desired state, it can technically spend up to 100% of free cash flow on buybacks.

A 3.5% FCF yield at $2.00 Henry Hub makes RRC highly attractive, as it implies a free cash flow multiple of 28x.

Other valuation metrics agree, as RRC trades at a blended P/OCF (operating cash flow) ratio of just 8.4x in this market. Next year, analysts expect OCF to rise by 23%, potentially followed by 13% growth in the year after that. This implies a $56 stock price, as the chart below shows. That’s 60% above the current price.

Although RRC will have a very hard time recovering without support from rising natural gas prices, I believe the future for natural gas is bright, making RRC a fantastic play.

If I’m right, we could be looking at a (volatile) natural gas bull market to $4-$5. In the second half of this year, I expect RRC to reveal exactly how it will reward investors.

Eventually, we will likely be looking at both a natural gas bull market and aggressive RRC buybacks, making the risk/reward even more attractive.

After all, based on its current market cap, the company can technically buy back 11-12% of its shares at $4 Henry Hub. To me, that’s a great deal, which is why I own some RRC in my trading account.

However, please be aware that this is a highly volatile play. That also explains why I do not own it in my dividend account. If you usually only buy blue chips, the main takeaway of this article should be the favorable outlook for natural gas, not that you need to jump into RRC. Please keep that in mind.

Takeaway

While natural gas faces short-term pressures, long-term prospects are promising, especially with rising global demand and the potential impact of artificial intelligence on electricity consumption.

Range Resources stands out with its robust portfolio, efficient operations, and favorable market positioning, offering tremendous potential shareholder value.

However, caution is advised due to the inherent volatility, emphasizing the need for a diversified approach.

Pros & Cons

Pros:

• Strong Positioning: Range Resources ranks among the top natural gas producers in the U.S., benefitting from deep reserves and low-cost production in the Marcellus Basin.
• Efficient Operations: With peer-leading reinvestment rates and a focus on cost-effectiveness, RRC has significant free cash flow generation opportunities.
• Favorable Market Access: RRC enjoys favorable market access, with significant portions of its gas directed towards higher-margin markets such as the Gulf Coast and LNG production.
• Attractive Valuation: Despite market challenges, RRC presents an attractive valuation, supported by metrics like low P/OCF and P/FCF ratios.

Cons:

• Volatility: RRC operates in a highly volatile market.
• Limited Dividend Yield: The company’s emphasis on buybacks over dividends means investors seeking immediate income may find RRC’s dividend yield less appealing.
• Market Dependency: RRC’s recovery and future performance heavily rely on supportive trends in natural gas prices.