The Way to Play Utica Shale

 | Sep 04, 2012 | 3:10 PM EDT  | Comments
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As a new contributor, I want to introduce readers to my best ideas, which still have plenty of room to run. My investing philosophy is a bit more aggressive than others here, but I want to present readers with my more conservative ideas, which I believe have solid risk/reward scenarios. 

The Utica Shale was introduced to investors via a lot of pomp from Chesapeake Energy (CHK) not long ago and investors initially cheered and then worried. The fears for many of the Utica plays, and companies focusing on other shale plays around the country, center around companies' need to drill and up their capital expenditures to levels that may force certain entities to outspend their operating cash flow (think Devon (DVN), Encana (ECA) and SandRidge Energy (SD)). In our investing experience this has been a necessary evil and the norm, but after the capital freeze that resulted from the housing collapse it has become a point of emphasis among investors as to which companies are able to operate within operating cash flow. 

EV Energy Partners (EVEP) is a master limited partnership with ties to Enervest Partners. Enervest is considered by many to be one of the top managers for institutional money in the oil and gas industry and has dropped assets down to EV Energy Partners over the years, which have greatly increased the size, revenue and bottom line of the partnership. This is also how EV Energy got involved in the Utica.

Whereas most of these upstart E&P companies are busy trying to drill out their acreage in hopes of fulfilling their lease obligations, EV Energy Partners has a luxury not enjoyed by many others in these new oily shale plays.  It can spend when it wants and, for the most part on the vast majority of their acreage, it has no fear of losing rights should it not drill out the Utica. It already has the acreage held-by-production, or HBP. The production results from other formations that have been producing oil for decades, namely the Knox formation.

When Chesapeake was assembling its industry-leading Utica position it came to Enervest and EV Energy Partners, among others. Today, EVEP has roughly 20,000 net acres tied up in joint ventures with Chesapeake and another 130,000 net acres which have not yet been joint-ventured with anyone. Within those acres is the real hidden value in this MLP play. The company has been looking to monetize the acreage as it is not really looking to spend that type of money on capital expenditures and would much rather prefer to unload this undeveloped asset in order to buy mature fields and enable it to increase its distributions. 

The company's last conference call highlighted how this monetization will occur and we should see a tax-free property exchange whereby EVEP hands over a portion of their Utica acreage or the entire portfolio for mature producing assets, which will most likely have oil production attributable to them. In either scenario the company has indicated that it will keep the overriding royalty interest (ORRI), which averages about 2% over roughly 880,000 gross acres in the Utica, including acreage held by Chesapeake in joint ventures. 

The company's acreage is in the oil window and we got our first results reported during this quarter's results. The first well reported was the Frank 2H well, which "was brought on line and flowed at an initial unassisted rate of 515 BOE per day with a very high liquids content. Approximately forty percent of the equivalent production is light crude oil and forty percent is NGL's." When the company presented at the 2012 Citi One-on-One MLP/Midstream Infrastructure Conference production had already increased to 870 BOEPD, with 360 barrels oil production, 312 NGLs and 1.2 Mmcfd natural gas. The second well announced by the company, the Cairns 5H well, showed even more promise with 1,690 BOEPD announced and the production breakdown being 729 barrels oil production, 587 NGLs and 2.2 Mmcfd natural gas. 

The results have taken longer to get to market as the dissipation period on these wells has increased over the initial expectations. From listening to many Utica focused companies discuss their operations during conference calls, this play is much like the Eagle Ford shale and requires that wells be shut in following drilling in order to let the drilling fluids dissipate and provide for greater production.  The industry is still attempting to find the optimal resting period, however it appears to us that depending on the window and the area that we are looking at a 60-90 day window. 

These assets appear to hold a lot of hidden value, and although the partnership's units do trade at a premium to the industry's, in the next 6-12 months it will become apparent that they are still undervalued at today's prices. The company has already divided up the portfolio into three projects and continues to state that it will close a deal by year end for unit holders.  Regarding price, it is important to highlight that all along management has been adamant that they believe the Chesapeake JV in the Utica set a floor of $15,000/acre for the play, not a high-water mark. We think that the company will be able to realize somewhere in the neighborhood of $15,000-20,000/acre for its oil and wet gas window acreage.

When all is said and done, the units could be worth in the neighborhood of $90-100/unit while paying out a distribution roughly twice as high as the current one. The logic behind this is the realization of producing assets from the swap of non-producing assets coupled with the partnership's need to leverage up the balance sheet again to come back in line with the industry average, which would be done by taking on new debt to fund the acquisition of further properties.

We have tremendous faith in this management team, including current CEO Mark Houser, who has been involved with both Occidental Petroleum and Nexen and the former CEO and current Executive Chairman John Walker, the man behind Enervest. When you have great assets and a great management team led by an industry veteran such as John Walker, it generally leads to good things in this industry. This is a story many are not telling or are unaware of, but based on the price action in the market those in the know truly like what management has been saying over the past few weeks.

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