Where's the price of oil and gas going? The volatility in the today's market is unprecedented for commodities, which Michael Hall, lead publishing analyst at Stifel Nicolaus Research Team, believes will elicit a big spike in price. In this exclusive interview with the Energy Report, Michael sifts through theories and trends in the hyper-cyclical oil and gas business and discusses future implications of declining rig counts and what that means to domestic energy.

[Editor’s note: For Part 1 of this article, please click here]

TER: Can you give our readers some of the ideas and ways you think they can position themselves in your sector with stocks that you like?

MH: Sure. Chesapeake’s one I’ve always liked a lot. Unfortunately, I’ve ridden it all the way up and down, but I do see a lot of potential, particularly long-term, with Chesapeake. Another on the large-cap side is XTO Energy Inc. (NYSE: XTO, Stock Forum). XTO is what we call the highest quality of all the large cap gas names that we look at. They’ve done a tremendous job of hedging over the last year. They ended up monetizing over $2 billion in hedge gains over the last couple of months, paying down debt, and fixing up a balance sheet that had some leveraging on it after roughly $11 billion in acquisitions during 2008. The push back is, let’s say, people say they bought at the top. My rebuttal and theirs would be, well, they hedged very well and they locked in their returns when they did those acquisitions. What it really did was just recharge the inventory position at the company. They think they have a good solid five-year inventory to continue growing the company at a peer-busting clip. I think probably over 15% a year in terms of production growth on their current inventory. So in theory you could have significant appreciated growth over the next five years. Our target on XTO is $39. Both of these companies are extremely well hedged looking out this year and next.

TER: What about a smaller cap company?

MH: One down the cap structure that I have been highlighting a lot is Petrohawk Energy Corp. (NYSE: HK, Stock Forum). This is more of a mid-cap producer that’s had extreme volatility in last 12 months and the big reason being is that they, along with Chesapeake, really, helped expose what’s now thought of as one of the industry’s leading shale plays, which is the Haynesville Shale. The Haynesville Shale is in Northern Louisiana and East Texas, although the Northern Louisiana part is kind of leading the economics at this point. Petrohawk’s put up, frankly, the best wells, as their legacy acreage happened to be right smack in the heart of this Haynesville Shale in their Elm Grove field. So they’ve put up wells that have initial production rates in excess of 20 million cubic feet a day.

These wells come off hard, come off fast, 80% in the first year or more, so you’re setting up a steep treadmill as soon as you stop drilling because it’s going to be hard to get back on for all these companies, and for the industry as a whole, with all these shale plays. But I think Petrohawk, for a mid cap, has one of the brightest outlooks out there. They did just do a follow-on stock offering to help shore up the balance sheet for some acquisition opportunities they see in the core of the Haynesville Shale, and then they also did a significant amount of high yield back earlier this year in the January timeframe. So they’re well capitalized at this point and they’re actually still planning to grow their production 40% in 2009 despite the current environment. My most recent target is $25 per share.

The 52-week high on it is well over $40, so you’re well within that range and still have meaningful upside potential from here. Frankly, long term, and while I have no knowledge of any M&A activity, I believe it could be a take out. I think eventually it’ll get acquired just given the quality of the asset they have in the Haynesville. It’ll probably end up in the hands of a larger company with greater capitalization.

A small cap favorite I’ve been pushing is Bill Barrett Corp. (NYSE: BBG, Stock Forum). Bill Barrett’s predecessor company, Barrett Resources, was the Rockies gas explorer that was sold to Williams several years ago and Bill Barrett Corp. is the follow-on company. Fred Barrett is the CEO, the son of Bill Barrett. Bill Barrett’s still on the board. The company remains an active explorer and developer in the Rockies region. Historically, the Rockies have kind of been thought of as a long supply/short demand environment, so you end up with export constraints and issues getting the gas to market. So, you’ve had big price discounts on Rockies gas for the last few years. You had a big pipeline come around in 2008, the Rockies Express pipeline, which opened up a lot of opportunities for Rockies producers. Again, in 2008, we’ve already almost filled it up. But here we are, as everyone is laying off rigs, the Rockies has laid off rigs at a faster clip.

There are indications that Rockies production as a whole, industry-wide, is actually starting to decline. I think that could help the pricing issue, particularly from a relative standpoint. The company currently trades at almost $24 a share. I’ve got a $36 target on it. It trades at significant discounts to everyone I cover. It’s at 2.9 times cash flow, 3.7 times EV/EBITDA. You’re paying just $1.48 for proved reserves in the ground. My peer averages on all those are 4.9 times cash flow, 6.1 times EV/EBITDA, and $2.14 for proved reserved.

It’s a small company; it’s somewhat under-loved, under-appreciated in my opinion. I think as prices eventually recover, the Rockies could well lead that recovery because of this additional capacity that was brought on line in 2008 that we’ll have to fill back up again. They’ve done a good job of delivering with the drill bit on the exploration front. In 2008, they discovered a play called the Gothic Shale. It’s in the Paradox Basin in Colorado and it’s a shale gas play like any of the others. It’s just in the Rockies and it looks like they’ve got a significant multi-year development project on their hands that they’ll be continuing to prove up in 2009.

TER: Are they going to need funding? How do they get their capital?

MH: They are currently drilling and spending within cash flow, which is the mantra of the industry at this point. Historically, they’ve been conservative with the balance sheet, and they tend to keep things that way. They’ve done a really good job of hedging as well, so they’ve locked in their significant cash flows for this year and next. I don’t show them in an immediate need of any funds. And, if things get back off to the races, then if they want to try to accelerate development in this Gothic Shale or some other play, it’s an option out there.

TER: What about in the limited partnerships?

MH: The one I would probably choose to highlight would be Atlas Energy Resources (NYSE: ATN, Stock Forum). A big part of what they do is offer what are called ‘drilling program partnerships’ to the public. So you can be a general partner in their drilling program and they’ll flow through tax write offs, basically, so you can shelter a lot of income.

The new budget being proposed by the Obama administration is proposing a repeal of what are called ‘intangible drilling costs’ and the expensing of intangible drilling costs (IDCs). That could affect that part of their business. I don’t know if it would eliminate it. From my talks with the company and after thinking things through, I think there are some opportunities to restructure how the partnerships would be offered. There still would be some deductions it seems like from the IDC standpoint. It just wouldn’t be overnight; you wouldn’t get to expense it all up front. But, that said, even if that part of the business goes, there still is a stream of cash flow that would basically deplete over time like a well that is still flowing to Atlas. If I just take what I’d call a normalized cash flow assumption for 2009 and back off the part that’s at risk because of the proposals in the new budget, I still get a $2.68 per unit normalized cash flow. If I slap a five times multiple on that, which is a pretty normalized mid-cycle multiple for an E&P company, you still get about $13.40 per unit.

I’ve got a $34 target out there on the company. I think there’s a significant opportunity here, frankly. You’ve got around a 20% yield. But even taking the much more conservative approach as just a walk-through with that somewhat normalized cash flow, you still get over $13 per unit in potential here. I think it’s a very interesting entry point, as I think the market’s somewhat overreacted to some proposed legislation. There’s still headline risk out there, maybe you wait to see what actually ends up happening with the budget. But I believe for those that can take a bit of a longer view, it could be a big opportunity.

TER: You say if they lose this part of the business, they still have almost a royalty, in a sense, operation. What would be the value? Let’s say that business totally goes away, now we’re left with what we have. Is your $52 target still intact?

MH: That’s where the other interesting part of the story lies—they’re sitting on over 240,000 net acres in the heart of what’s called the Marcellus Shale. The Marcellus Shale is in Pennsylvania, all throughout, really, New York, West Virginia, thought to be potentially the largest gas find in the world at this point. They’ve got a big core position right in the heart of what’s going on in southwest Pennsylvania.

At this point, I don’t think you’re paying anything for that in the stock and that’s where the majority of what’s called the ‘upside’ in my target price comes from; over time, I think they’re going to prove this asset up. They’ve already drilled several wells, proven it up. They’re one of the leading producers out of the Marcellus Shale and they’re kicking off a horizontal drilling campaign in 2009 that’s going to, I think, prove this asset to be worth multiple billion dollars to unit holders. So it’s almost, I call it, a special situation because I think you probably end up having a restructuring of the company. It’s currently an LLC; they pay out a significant distribution, currently 61 cents a quarter. I see that distribution as safe so long as they continue to have the structure they're in. But, again, if you think about the asset they’re holding in the Marcellus, it’s basically a growth asset, or it should be; so I believe you ought to be plowing 100%-plus of the cash flow that that asset generates back into the asset to continue growing it.

If you’re paying out significant distributions, you can’t grow that asset as quickly as you should, in theory. So from my talks with them and from my own personal view, I think a restructuring of the company is possible and some sort of carve-out or another sale of the asset. It’ll be complicated if it happens, but I think ultimately a lot of value will be unlocked here and I think it’s an extremely compelling opportunity.

TER: Is this an industry wherein the price of gas falls victim to what the storage is at any given point? Now we’re taking rigs off, so the storage is eventually going to go down. Gas will go up; but once it goes up, you fill up the storage. So is it always this never-ending fluctuation?

MH: It’s a hyper-cyclical business and it’s extremely volatile. It’s very seasonal on top of very cyclical. Natural gas, stepping way back from a macro perspective, it’s really a heating fuel in the winter, and it’s a power-generating or cooling (air conditioning) fuel in the summer. You add not only cyclical pressures from industrial demand, but then also seasonality to it. Yes, it’s very, very volatile; it’s very, very seasonal and those who are faint of heart should be wary.

It’s a risky sector; it’s very, very volatile, but there’s more to it than just storage. There are some long-term secular themes that are important. The industry is kind of a victim of its own success. When storage runs out, it’ll do its best to fill it back up—but it kills its own cycle every time. That’s what’s happened over the last five to seven years. The industry had been thought of by consumer, and maybe by regulatory, groups as an industry that couldn’t grow. What’s really been proven over the last few years is that it can grow if it gets the right pricing to do it. The resource is out there.

From a long-term perspective, from a consumer standpoint, you don’t want to rely on an industry that can’t grow, right? But if it can grow, then it’s a much more viable fuel for power generation, and possibly transportation, and it becomes that much more interesting from a regulatory, as well as a consumer standpoint. It’s a changing industry; it’s an interesting industry in that sense, but I think it’s highly investable still because of what’s being exposed this year.

TER: How long are these business cycles? You say it’s hyper-cyclical. You mentioned we’ve been building up for seven years and this is a seven to ten-year cycle. Can it really change within two years?

MH: That’s a good question. By the cyclical side of things, I mean the broad economy. Industrial demand is 18 billion cubic feet a day of demand on 64 billion cubic feet a day. So it’s nearly a third of total demand. So if industry is shrinking, you’re going to have demand headwinds, and that’s more what I mean on the cyclical side of things. So that’s more dependent on how long it’s going to take the U.S. and world economies to start back up again. In terms of a six, seven, or ten-year cycle–it’s hard to say. I think it’s different every cycle.

From a macro perspective, you’ve got a lot of ultimately inflationary actions coming out of the government, and it could take some time for the multiplier to kick back into effect and dollars start changing hands again. But, when they do, I think a lot of these commodities plays will have real businesses, will throw off real cash flows and are worth a lot more than what they’re trading for today. If you can take a longer view on things, it’s a sector that’s worthy of looking at, I think, but it's also high risk. I would emphasize that.

TER: Michael, thanks so much for your time.

For additional comments on Baker Hughes Inc. (NYSE: BHI), Chesapeake Energy (NYSE: CHK), XTO Energy Inc. (NYSE: XTO), Petrohawk Energy Corp. (NYSE: HK), Bill Barrett Corp. (NYSE: BBG), and Atlas Energy Resources (NYSE: ATN) from newsletter writers, money managers, and analysts, click on the respective links or visit The Energy Report.

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Michael A. Hall, CFA, joined the Stifel Nicolaus Research Team in August 2007. He has been covering the energy sector for roughly six years. Most recently, Michael worked as a Senior Associate covering domestic Exploration & Production at Wachovia Capital Markets. Prior to that, Mr. Hall was a lead associate on the same team at Jefferies & Company and initially at First Albany Capital. He previously worked at Stifel Nicolaus from 2003–2004 and started his coverage of the Energy sector following the Oilfield Services industry. Mr. Hall's return to Stifel Nicolaus marks his initial effort as a lead publishing analyst and he intends to continue to focus his coverage on the domestic Oil & Gas Exploration & Production industry.

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Disclosure: Additional disclosures are available upon request. View here. Additional disclosures include our risks to target prices, which are:

Chesapeake Energy (CHK): In our view, there are a number of risks to our target price on CHK shares. Those risks include, but are not limited to, the failure of management to adhere to its financial plan, the inability to bring F&D costs more in line with industry peers, the failure of emerging resource plays to materialize or at least the potential of those plays to emerge as much less economic than the company's current set of projects, the inability to lock up leases through production, and a sustained downturn in commodity prices in general.

XTO Energy (XTO): In our view, there are a number of risks to our target price on XTO shares. Those risks include, but are not limited to, the failure of management to integrate recent acquisitions, the inability to execute on substantial growth plans, the failure of emerging resource plays to materialize or at least the potential of those plays to emerge as much less economic than the company's current set of projects, and a sustained downturn in commodity prices in general.

Petrohawk Energy (HK): In our view, there are a number of risks to our target price on shares of Petrohawk Energy. Those risks include, but are not limited to, an overly aggressive assessment of resource potential in the company's various plays - particularly the Haynesville Shale, a blowout of the basis differential at the Henry/Perryville/Carthage Hub, a dramatic tightening in the supply of rigs, completion services, and pipeline capacity, as well as a sustained downturn in commodity prices in general.

Bill Barrett Corp. (BBG): In our view, there are a number of risks to our target price on shares of Bill Barrett Corp. Those risks include, but are not limited to: a sustained downturn in commodity prices in general, expansion of the discount of Rockies gas prices to NYMEX due to a tightening of pipeline takeaway capacity (specifically as it pertains to capacity on the Rockies Express pipeline), a negative record of decision from the BLM on the West Tavaputs EIS, as well as a failure of the market to recognize the company's vast resource potential and to price shares as such.

Atlas Energy Resources (ATN): In our view, there are a number of risks to our target price and distribution estimates for Atlas Energy Resources. Those risks include, but are not limited to, a rising corporate decline curve, the suitability of the prospective Marcellus Shale for the MLP structure, and a tightening of the service market in the Appalachian Basin. In addition, given the importance of the tax treatment on MLPs to their consideration as an investment opportunity, any negative changes in tax treatment could likely result in significant underperformance in ATN units.