There are three quality energy companies I bought in last month’s Investor’s Edge – and one I sold. It wasn’t easy selling Shell (RDS-A). I’ve made big money on it before; indeed, the very first article I wrote for SA was about Shell being defrauded by Russia.  But lately, Shell seems to be doing enough on its own to warrant concern.

Shell’s economic mistakes of paying top dollar for BG, insisting on continuing to pursue the high-cost deepwater drilling in the Arctic, just ended with a more than $2 billion writeoff, and spending $2 billion on heavy oil in Alberta only to shut it down, show a management that has lost its way in search of The Big Score. We aren’t “big score” portfolio managers.  We are slow and steady advisers that like to see incremental gains during bull markets but buy big when we see serious value, typically after a market or individual stock decline. Shell started out just fine but they are no longer thinking protection and steady growth.

With these recent mis-steps and a return on invested capital that has recently declined to 7.3%, I believe that Shell’s marvelous dividend may now be in jeopardy.  We will sell our RDS-B but retain exposure to the oil and gas industry by buying firms that are even cheaper in price per revenues and earnings.  Because (in 2 of the 3 cases) they have a lower profile to most investors, they are actually down a greater percentage than Shell.  All enjoy the same or better credit quality.

Per our last issue, we anchored this trio with Chevron (CVX)  Unlike Shell, Chevron continues to be a company that moves slowly and inexorably toward better returns.  Almost alone among the major international energy firms, CVX did not rush into Iraq, Burma, Russia et al during the boom times for oil and gas.   The company picks its geopolitical partners well (perhaps because it was burned once in Ecuador it is now twice shy.)  Like us, Chevron chooses steady returns over Big Scores (that often aren’t.) This is reflected in its return on capital, which is among the highest in the energy sector.

Also like us, CVX takes the long view.  Its new production, particularly from the Gulf of Mexico and western Australia will provide a growth engine for Chevron for years to come.  In fact, two liquefied natural gas (LNG) projects in Australia, Gorgon and Wheatstone, will be the primary drivers of Chevron’s international growth in the coming years.  These two projects  will marry CVX’s massive natural gas finds offshore Australia with the insatiable demand for LNG in Japan and other Pacific rim nations, lessening their dependence on Russian or Middle Eastern oil and gas.  LNG, with both a high– and a long-plateau production profile (and little capital expenditure) will provide significant cash flow to support reinvestment or increased shareholder returns.

We also placed in this troika two less-well-known firms, both on the NYSE, that have fallen considerably more than Shell, giving us the opportunity for an even greater rebound when oil and gas firms spring to life again.  (P.S.  No matter what the prevailing opinion, we don’t know if that day will come in 2016, the current consensus, or tomorrow, if terrorists take production offline in one of the top producer nations.  That’s why we buy at least some positions today…)

The first of these is Range Resources (RRC)  The biggest risk I see to Range is the Pennsylvania legal and regulatory environment.  Pennsylvania has had declining manufacturing revenues for years and is currently facing an underfunded pension plan crisis.  By fortuitous happenstance, however, it was discovered a few years back to rest above what may be the most valuable of all the shale oil and gas formations in the country.  Rather than say “Thank you, Mother Nature” for this windfall and the high-paying jobs it creates, local regulators have slow-rolled many projects and local governments have banned drilling outright.  They’ll catch on – or be forced from office. In my opinion, Range has the best position of any energy company in the Marcellus and other smaller formations in PA.

As fracturing and drilling become more sophisticated, I believe these local objections will wither as they realize the safety of these operations is high, the jobs created are a windfall, and the returns will allow them to bail themselves out of their pension difficulties.   Plus, Range has the highest number of the lowest-cost multi-year leases of any major firm in the Marcellus shale region.  With drilling inventory lasting at least through the year 2035, Range has large blocked-together acreage with low royalty, operating, and development costs. Range will be in the catbird seat as oil and gas prices recover.          

Antero Resources (AR) is also a big player in the Marcellus formation, including that portion which sits under West Virginia, as well as in the Utica formation in eastern Ohio.  Just as CVX has positioned for LNG sales to the Pacific rim from its facilities in Oz, the major players in the Utica and Marcellus stand to benefit in coming years from LNG deliveries to Europe.  Europeans currently get most of their natural gas from Russia.  If you are a German or Latvian or Bulgarian shivering in the winter, who would you rather depend upon for a dependable supply without geopolitical demands attached, US companies or the bullying and capricious Russian government?

Production costs are quite low for Antero.  In fact, Morningstar estimates that AR’s natgas production  is still quite profitable at $2.50 per mcf, and break-even at the current pre-winter spot price.  As we approach winter in the upper Midwest and Northeast, of course, that price typically rises.  I think it is likely to do so this winter, in particular, with so little new drilling and so many operations shut in.  Antero will benefit.  In times of pricing pressure, the lowest cost producers always benefit.  I believe the quality of Antero’s assets, coupled with management that holds a slow and steady hand in production as well as new exploration, assures them of continued success.

Please note:  My expectations for increased revenue, earnings and stock price are not based on higher oil and gas prices, but upon the lower costs I see as shale, exploration, and transport technologies reduce expenses.