Gadfly

There's a Good Story Lurking Somewhere in This Gas Deal

EQT can cut costs buying Rice, but its pitch to shareholders needs work.
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The tool pusher (the guy controlling the drilling rig) sits behind the controls of an EQT Corp super triple fracking rig while drilling for natural gas on a site in Washington Township, Pennsylvania.

Photographer: Ty Wright

EQT Corp.'s $8.2 billion acquisition of Rice Energy Inc. is a sound deal that could use some better marketing.

EQT's stock slumped after the company announced it was buying its rival Appalachian natural gas producer. At one point on Monday, $1 billion, or 10 percent, had been wiped off EQT's valuation (it was down 8 percent as of writing this). To be fair, announcing any deal of this size often provokes a negative reaction against the buyer. But it doesn't help that, when quizzed by an analyst about the synergies EQT hopes to realize, CEO Steven Schlotterbeck responded with this:

Drew Venker (analyst with Morgan Stanley): OK. And what's driving that big cost reduction?

Schlotterbeck: Just the operational synergies from the scale, and the overlap of operations, and some of the benefits we'll get on water movement, water logistics. People having to move smaller distances. So, it's just – this a perfect fit for our existing position, so we'll generate a lot of ongoing efficiencies on the LOE [lease operating expense; essentially, production costs] side that – but as a result, our LOE is fairly low already, so it's kind of small in comparison to the synergies we get from a longer laterals but it's real.

In general, when selling investors on the concept of synergies, credibility goes hand in hand with specificity -- something not helped by the phrase "people having to move smaller distances". Neither does EQT's somewhat bald assertion that synergies would be worth $2.5 billion in net present value terms, without much underlying detail beyond $100 million of annual overhead savings and the promise of being able to drill longer wells. And asked when investors could expect the company to present a long-range plan, EQT responded it will have "firmed up" its thoughts by the end of the year, but don't expect it to "lay out a grand plan".

It's hard to escape the impression this deal was pulled together pretty quickly (asked for details on that during Monday's call, management demurred). That would make sense in the context of Rice's stock-price performance. Ever since it announced a big acquisition of its own last September, Rice's shares have been relative laggards. Monday's deal takes them back roughly to where they were then:

So investors are right to be cautious. That said, it is hard to argue with the logic of the deal.

When you pump natural gas for a living, you really have to make your own luck:

That means becoming as efficient as you can to cope with flat, low pricing as far as the eye can see. EQT looks good on this front already:

Adding in Rice, however, should take those costs down even further. The general and administrative savings of $100 million a year EQT did detail, along with the 20 percent cut in drilling and completion unit costs it mentioned on the call, point to a meaningful reduction in its pro-forma costs per cubic foot of gas:

And this is before EQT gets to the biggest area for potential productivity gains. The bulk of its ill-defined synergies relates to the fact that marrying up the overlapping acreage of EQT and Rice will let it drill longer horizontal wells, or "laterals", beneath their combined territory. EQT expects these will now be 12,000 feet on average, rather than its recent average of 8,000 feet in the core area of southwestern Pennsylvania. Longer wells mean more contact with gas-bearing rocks and, therefore, more bang for each buck spent on drilling and fracking.

And Rice will help EQT with another problem: namely, its exposure to the glutted Appalachian gas market. Pipeline constraints have kept much of the Marcellus shale's surging production bottled up in the region, leaving producers stuck with taking big discounts on any output they can't shift further afield:

Adding Rice should roughly double the proportion of EQT's gas able to reach higher-priced markets near the Gulf coast (Range Resources Corp.'s acquisition of Memorial Resource Development Corp. last year was in part motivated by similar logic).

As it stands, at a 37 percent premium, EQT is paying 6.2 times forecast 2018 Ebitda for Rice, higher than its own multiple of 5.8 times. Paying 80 percent of the consideration in stock definitely weighed on the shares on Monday; but, equally, it likely would have been impossible to get Rice or its shareholders on board without a deal that left them able to capitalize on any future gas-market gains. It also preserves EQT's balance sheet, with net debt rising from 1.5 times trailing Ebitda to a still-manageable 2 times, pro forma.

No deal is ever a slam dunk, and EQT will have to prove it can sweat that combined acreage in Pennsylvania to justify the premium. Still, consolidation provides a sorely needed catalyst, given that the gas market isn't offering any. A stronger sales pitch wouldn't hurt, either.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

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