Antero Gears Up for NGL Growth

Antero Resources AR produces natural gas from the Marcellus Shale in West Virginia and the Utica Shale in eastern Ohio. Henry Hub prices are close to our midcycle estimate of $3 per thousand cubic feet, which is well above the company's cost of production. Though basis differentials in Appalachia remain far wider than historical norms, Antero is managing this with its extensive firm transport portfolio, enabling it to sidestep takeaway bottlenecks and sell into premium markets outside the basin. Consequently, we expect the company to earn a slight premium over Henry Hub until at least 2020. That's much better than what most peers can achieve, even after adjusting for the incremental cost of $0.50-$0.60/mcf.

Another advantage that separates Antero from other operators is leverage to liquids. Realized prices were disappointing in 2016, but the outlook is brighter as a result of increasing domestic demand, slower production growth, and more exports. We expect the natural gas liquids/crude price ratio to improve gradually over the next two to three years, and Antero, with 40% of the entire basin's undeveloped liquids-rich acreage, is better positioned to capture this upside than its peers. Roughly 25% of its current production is NGLs and condensate, and half of its 3,500-plus future drilling opportunities will deliver significant liquids volumes (at least 20% of each well's production).

It would take more than 20 years to develop Antero's holdings at the 2017 activity rate. However, the West Virginia portion of the portfolio contains stacked pay zones and is also prospective for the Utica and Upper Devonian plays as well as the Marcellus. The commercial potential of these bonus reservoirs has yet to be established, but the potential for upside is there.

In addition, though Antero has above-average leverage, it consolidates its 59% stake in Antero Midstream, which is a less risky business that can comfortably operate with a higher level of borrowing. Thus, a portion of its debt is a third-party obligation. This $3.8 billion investment is publicly traded and could easily be sold in a pinch, along with the firm's $1.6 billion derivatives portfolio.

Advantages Don't Add Up to Moat
Antero has sidestepped takeaway bottlenecks in Appalachia with its firm transport portfolio, which enables it sell much of its Marcellus and Utica production in favorable markets. As a result, the company is expected to earn a slight premium over the Henry Hub benchmark--a relatively rare feat. It also holds more acreage in the liquids-rich portions of these shales than its peers, positioning it well to capture the upside from strengthening NGL prices. As a result, we project very attractive drilling economics, with field-level internal rates of return near 50% for much of its inventory.

The company's undeveloped acreage contains almost 3,500 potential drilling locations, which could take more than 20 years to work through. The industry has yet to prove the commercial viability of the Utica and Devonian Shale plays in West Virginia, where Antero's Marcellus position is located. But if these reservoirs are indeed economic, then they could further boost the company's inventory.

Despite these advantages, we do not expect Antero to consistently earn its cost of capital for several years. Accordingly, we award a no-moat rating.

Lower Energy Prices a Risk
As with most exploration and production firms, a deteriorating outlook for oil and natural gas prices would pressure Antero's profitability, reduce cash flows, and drive up financial leverage. Other risks to keep an eye on include regulatory headwinds (most notably environmental concerns) and uncertainty regarding future federal tax policy. Given the volatility of oil and natural gas prices, we assign a high fair value uncertainty rating.

Antero holds about $4.7 billion of debt, resulting in above-average leverage. At the end of the last reporting period, debt/capital was 38%, but net debt/EBITDA was more than 3 times. At first glance, that degree of leverage looks high. But there are several mitigating factors. Antero Midstream, which represents about 25% of Antero's enterprise value, is a less risky business than its parent, so it can operate comfortably with a higher level of borrowing. Further, since Antero only owns 59% of the subsidiary, a portion of this entity's $860 million debt is a third-party obligation. And finally, the company has substantial marketable assets that could theoretically be sold at any time. Therefore, it could become more or less debt-free. Of course, the firm is actually holding these assets for strategic purposes and would only monetize them if backed into a corner. But this liquidity backstop still enables the firm to run with a higher-than-average degree of borrowing without being reckless.

The 2017 capital budget is $2 billion. The drilling and completion component ($1.3 billion) is well matched with operating cash flows. But the remainder, which will be directed to midstream infrastructure and leasehold, will require extra borrowing. Therefore, the consolidated entity's total debt will increase this year, but we expect leverage to decline slightly anyway, thanks to rapid production growth. Antero has no debt due until 2020, and we anticipate no difficulty rolling this over if management chooses to do so. The company has $400 million drawn on its $4.75 billion revolving credit facility.