RIL: Buying stake in Marcellus Shale acreage

Analysts see long-term benefits from the move.

Last Friday evening’s announcement of Reliance Industries (RIL) buying a stake in US-based Atlas Energy’s Marcellus region suggests long-term benefits for the company. RIL will pay $339 million cash on the deal’s closing and an additional $1.36 billion under a carry arrangement for 75 per cent of Atlas’ capital costs over a seven-and-a-half year development programme.

Additionally, the joint venture will spend $8.5 billion over the next ten years (RIL’s share $3.4 billion) to develop shale gas assets.

For RIL, it will get 40 per cent stake in the 3,00,000 acres of undeveloped leasehold in the core area of Marcellus Shale in south western Pennsylvania with net resource potential of 13.3 trillion cubic feet; RIL’s share is pegged at 5.3 trillion cubic feet.

Considering the high quality of gas, analysts expect the joint venture to fetch $6 per million cubic feet, while low operating costs, proximity to markets and relatively lower levies should ensure higher margins.

However, the deal is likely to generate free cash flows only after four-five years of gas production. Ambit Capital’s analysts say, “Free cash flows are expected to become positive, with potential peak earnings before interest tax depreciation and amortization of $1 billion (RIL’s share) from the 6th year of operations (assuming gas price of $6 per mmbtu).”

While the deal is expected to yield marginal results in the near term, it will substantially benefit RIL in the long run. First, it will enhance RIL’s technical capabilities (it allows RIL to act as development operator in later years), and notably give it the right to acquire 40 per cent stake in all new shale acreages of Atlas. Besides, RIL also gets the first right to acquire stake in Atlas’ 2,80,000 acres in the Appalachian basin whenever it comes up for sale, at $8,000 per acre. Regarding the valuation, analysts suggest that while it is somewhat higher than some recent shale acreage deals, it is largely in line with the valuation of peers that hold large Marcellus Shale acreage. Nevertheless, considering the longer-term benefits that accrue to RIL, the deal value appears fair.

Meanwhile, based on the outlook for RIL’s refining and petrochemicals businesses as well as rising gas volumes from the KG-basin, analysts expect its earnings per share to rise to about Rs 69 in 2010-11 from an estimated Rs 50 in 2009-10.

On Monday, RIL’s stock inched up Rs 1.70 to Rs 1,125.65 (against a 0.45 per cent decline in the Sensex), which translates into a one-year forward price to earnings of 16.3. Given that analysts peg its sum-of-the-parts valuation around Rs 1,190 to Rs 1,230, there is little upside from current levels.