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). 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.

By arrangement with: www.theenergyreport.com

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