We have all heard the expression that "the best cure for low natural gas prices is low natural gas prices". A drop in the price of the commodity should trigger a reaction from producers (a drop in drilling) that results in an improvement in the commodity.
For those of us in North America, that expression has not come to pass over the past four years. Natural gas prices tumbled late in 2008 and have yet to recover.
I've been reading and listening to what the largest producers of natural gas in the United States are saying and I think 2013 will be the year that we see natural gas production finally start to roll over.
Because of the improvement that may be coming in natural gas I've been kicking the tires on some ideas in the natural gas sector. One set of tires that I keep kicking belong to Chesapeake Energy (CHK).
Chesapeake is set up with an unrivalled portfolio of natural gas share assets.
That of course is no surprise to anyone. What surprised me and might surprise others is just how much Chesapeake's leverage level and EBITDA is impacted by small changes in natural gas prices.
Chesapeake's CEO Aubrey McClendon discussed this in the Q3 2012 conference call:
To highlight just how much we will benefit from strengthening natural gas markets, I'd like to remind you that in 2013, every $0.10 per mcf change in natural gas prices roughly translates into $100 million of additional EBITDA.
It is hard to imagine, cash flow fluctuates by 100 million dollars for every ten cent move in natural gas prices! How does anyone at the company do anything but stare at the natural gas price ticker all day long?
I like nice round numbers, so we can easily do some modeling of the impact on natural gas prices on Chesapeake's EBITDA and leverage levels. Chesapeake's 2012 financial projections are as follows:
In 2012 Operating Cash Flow is $3.780 billion. Here is what it looks like assuming the following increases in natural gas prices and Aubrey's guidance with respect to the impact of at $0.10/mcf change in prices:
Natural Gas Prices up $0.50 - EBITDA becomes $4.280 billion
Natural Gas Prices up $1.00 - EBITDA becomes $4.780 billion
Natural Gas Prices up $1.50 - EBITDA becomes $5.280 billion
Natural Gas Prices up $2.00 - EBITDA becomes $5.780 billion
Natural Gas Prices up $2.50 - EBITDA becomes $6.280 billion
Natural Gas Prices up $3.00 - EBITDA becomes $6.780 billion
Natural Gas Prices up $3.50 - EBITDA becomes $7.280 billion
There is certainly a school of thought out there that believes the shale gas plays in the United States are going to require natural gas prices of $6/mcf and higher long term in order to make them economic, so a $3.50 per mcf increase in natural gas prices might not be out of the realm of possibility for the long term.
What really strikes me is how much Chesapeake's balance sheet is deleveraged by these EBITDA increases. From an Enterprise Value to EBITDA of 3.9 to 1 in 2012 Chesapeake could get down to under 2 to 1 with an increase in natural gas prices. Throw in the debt reduction that Chesapeake plans from assets sales that are designed to reduce net debt to $9.5 billion and this company starts to look almost sensibly leveraged.
Of course crunching some numbers like this is easy. Whether natural gas prices are going to rebound to the higher end of my model is still very debatable.