Beaten Down Natural Gas Likely to Stay Down, Making Producers a Short 33 comments
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Oil and Natural Gas equities have rallied on the prospect of an economic recovery, reflation gaining traction and dollar weakness. Although I do understand (and agree) that dollar weakness should act to support all commodities in general, I’m confident that the fundamentals on the whole favor sustained weakness in prices as supply, demand and inventories are all likely to pressure prices both short and long term. If the emerging view that rapidly declining land rig activity signals a speedy return to balance in natural gas supply and demand as inventories get drawn faster than is generally expected is incorrect (as I believe it is), then you have an excellent opportunity to short natural gas levered equities like DVN, XTO, CRK and RRC.
If I’m right, then sustained natural gas price weakness is apt to weigh on profitability, cash flow and multiples. Estimates for 2010 would have to come in considerably and multiples would compress such that shares of most nat-gas producers would decline significantly. And I have little doubt that the bulls, which hang their hat on significant rig activity declines leading to meaningful production declines, will be wrong. They'll be wrong because although land rigs are coming offline at a rapid rate, the production decline is likely to be less sensitive than generally believed and has historically been the case. I think production will remain high for several reasons but the most under-appreciated in my view has to do with the nature of recent production increases. It's going to take many more rigs coming offline than most think in order to rebalance this market and get prices going up meaningfully.
Recent production increases have come from relatively low cost shale plays which have been, in many cases, financed with increased debt on balance sheets of companies which, in many cases, bet their balance sheets on sustained high prices. In prior cycles, it had been the case that relatively high cost resources (which required high prices to be profitable) came on line in the late stages of a bull market in energy. This is similar to what has happened to oil sands and the like. In the current cycle, unconventional gas plays like the Barnett, Fayetteville, Marcellus and Horn River Basin shale plays have ramped at a higher rate and faster pace and have done so on favorable unit costs and overall superior economics. The Finding and Development costs have surprised to the downside, as the initial production has been much better than expected in most cases while improved technology has also led to a lower initial decline rate, as well as a fatter tail with regard to out-year decline rates.
The net-net of this is that the recent industry production additions are profitable on lower prices. The important drivers as I see them all have risks to the bearish side. On the demand side, industrial and residential demand both have risk to the downside in my view. Utility demand might increase slightly but it is likely to happen as utilities let lower prices come to them. And even at $4/mcf, coal is competitive and often hedged more so than other utility raw materials. If you also consider competition from alternative energy sources this cycle, it's reasonable to expect sustained price weakness.
On the industrial side, demand related to chemicals, steel, fertilizers and other industrial end markets all have risk to the downside in my opinion. And if that wasn’t enough, there has been a tremendous amount of LNG capacity that has come online in recent months. Huge fields in the Middle East, North Sea and Russia have ramped up production, including some of the largest fields in the world (in Qatar and Kuwait). The north field in Qatar is huge (probably the largest ever) and it has ramped up, importantly with liquification capacity, at a time when worldwide inventories are high and demand in Europe and North America are weakening significantly. With shipping rates down sharply, LNG can be delivered to North America at $1.50/mcf. With nat gas in the high $3s still and demand in Europe and Asia weakening, it's quite likely that LNG imports to the U.S. will rise meaningfully, and take share from conventional gas.
Although I do agree that energy markets are self correcting, I think that the market is underestimating the duration of the adjustment phase. By all accounts, supply is likely to continue to surprise on the upside while demand surprises on the downside. There has been billions of dollar of capital invested in capacity expansion, whose variable costs are relatively low and the associated debt must be serviced even though all-in cost economics suggest such production is better shut in.
So a washout is in the making and although I do think the market is likely to correct sometime in 2010, there will be a lot of pain in the meantime. First class companies like DVN will struggle to be profitable. Excellent operators like XTO will see their solid 2009 cash flow consumed by debt service and be forced to hedge 2010 production at substantially lower prices than 2009 was hedged at. Many of these companies managed to hedge the bulk of their 2009 production at $9+/mcf. Today, spot remains under pressure and the futures continue to flatten out through 2010. This suggests that bullish promoters like T. Boone Pickens and Aubrey McClendon are crazy to expect a return to $8 or 9/mcf anytime soon.
More importantly, persistent price pressure and futures price weakness suggests that all substantially unhedged nat gas producers will have no choice but to eventually hedge 2010 production at prices less than $6/mcf at best. And at such prices, most natural gas companies are barely profitable. If that turns out to be the case, then estimates for 2010 are way too high and most if not all companies are going to guide down and/or miss expectations over the next few quarters. The current stock prices would thus be significantly overvalued.
Full Disclosure: I have been short CRK for months and just bought puts on DVN on Friday.
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This article has 33 comments:
On Apr 02 09:57 AM yblarrr wrote:
> Taking your article as a sign to go long.
On Apr 02 09:57 AM yblarrr wrote:
> Taking your article as a sign to go long.
oil and the dollar have nothing to do with supply and demand. yes a euro can buy more dollars, and therefore buy more oil, but what about the people already holding dollars? A weaker dollar, in and of itself, means that they can't buy as much oil as before. Last time i checked, the dollar was the most pervasive currency on the planet. if you look at any period during the 90's, this dollar/oil inverse "trade" did not exist. i have an idea why it started picking up during the past few years, but i'm not going to say it, as its far from conclusive.
On Apr 02 10:15 AM Ranjit Thomas wrote:
> Agree with the article. RRC and HK seem to be the most overvalued
> at 40+x EPS and 5x revs. And this includes the benefit of significant
> hedges this year. As the hedges roll off, bankruptcy is a possibility.
Dec 2007 613.2 BCFG
Jan 2008 543.6 Jul 2008 586.2 BCFG
Feb 503.6 Aug 595.1
Mar 570.6 Sep 570.8
Apr 552.6 Oct 626.9
May 577.1 Nov 604.2
Jun 566.6 Dec 606.5
Jan 2009 568.9
Source: TX RRC
This looks like a 33% per year decline as stated by XTO's Bob Simpson. If your shale plays are low cost, we may not be on the same planet.
"We believe that natural gas prices below the cost of marginal reinvestment is no longer sufficient to balance the market. Instead we believe that prices may need to fall below the marginal cash cost of existing production to incentivize shutting in production from existing wells. Thus, prices may need to fall to below marginal cash production costs which are probably in the $2-3.50/Mcf
range.
Our new commodity price forecasts reflect this view where we are setting 2Q and 3Q prices to levels anticipating several weeks of gas falling to ~$3.50/Mcf and below and possibly below $3 for a short time later this year."
Economy is improving. Energy demand will increase across the board.
Sadly, with Detroit now being run out of Washington, we will probably not have the choice of purchasing a low cost CNG powered vehicle, instead we will be offered an expensive EV fueled by coal powered electricity, with battery's of questionalbe lifetimes. Hurray for Global warming, the demise of America's middle class.
YANK; "The other wild card is does nat gas figure into Pres. Obama's energy/transportation reform proposals? I mean if the nat gas is there why not use it to power vehicles? The US Post office, FEDEX, and UPS have been using nat gas powered vehicles for years without any problems.", Right On Yank, ATT just announced their plans for a $500Million purchase of CNG cars and trucks from Ford".
If supply / demand balance returns we should expect NG prices to rise back to at least $6-$8/mcf during the cold winter months. These companies will still thrive if that happens. The companies listed may trend lower for the short- to Intermediate-term, but moving out into the late 2011 or early 2012 time frame these prices will look like great bargains. I plan to dollar cost average on the way down and sit back, collect the dividends, and wait patiently for the capital gains.
My play is LNG, LNG Tankers, LNG Terminals...
Just an opinion
Conclusion: if oil stays above $50, I expect gas to be in the range of $5-$8. This is more likely in my view than gas in the 3-5 range.
On Apr 02 04:25 PM Mike T wrote:
> And what happens to all of those shorts if and when we get another
> Gulf hurricane? All of this silly $2 handle stuff implies no increasing
> demand, no decreasing drilling, and demand destruction. The greens
> are out touting sustainability and oil to gas every minute of every
> day. Do what you want in the short term. I see UNG as an easy 1-2x
> from here...not today, not tomorrow, not next month, but given ANY
> recovery, it's bound to recover. The more the CNBC hawkers pimp
> $2 natural gas, the more I buy right here, right now.
On Apr 02 02:58 PM jimboy wrote:
> Surely the key point here is balance sheet strength - who, of all
> the players, has the biggest "margin of safety" in terms of cash
> on hand to pay their way if prices stay depressed or fall for longer
> than expected and also to take advantage of the upturn? Husker Mark
> won´t be able to sit back and collect the dividends of some of the
> companies go bust. Is this a possibility?
On Apr 02 07:01 PM E.D. Hart wrote:
> Let it be stated that Oil is trading at above 50 a barrel and has
> improved from 35 in October/November. Watch oil to see what gas might
> do, as oil becomes more expensive, natural gas looks like a cheaper
> alternative. Oil above $50 implies gas above $5 .At an energy equivalent
> price oil above $50 implies gas above $8 (50 divided by 6) .
>
> Conclusion: if oil stays above $50, I expect gas to be in the range
> of $5-$8. This is more likely in my view than gas in the 3-5 range.
LNG – LNG was supposed to be the big play at high gas prices – that story has gone bust. LNG terminal stocks GLNG and one another that went bankrupt. At these gas prices I am not sure transportation would be viable from the Middle East.
I would be bearish in gas stocks.
On Apr 02 01:50 PM jack kreg wrote:
> Yank, absolutely, CNG is clean burning available in USA, priced in
> USA (not global OPEC), lets get those drill rigs back to work and
> start powering our transportation fleets with clean burning and cheap
> CNG, thanks Yank.
>
> Sadly, with Detroit now being run out of Washington, we will probably
> not have the choice of purchasing a low cost CNG powered vehicle,
> instead we will be offered an expensive EV fueled by coal powered
> electricity, with battery's of questionalbe lifetimes. Hurray for
> Global warming, the demise of America's middle class.
>
> YANK; "The other wild card is does nat gas figure into Pres. Obama's
> energy/transportation reform proposals? I mean if the nat gas is
> there why not use it to power vehicles? The US Post office, FEDEX,
> and UPS have been using nat gas powered vehicles for years without
> any problems.", Right On Yank, ATT just announced their plans for
> a $500Million purchase of CNG cars and trucks from Ford".
There may be money to be made on the short side of some NG producers but frankly, I don't like the odds and the risk-reward ratio.
I think it will be much more profitable to keep an eye on the best managed, low-cost producers and gradually scale into those - above all MCF, followed by CHK and XTO. CHK's convertible preferreds (D) look like a decent play in this regard - paying you to wait and giving you an additional margin of safety versus the common.
Also, I'm worried that we just had one of the coldest national winters in a while, and nat gas fell all winter long. Nat gas should never dip below 5 in a cold winter.
We hit 2.80/mcf a couple of years ago, and Chesapeake shut off their valves and help get the price back up immediately. This time, Chesapeake is struggling to keep their doors open right now, so they aren't shutting off anything, but outside landmen.
Green initiatives will take several years to have any real effect on prices in my opinion.
Nat Gas will rule the roost one day, but I'm afraid that the author might just be right for the time being.
I will say this though, as a guy in the landman business, I still have a job in the Fayettville, but other than that, most of the plays are so shut down, it's not even funny.
I'm not getting short, but I'm covering my longs.
Good luck. And a preemptive thank you for when you get squeezed and the longs get a good bonce.
Cheers
My take is that the author isn't talking about NG futures but rather NG producers, who would barely be profitable at $6. Going long an ETF like UNG allows a lot of upside before the NG producers even begin to become profitable.
That's how I'd currently play NG anyway.
I doubt CHK can afford to shut off much of its production this time, unless the price has fallen beneath its production cost.
The biggest problem facing many NG producers is just one word: debt, like the rest of our society.
the big question mark is the lng outlook for the us. big fields are now opended and lng is the name of the game. how will this affect the world price and producers here in the us.
are there terminals available to bring in lng. if not gas is a short term price play until the terminals are available. after they are available gas will drop in price again.