One of the most surprising trends during Q4 2013 has been the sharp increase in natural gas prices. From the early November low of about $3.40 per MCF, natural gas prices have gone up 30% and are now trading between $4.25 to $4.50 per MCF. While these prices are still well below their historic levels, they do mark a massive 80% improvement from year ago levels and a 35% quarter to quarter increase.
One of the companies likely to benefit greatly from this trend in natural gas prices would have to be Pengrowth Energy (PGH). About 45% of Pengrowth Energy's production is currently natural gas. Yet, natural gas contributes only 9% to its operating netbacks. This leaves much room for improvement for the company as even a small increase in natural gas margins can lead to an outsized impact to Pengrowth Energy's profitability.
Why have natural gas prices climbed higher during Q4
While it is always difficult to pinpoint the causes for price swings in commodities, for natural gas there at least seems to be a fundamental reason for the increases. For starters, Q4 is a seasonally strong period for natural gas due to its use in heating. A nationwide cold spell can do wonders for the price of the product, as demand spikes and inventories fall. As reported by the WSJ, this seems to be exactly the case with the current spike in prices, with the colder than normal December sending demand for heating fuels higher. As the end result, the last EIA natural gas inventory report shows US natural gas underground storage 9% below its five-year average and 16% below its year ago levels.
What impact will higher natural gas prices have for Pengrowth Energy's Q4 results
Now that we know the cause of the spike in natural gas prices we need to figure out its impact on Pengrowth Energy's bottom line. As I noted in the intro, natural gas is about 45% of production yet only about 10% of operating netbacks. Therefore, any improvement in its margins will send Pengrowth Energy's profits higher. We can estimate the impact, but will need to make a few assumptions. Below are these assumptions:
My first assumption will be that Pengrowth Energy's natural gas production will remain flat quarter to quarter. As of Q3 2013, the company averaged 225,081 MCF per day of natural gas production. My estimate does not adjust for the yet to be closed Lindbergh financing related divestiture of 5,900 BOE/D of production.
My second assumption will be that Pengrowth Energy's natural gas production sells at a $0.65 per MCF discount to Henry hub prices. Using this discount, I estimate Pengrowth Energy's realized price for natural gas excluding hedges has averaged $3.21 per MCF during Q4. This would be a 13% increase from $2.83 last quarter. Canadian natural gas prices usually follows the Alberta AECO hub pricing. YTD, the AECO discount to Henry hub has fluctuated wildly, ranging from $0.50 to as much as $2.00 per MCF. However, in recent months the discount has narrowed significantly, thanks to increased pipeline capacity and more storage infrastructure in Western Canada. In addition, not all of Pengrowth Energy's production is priced off of AECO.
My third assumption will be that Pengrowth Energy's natural gas production operating expenses, transportation costs and royalties will combine to total $2.60 per MCF, or 4% higher from last quarter. I think this may be a too high of an estimate. However, power prices in Alberta have been showing extreme volatility, therefore some caution is warranted. This figure also adjusts for the one time freehold mineral tax benefit Pengrowth Energy saw in Q3.
Finally, my last assumption will be that 63% of Pengrowth Energy's natural gas production is hedged at an average price of $3.34 per MCF. This information is taken directly from Pengrowth Energy's filings.
When all these assumptions are put together, I estimate Pengrowth Energy average natural gas sale price will be roughly $3.31 per MCF after hedges for Q4, a $0.20 per MCF, or 6.4%, increase from $3.11 last quarter. When backing out the increased operating costs, this should lead to a $0.10, or 11%, increase in natural gas operating netbacks to about $1.01 per MCF. In terms of BOE, this represents margins of $6.06 per BOE.
To put this into perspective, this would mark a nearly a 400% increase in operating netbacks from year ago levels. At current prices, natural gas is finally somewhat profitable to produce for Pengrowth Energy. However, even with this increase, natural gas will still only represent a small fraction of Pengrowth Energy overall profits. I estimate that the net benefit to Pengrowth Energy's overall margins per BOE to be less than 2%.
That being said, there is some good news on the way. In 2014, Pengrowth Energy's average natural gas hedge price is slated to increase 15% to $3.83 per MCF from the current $3.34, while the percentage hedged is slated to decrease to 46% from the current 63%. The end result for Pengrowth Energy will be that it becomes much more exposed to swings in natural gas prices while also having nearly half of its production hedged at favorable levels. If the current price trends in natural gas carry over to next year, Pengrowth Energy is likely to see a much greater benefit to its overall profitability.
Final Thoughts and Conclusion
Pengrowth Energy remains my highest conviction position for multiple reasons, including a massive 38% discount to its $8.61 NAV excluding debt, a meaningfully high 7.20% dividend yield, and the growth potential of its thermal oil Lindbergh project. Applying a 10% discount rate to future cash flows, Pengrowth Energy is worth closer to $10 per share when factoring in Lindbergh production through 2020.
Do note that in the coming days I will have fuller analysis of Pengrowth Energy's Q4 2013, including estimates for its revenues and entire operating netbacks, not just for natural gas.
Disclaimer: The opinions in this article are for informational purposes only and should not be construed as a recommendation to buy or sell the stocks mentioned. Please do your own due diligence before making any investment decision.