While there are several different factors that are challenging me to rethink my bearish thesis on natural gas prices that I have been developing and sharing over the past 8 months, I believe that the negative trend remains intact. In case you missed it, here are the prior posts in which I have reviewed what key executives in the industry have been telling investors and why I thought their unanimous optimism was most likely bearish.
- Profitless Prosperity Ahead (2/13/10)
- Time to Bail on Shale (11/22/09)
- Natural Gas: Extreme Contango (9/5/09)
- My view is less divergent from the consensus now
- Less drilling to keep leases
- Environmental concerns
- Some key "towel throwing"
- A better understanding of why utilities keep buying forward
The first point is ancecodotal, but when I first started sharing my view, it was clearly contrary to popular opinion that shale plays were going to be value creation drivers for the E&P companies. Now, I have seen a more universal understanding of the impact on supply.
One issue that I have come to understand better is that there have been several different motivations for increased drilling in the resource plays despite weak spot gas. While I was well aware of the positive impact of hedging, which allowed drillers to earn a price much higher than spot, I have come to learn about two other factors. First, some companies are drilling to learn. Experimentation in this vastly new area with technology and production techniques is an investment that can help drive value in the long-run. Second, and more importantly, a lot of drilling has been done to keep leases. Thus, despite lower prices today, companies that have invested in acreage have been drilling despite seemingly poor economics.
Perhaps the most significant change recently has been environmental concerns. Questions about fracturing have popped up in several parts of the country, and, of course, the recent oil spill could perhaps change the landscape for quite some time regarding off-shore drilling.
While I will highlight more below, one of the biggest gas bulls around, Chesapeake (CHK), has suddenly taken a liking to oil. The contrarian in me has taken notice!
Finally, I had the opportunity to discuss hedging with a CEO of a major gas utility, and I understand better why forward prices are so sticky. After having been burned by having so much spot exposure when gas prices shot up on several occasions last decade, utilities and their regulators are now very comfortable hedging, even when spot prices are dramatically lower than forward prices. This dynamic will take some time to play out - is there anyone out there lobbying on behalf of the end user (that's you and me)? No.
While I respect these developments, I still expect that the supply pressures will remain quite strong. Quite simply, the companies that have made these resource plays are promising high production growth. Until we see some willingness to change that tone, I believe that the producers will produce excessively. Easier capital doesn't help. Until the forward price gets more in line with spot prices, we can count on companies hedging and drilling.
But, who cares what I have to say? Let's hear from the CEOs:
I start with Mark Papa, because he has been pretty bearish on gas. This quarter, he shared a major strategic change for the company, as it has shifted its focus towards oil. Interestingly, they are not hedging much currently despite longer-term bearish views:
Regarding North American gas, we're short-term moderately bullish and long-term rather bearish. We think last week's EIA-914 downward revision was only about one-third of what we calculate, so we continue to believe the market is tighter than common perception. We'll be watching the storage build this summer to confirm or disprove our thesis. We currently have only a very small 2010 gas hedge position and don't think this is the time to be adding gas hedges.
When asked about current drilling plans, he said:
So we're very cognizant of the fact that the gas market has got a whole lot of gas in storage right now and the last thing we need is everybody to be drilling a zillion gas wells in North America. And so what we've done is, we've tempered, significantly, our gas drilling in all those discretionary areas such as in our Rocky Mountain gas drilling area, and we've considerably slowed down in the Barnett Shale where we've got most of our acreage vested. And so that kind of leaves us with three places where we have to drill a certain amount to hold acreage. The biggest of those is the Haynesville and then we've got the Marcellus and, to some degree, the Horn River. At this stage, we're going to stick with our plan of running roughly 11 rigs and generating that 1% to 2% North American gas production growth. I guess if gas were to fall south of $4 and we were to believe that it was just going to stay there permanently, we'd reassess that.
Suddenly, CHK is talking like EOG, with gas perma-bull Aubrey McClendon giving plenty of time to discussing oil.
As for why we are seeking new plays, it's because we continue to focus primarily on oil and liquids-rich areas. That's where the money is these days, with oil to gas values now exceeding 3:1. As for oil plays, it does surprise me that some analysts have commented that Chesapeake is a Johnny-come-lately to the unconventional oil business, and that it's simply not true.
In March 2008, after two years of quiet development, we announced the discovery of the Colony Granite Wash, which over time could net to Chesapeake more than 800 million barrels of oil equivalent. At that same time, we also announced that Chesapeake would embark on a program to develop new unconventional oil plays.
Back then, we had five unconventional oil plays in mind, four of which have turned out to be successful. We have now supplemented those original four plays with eight additional unconventional oil plays. And across our company, every asset team plus our new ventures group is very focused on continuing to develop new oil plays.
OK, that's my first big towel-throwing example - when Aubrey McClendon talks up oil, perhaps we should pay attention! As far as gas, here is what he said:
Finally, in response to continued low natural gas prices and the ongoing success in our liquids-rich play, we have redirected capital from our natural gas shale plays to focus more on oil. On our gas-focused plays, we now plan to spend about 12% less in 2010 and 17% less in 2011 than we previously have planned to spend.
CFO Marc Rowland described their drilling activities:
I believe at least half and probably 2/3 or 3/4 of our gas drilling is what I would call involuntary. It's being incentivized by something other than the gas price. It might be the realization of a carry in the Marcellus or in the Barnett. It might be the need to hold acreage in the Haynesville, for example or it could be a combination of those two things. And I think that's, in large part, true across the industry that there's an enormous amount of drilling today that is economic. It's just economic for reasons other than what current gas prices are.
On gas prices, while he surely hasn't admitted the flaws in the model in which he was so confident, McClendon said:
And I think we've kind of -- we're scraping along the bottom. I don't know if that's $3.50. I don't know if that's $4 right now, but I do think the bottom is continuing to come up. And I think there's some reasons to be optimistic about a return to kind of a $6 or $7 gas price in the U.S. over the next few years because I think it's very favorable to consumers and is a decent price for producers as well.
No mention of the infamous model - just his gut now...
I have come to really respect Jay Allison and his team. If I weren't so concerned about gas prices, I think it is his stock that I would buy. Unlike EOG and CHK, here is what he had to say about oil:
I do think that if you look at our other regions where we have 13 million to 14 millions a day production and 54 plus Bcfe reserves which is San Juan, which is Mid-Continent and in the rural Mississippi area. If you add all that up it's about 60% oil.
One of our goals is probably to monetize that. If you were to monetize that and you were to go ahead and sell the remaining Stone shares at some point in time, you would add somewhere north of $200 million to add new core acreage in the Haynesville or add a new core area.
CFO Burns' commentary suggested that the company is considering cutting production, which would be a positive if it actually happens:
Actually we are running seven rigs now. In the beginning of March we added the seventh rig to the Haynesville program. So we are running seven rigs in that program and of the seven we mentioned that three come off contract this year and the first of those three is in June. So I think as we looked forward, we set our overall plan into the seven rigs based on around a $5 NYMEX gas price because we achieved that in the first quarter and we are obviously off of that for the month of April and May. It's not looking like we will hit that, so I think that we will have to, we do not really have a set number on the pas price that we are looking to not utilize that rig. We will have to kind of evaluate how we think the gas market looks for the next twelve months plus and just aside on if we want to continue to drill or if we want to start to pull the budget in a little bit.
For those interested in the science and technology angles, the call was very detailed regarding a lot of the experimentation tha the company is doing regarding the number of stages, the amount of proppant, the "choke" rate and many other issues.
EQT's new CEO had one of the earlier calls (4/28). Porges also shared a lot of technology in his discussion and certainly sounded bullish (after a surprise equity offering he had better!):
I would like to conclude my remarks by reiterating our production guidance. We recently upped the sales growth guidance to 26%. In the first quarter, we beat that number.
Still, his remarks were somewhat tempered by his concerns over midstream capacity constraints and his mention of liquids as well.
CEO Floyd Wilson was talking up oil too:
So while crude oil and natural gas liquids are a small part of our production today, we can grow it quickly without compromising our plan to secure and maintain leasehold at Hawkville, at the Haynesville Shale or anywhere else within our holdings.
Of course, we aren't alone. Several companies are playing the oil card where it exists within their portfolios. This makes sense today. We believe natural gas is an important part of the U.S. energy security and clean air picture, but while natural gas prices are low, we will continue to grow our crude oil components as quickly as possible. When the balance of supply and demand again tips in favor of natural gas, we will be there with an aggressive response...
....We're certainly hopeful that natural gas prices firm up a little bit from $4. We have an awesome field there in the Haynesville and we intend to be as active there as the economy's gas prices versus cost will allow.
Range Resources (RRC) (link to transcript)
Range's comments should help those who follow the rig count understand better why their models have broken down:
In 2007, although we have decreased our well count from about 14,000 wells to 6,000 wells, production from 2007 to our 2010 forecast is projected to increase from 320 million per day to about 490 million per day.
Quite simply in 2007, we decreased our well counts by 57% while increasing our projected production by 52%. Bottom line we are a much more efficient company. The combination of adding higher quality plays and focusing our people and capital there, well selling relatively high cost, low growth periods have led to better production in reserve replacement, lower F&D, lower LOE and better rates of return. This in addition to our resource potential which is ten times our current reserve base coupled with one of the best teams in the business will lead to you an exciting future for Range.
As far as hedging:
As you probably noted we have increased our 2011 natural gas hedges is 51% of our anticipated production at a floor price of $5.73 and a comp of 683. Our fair tails [ph] are fairly simple and that we wanted the blocking cash flows that we could fund our capital fund program for 2010 and for 2011.
By many of you I'm concerned about the number of rigs drilling for natural gas in the U.S. I'm also concerned with the ready access to capital that the industry enjoy. While I'm convinced the industry will ultimately adjust capital spending to fit gas prices, we are taken the timing of the industry response of the table by locking in floor on half of our gas production for 2011.
So, the tone has definitely shifted dramatically since I last wrote in February. Except for EOG, everyone has been surprised by the declining price. Predictions of higher prices and explanations for why it makes little sense to hedge have been replaced by merely "hope" that the price at the wellhead has bottomed. At this point, production continues, though we are seeing hints of retrenchment ahead. In any case, it seems to me that there are huge sellers (producers) at prices near $5. It remains to be seen how much more production we will see at these "low" prices. Ironically, since these gas guys started talking up oil, it has finally started to decline. I caution investors in these companies that continued pressure on oil could lead to more production of gas as these companies seek to realize sufficient revenue. Betting against gas seems to be a good bet - supply from above and uncertainty regarding behavior of industry participants if prices continue to fall. Keep in mind that many costs of production continue to fall too.
Here is a chart (click to enlarge) of the June 2011 NYMEX contract - note that it has declined substantially over the past year but still remains quite elevated to the June 2010 price of 4.31.
I don't short stocks, so, for the most part, avoiding longs in the area is about the best I can do. I have previously pointed out several ideas about how to invest in companies that may benefit from an environment of abundant gas. Carbo Ceramics (CRR) is certainly an obvious candidate, and everything I hear regarding the number of stages and the amount of proppants needed, seems bullish. While it's a small part of Ceradyne (CRDN), they have several technology plays that they are pursuing. We own CRDN in the Top 20 Model Portfolio as well as Haynes International (HAYN). HAYN is poised to benefit from the commercial aerospace recovery, but I was attracted to the company also because of its high exposure to land-based natural gas turbines. There are lots of other ideas, many of which readers shared with me the last time I wrote, including MLPs (pipelines, storage) and perhaps something like Clean Energy Fuels(CLNE).
Disclosure: Long HAYN and CRDN in a foundation I manage and in the Top 20 Model Portfolio