As value investors, we often find ourselves looking for bargains amongst the hated and beaten down areas of the markets.I can’t think of anything that has been more beaten down -- and kept down for longer -- than the price of natural gas.
The reason natural gas is depressed is no secret. The shale revolution in the United States has provided the country with a huge wave of new natural gas production. What is beginning to surprise me is just how long this surge in new production is being sustained, and how long prices are staying low. At current natural gas prices, I don’t think much of this new shale gas production is making any money. After all, isn’t the best cure for low prices low prices?
I’m not the only one who has been surprised though.
Confused on Nat Gas Example #1 – Mark Papa, Q2 2009, EOG Resources
Our view of the North American gas and oil markets is consistent with our previous earnings call, except that we've become more bullish regarding 2010 and 2011 gas prices. We still expect North American gas prices to remain quite low through year-end.
As you know, we've historically devoted a lot of work to developing domestic gas supply models and we think our current model is the most granular and best we've ever built. It's telling us that December 2009 domestic production will be 4.8 Bcf a day lower than year-end 2008 and this deficit will deepen further throughout 2010. When added to the Canadian supply drop of at least 0.8 Bcf a day, we expect the gas market to turn sometime early in 2010 almost regardless of what happens to LNG imports.
Everybody seems to be focusing on the supply growths from new horizontal plays, but the 800 pound gorilla in the room is Texas vertical gas production. This represents the largest single block of production in the U.S. 16.3 Bcf a day in December '08, and the rig count here has fallen from 450 rigs in January 2008 to 145 rigs today.
Our model shows production from this large segment of domestic production will fall from 16.3 Bcf a day at year-end '08 to 13.2 Bcf a day by year-end '09 and then 11.6 Bcf a day by year-end 2010 down 4.7 Bcf a day over two years. In my opinion, this is the most important well population that people should be focusing on if they want to understand what's going to happen to gas supply over the next 24 months.
Papa, who had access to better data than virtually anyone, saw natural gas prices staying low through the end of 2009 and then improving thereafter. We are almost into 2012, and we just recently touched three-year lows.
Confused on Nat Gas Example #2 – Legendary Oil Price Prognosticator Henry Groppe
I pay attention to the opinions of experts who have a track record of being correct. One such expert is Henry Groppe who has repeatedly nailed the direction of oil prices. Natural gas prices though, apparently not so much.
In April 2010 Groppe said that natural gas inventories were about to get a lot tighter and that natural gas would hit $8 by the end of that summer.
Groppe based his view on the fact that shale gas still only represented about 6% of total natural gas production and that rig counts directed at conventional natural gas drilling were falling so fast that the decline there would overwhelm the shale gas increase.
I read this prediction from Mr. Groppe at the time and thought his reasoning made a lot of sense. Fortunately I didn’t act on it. Groppe saw $8 natural gas and tightened inventories in the summer of 2010. Here we are at the end of 2011 and we are still setting records for amount of natural gas in inventory.
Confused on Nat Gas Example #3 – America’s Top Gas Driller, Aubrey McClendon
If anyone in the United States should be able to predict the direction of natural gas, it would be the head of the most active driller, Chesapeake Energy. If you control more natural gas drilling rigs than anyone else, your actions alone should tell you where supply is headed.
Maybe not. Below is a quote from McClendon during the Q2 2008 Chesapeake conference call, where he predicted $9 to be the floor for natural gas prices going forward.
We think gas prices will stay in this $9 to $11 range, there’ll be times like in July when they’re above it, there’ll be times when they’re below it and of course the weather will matter a lot as well. But we’re pretty confident that much below $9 you’d see a drop off in drilling activity particularly among the conventional drilling and then those pretty aggressive 35% to 40% first year declines are going to kick in and rebalance the market.
I saw something the other day where some analysts had come up with production in 2010 was going to be up by something like 8 to 10 BCF a day and gas prices were going to be $6.25. That kind of analysis I think can only come at the dangerous intersection of Excel and PowerPoint, it can’t happen in reality.
So far $9 certainly has not been the floor. $3 is more like the floor so far.
These are wildly inaccurate predictions of natural gas prices from three of the most knowledgeable men in the world. I’ve long been tempted to start accumulating natural gas producers and wait for a rebound in prices. But when I see how off base even the experts are in predicting the direction of natural gas, I quickly realize that I have no business trying to time a rebound myself.
Disclosure: I am long CHK.
