Chesapeake Energy (CHK), a favorite pick for those seeking exposure to natural gas, reported results yesterday that missed by a penny. Nothing to truly fret about in an environment where expectations often move on a weekly basis. The data I was waiting for was the natural gas hedging information, and there it was...goose eggs.
Going into the previous quarterly earnings, CHK had closed out all remaining natural gas swaps at a price that was in the neighborhood of $3.70 on a prompt-month basis at the time. In the conference call, Aubrey had mentioned the belief that the natural gas market is at or near the bottom and they closed out hedges to take advantage of prices moving higher. Since that time, prompt month futures have traded down as low as the $2.20s and as of this writing, currently reside in the $2.50s (roughly 33% lower than when the hedges were lifted).
CHK continues to carry zero open positions for natural gas protection. I understand of course that $2.50 is not an attractive area to initiate new hedges, however the fact a speculative call was made on this market by management that now has created further risk for the company is not something shareholders should take lightly. After all, it has cost shareholders and will continue to do so until the natural gas supply glut finally subsides.
Looking at the fundamentals of natural gas, the supply shock looks likely to hang around for quite awhile still. The growth of supply has dwarfed any upticks in demand created by low prices. It will take several years before demand gains can play catch-up; new gas-fired generation, converting trucks and building a refueling infrastructure, gas-to-liquids, etc., all are going to take time. The problem the market will face this year is of a physical nature. The record supply growth coupled with a warm winter is leaving an almost unmanageable surplus of gas in underground storage (+817 BCF to same time last year and an amount that is equal to 20% of all working gas space combined just in the year-over-year surplus). This surplus will leave very little room for summer injections before storage is completely full. The only way to deal with this issue now is through price, which will need to fall far enough to price off at least a few more BCF a day. A further decline in price will weigh further this company's earnings.
Beware of falling rig counts in natural gas; while it certainly will be helpful to price down the road and beyond, it is being more than offset at the moment by the parabolic climb in oil rigs and associated gas that results. Associated gas has gained over 3.0 BCF a day in the past year alone to roughly 6.5 BCF, and will continue to grow. In the old days and in areas of the world that don't currently have the infrastructure, associated gas from oil drilling is flared off. Unfortunately for gas prices domestically, we indeed have the infrastructure in most areas and even getting $1.00 for the gas is better than just flaring it. The growth that will continue in associated gas production will more than offset any declining dry gas production for quite awhile. As illustrated in the chart below, oil rigs have climbed from 179 rigs in mid-2009 to a current record of 1,272 and climbing (610% growth).
CHK mentions it has now shut-in nearly 1.0 BCF a day due to low pricing. The problem for it in doing so is it is still primarily a natural gas producer. Even with the push into liquids, CHK is still 82% natural gas as of the latest report, down from 88% a year ago. Cutting 1.0 BCF a day will reduce revenue by $2.5 million a day at a $2.50 gas price or $227.5 million for the quarter, not good when you need cash flow for debt servicing and operations. That is nearly $1 billion of lost revenue on an annualized basis.
At this price level and time, I would stay well away from owning this company. The debt load CHK is carrying in an un-hedged falling natural gas price environment that continues to face over-supply issues, coupled with the fact it has shut in roughly one-third of its natural gas supply, which will create a large hole in revenue, and it continues to raise capital are all red flag warning signs in my opinion. Once we see wider curtailments and have dealt with the storage capacity shortage, this stock will become more attractive. However that appears to be many months into the future. Still, 2012 will not be a kind year to gas producers.
Those trading the ETF United States Natural Gas Fund (UNG) may also find the underlying fundamental natural gas information useful.
Trade recommendation: At this juncture, the only trade I would recommend is owning intermediate-dated puts in both CHK and UNG. I believe CHK will easily trade under $20 and possibly down to my target of $18. UNG may trade down another 27% from here to roughly $16 a share.
Disclosure: I am short CHK. I hold March 2012 at the money puts currently.