By Tim Plaehn
Since late spring of 2011, the natural gas spot price - Henry Hub - has declined from close to $5 per million BTU to a current value of $2 per million BTU, translating into a 60% drop. The share prices of the largest natural gas exploration and production (E&P) companies have also experienced sharp declines. In the last year, the share price of Chesapeake Energy (CHK) was off 30%, while the U.S. traded shares of Encana (ECA) declined by more than 40%.
With the low prices for dry natural gas, both Chesapeake and Encana are making moves to increase revenue and profitability from other types of energy resources and to leverage profits if natural gas prices turn upwards. The positive factors for these stocks can be divided into two categories: Company Actions and Market Forces.
Company Actions
Encana is proceeding with a balanced capital expenditures approach in 2012. The company plans to use 55% of cap-ex money on natural gas liquids and crude oil projects. Historically, Encana has focused almost exclusively on dry natural gas E&P. For the existing natural gas projects, Encana will focus on preserving assets, not drilling for new production. Total capital investment in 2012 will decline to $2.9 billion from $4.6 billion in 2011. Instead of capital investments, cash flow will be used to strengthen the company's balance sheet. Also, the company is actively courting joint venture agreements to leverage the capital invested in existing projects.
Chesapeake Energy is even more aggressively turning a way from dry natural gas exploration. The company plans to use 85% of the 2012 projected drilling cap-ex on liquids resource plays. Capex spending on dry natural gas projects will be reduced by 70% - to the lowest level since 2005. By focusing away from dry natural gas, Chesapeake Energy expects gas production to decrease by 4% compared to 2011. The company has already curtailed gas production by 15%, which represents 1.5% of the total dry natural gas produced in the U.S. Lowering the amount of gas produced means the company will have a larger portion of production covered by in-place hedging.
Market Forces
Not too many years ago, the fear in the natural gas market was a shortage of supply. The next big thing was liquid natural gas terminals to accept LNG imported for other parts of the world. Then the gas E&P companies started discovering shale gas deposits in many areas of the country, plus horizontal drilling practices allowed each drilled well to produce about 10 times the amount of gas.
Instead of a natural gas shortage, the country has developed an over-supply resulting in the declining prices for natural gas discussed earlier. Now the gas E&P companies are starting to react as a group to the low gas prices. The number of drill rigs drilling for dry gas will decline rapidly as companies switch to liquids exploration and production. At this point, the value received for an equivalent amount of natural gas liquids is 5 to 8 times the value of dry natural gas. Even if natural gas returns to year-ago pricing, the E&P activity for dry gas will continue to decline and eventually total dry natural gas production will also start to decline.
This cycle of declining exploration and eventual price recovery for natural gas would be a very positive outcome for both Encana and Chesapeake Energy. The two companies already have very large portfolios of producing dry natural gas assets. Rising prices will increase income with very little additional capital expenditure. In the meantime, the reduced levels of cap-ex spending will allow the companies to build up cash and/or pay down debt, strengthening balance sheets. The amounts of capital spending that are made will go primarily to finding and producing the higher value natural gas liquids and crude oil.
A couple of other factors point towards higher values for natural gas in the future. Facilities that can convert natural gas into gasoline fuel are currently being built in the U.S. These projects will start coming on line in a couple of years. If the price of gasoline stays high, these projects will be hugely profitable and push up the price of natural gas. Trends are pushing towards the use of natural gas as transportation fuel, such as CNG and LNG conversions - primarily in the government and commercial truck sectors.
Chesapeake Energy and Encana offer two of the best opportunities to reward investors from both a rebound in dry natural gas prices and the current high values of energy liquids. A little bottom fishing at current share price levels will pay off handsomely two to four years down the road. Maybe sooner, if the market realizes where the cycle is heading.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
