Encana And Chesapeake Could Be Key To A Natural Gas Recovery

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 |  Includes: CHK, ECA
by: Devon Shire

A couple of months ago, I wrote an article for Seeking Alpha that detailed how legendary investor Jeremy Grantham thought investors should be looking in the natural gas sector for investment ideas.

Actually, what Grantham said was a little more interesting than that, so I'll use his exact words which come from his year end letter:

At the opposite end of the resource spectrum to record-priced Iowa farmland is natural gas. Natural gas is, for most purposes like home heating and electric utility plants, a better and cleaner fuel than oil or coal, but is for technical reasons in distress: there have been several recent decades in which the BTU equivalent price for natural gas did, at least for a second, reach parity with oil. But now it is at just 14% of BTU equivalency, the lowest in almost 50 years. Everyone who has a brain should be thinking of how to make money on this in the longer term.

I read that and combined the information with the fact that I have a brain, so I've been looking for investments in the natural gas sector. Recently, I continued my search by listening in on the conference call of major natural gas producer Encana (NYSE:ECA). Seeking Alpha provides the transcript if you are interested.

Much of the Capital Now Moving to Oil Drilling Is Not Coming Back to Natural Gas

Encana and Chesapeake Energy (NYSE:CHK) are two of the largest natural gas producers in North America. Both have been incredibly successful in finding and producing natural gas from unconventional sources. In fact they have been too successful as they have played a large part in oversupplying the market with the cleaner fuel.

I've been watching both of them, and what intrigues me is that while both are suffering from low natural gas prices now, both also have huge inventories of oil and liquids rich drilling inventories that are going to drive each company going forward.

At this point, it is pretty obvious that if you have the choice of drilling an oil well or drilling a natural gas well, you are going to go with the former. Companies like Chesapeake and Encana are at the point where they don't need to drill natural gas wells and won't need to for a long time because they have years of oil and liquids drilling locations. These two companies alone are taking enough capital out of natural gas to put a dent in supply.

In the conference call, Encana confirmed that they are not in a rush to go back to drilling natural gas wells:

Furthermore, when natural gas prices do improve, it is not our intention to flood the market with gas in response to a modest increase in price. We will need to see sustained prices in a range that provides competitive returns with our oil and liquids investments and which are more reflective of the marginal cost to supply, which we believe is in the range of $4 to $6 per 1,000 cubic feet.

Once natural gas prices return to a more sustainable level, we believe that Encana's shareholders will benefit more from the impact of higher natural gas prices on our base level of production than from increasing natural gas production at an aggressive pace. We see significant opportunities for oil and natural gas liquids developments in our current portfolio of assets.

Going forward, we believe Encana will essentially have 3 distinct and meaningful businesses focused on natural gas, NGLs and oil. While the market drivers for each commodity are very different, the technology and operational efficiencies required to develop each type of assets are the same.

Like Encana, Chesapeake had made a massive shift in spending away from natural gas and towards oil and liquids. And like Encana, that capital is not going to come back to natural gas for a long time.

Chesapeake makes this exact point in its April Investor presentation:

Once producers convert to drilling wells that produce $10-17/mcfe units and finish drilling to HBP their gas shale leases (90-95% done already), why would they go back to drilling natural gas wells if prices increase from $3/mcf to $4/mcf or $5/mcf or $6/mcf or $7/mcf? CHK believes this is the single biggest misunderstood aspect of the future bull case for U.S. natural gas.

The natural gas oversupply situation in North America was created by billions and billions of dollars being directed at drilling unconventional natural gas wells. This natural gas unconventional revolution came before the same unconventional revolution that is now going on for oil drilling. Much of the natural gas drilling in the past couple of years continued despite poor economics (low natural gas prices) because companies like Chesapeake and Encana had to drill wells or risk losing the acreage they had leased.

Now the Independent producers like Chesapeake and Encana have virtually stopped drilling dry natural gas wells because they have a much better alternative with oil and liquids rich unconventional opportunities. The capital that these companies have is always going to go to the highest rate of return opportunity they have, and even at $6/mcf a natural gas well can't compete for capital with a $100/barrel oil well. Chesapeake alone is dropping from 75 dry natural gas drilling rigs in 2011 down to 24 in 2012.

I'm not suggesting that I'm super bullish on natural gas even in the long term, but I am inclined to think that this redirection of capital is at least going to allow natural gas prices to get back to levels at which producers can turn a profit. I would guess that price being $4.50/mcf to $6.00/mcf.

I'm still not ready to invest heavily in natural gas weighted names, but I think later this summer might be a very good time to do so. What I am really interested in are names like Chesapeake which will work out well as an investment because of its exposure to oil and liquids, with a rebound in natural gas providing additional upside.

Now if I can only get a new Board of Directors and CEO in place at Chesapeake who will protect shareholders' best interests.

Disclosure: I am long (CHK).