With the introduction of hydraulic fracturing and horizontal drilling in North America over the last few years, it has become economically viable for drillers to extract and produce shale gas from tight rock formations. This has led to an increase in the supply of natural gas in the region, thus decreasing the price of natural gas to a decade low of $1.94/mmbtu by April 2012.
Prices rebounded at the end of June 2012 and peaked around $3.2 per mmbtu due to optimism regarding the increased demand for electricity, as the U.S. witnessed its hottest summer and utilities increased their reliance on gas for power generation.
The U.S. Energy Information Agency reported its ending weekly inventory of natural gas on August 9, 2012. The inventory as on August 3, 2012 reported an increase of 16.8% compared with the inventory held during the same period last year, and an increase of about 1% (24 billion cubic feet) compared with the previous week. This is a continuation of the trend witnessed in the previous week, as an increase in the inventory of natural gas led to a negative sentiment in the prices of natural gas; the prices decreased by 12% and are hovering around $2.84 per mmbtu.
Natural Gas Prices
As can be seen in the graph below, natural gas prices have been decreasing over the last few years.
Note: Investors can track the Natural Gas ETF (UNG) as well.
Impact of Low Natural Gas Prices on Demand
Due to the low natural gas prices prevalent in North America, there has been an increase in the demand for the commodity. Electric utilities have started shifting production of electricity from coal-fired generators, which are environmentally non-friendly, to natural gas-based generation, which has lower emissions.
There are expectations that consumption of natural gas will increase further, as the cheaper fuel's demand rises in the Transport Industry, due to the abnormal conversion ratio (32x), which is much higher than the conversion range of 8x-12x.
Weather conditions have a significant influence on the demand for electricity. The demand increases as temperatures drop in the winter, since electricity is required to keep houses warm. Likewise, demand for electricity increases as the temperatures increase in the summers to sustain cooler indoor climate.
Summers in the U.S.
This summer has been the warmest in American history, and it is expected that the demand for electricity will increase, thereby increasing the consumption of natural gas. This factor will then drive the commodity's prices upward.
Shift from Pure Gas to Oil-and-Liquids Plays
Due to the depressed natural gas prices, and excess supply of the commodity in North America, producers have shifted their exploration and drilling toward areas with oil-and-liquid reserves, which offer higher margins than natural gas production.
Inventory Figures for Last Week of July
The U.S. Energy Information Agency released the natural gas inventory numbers, as held on August 3, 2012. The inventory held at the end of the week was 3,241 billion cubic feet (BCF), showing an increase of 16.8% compared with the inventory of 2,776 Bcf held in the first week of August 2011, and an increase of 13.5% compared with the average inventory held for the last five years.
The inventory held at the end of the first week of August increased around 1% compared with the previous week, which was higher than expected, due to the warm summers in the U.S.
Stocks in billion cubic feet
Year Ago (08/03/11)
5-Year (2007-2011) Average
Outlook for Natural Gas
Natural gas prices in international markets are much higher than in North America, since it is not economically viable to transport natural gas in its gaseous form, and the fuel needs to be liquefied and transported by ships and containers. Even though liquid natural gas plants do exist in the U.S, there are restrictions on the export of LNG to other countries. However, the recent move by the U.S. government to allow the construction of Cheneire Energy Corp's (LNG) largest liquefied natural gas terminal on the Gulf of Mexico will bode well for the prices of natural gas in the U.S.
As reported by Baker and Hughes Inc. (BHI), the rig count for gas projects has decreased in North America, while the rig count for oil projects increased in the first half of 2012. This trend of high growth in rigs for oil projects and declining rig count for gas projects is expected to continue in the second half of 2012, and throughout 2013.
Therefore, we maintain our positive outlook on the rebound in natural gas prices, based on increased demand and decreased supply of the commodity. However, the trend of increasing inventory of natural gas is a cause for concern and a continuation of the trend will be a hindrance to our investment thesis.
Companies Expected to Benefit from Reversal in Natural Gas Prices
Chesapeake Energy Corp
CHK is an independent energy company involved in the exploration, drilling and production of oil, natural gas and natural gas liquids, with a market cap of $12.44 billion. The company only has operations in the U.S., and its production mix is 79% natural gas, 13% oil and 8% natural gas liquids. The company, as mentioned in our previous reports, has an aggressive plan to retire its debt obligation and incur capital expenditures to develop its oil and liquid assets, while disposing of its gas producing assets. The company has announced in its second-quarter 2012 earnings that it had sold assets worth $4.7 billion in the first half of 2012, and expects to sell assets worth $7 billion in the third quarter of 2012. The company also raised its 2012 expected proceeds from assets sales from $11.5-$14 billion to $13-$14 billion. The company also raised its production estimates, and expects lower capital expenditures in 2013.
The stock is trading at a forward P/E multiple of 50.97x and offers a dividend yield of 1.8%.
For a detailed analysis on the stock, please review our reports "Is Chesapeake Energy A Turnaround Story?" and "Chesapeake Earnings Review: Stock Seems Geared Up For Turnaround."
Devon Energy Corp
DVN is an independent energy company involved in the exploration, drilling and production of oil, natural gas and natural gas liquids, with a market cap of $23.89 billion. The company has operations in the U.S. and Canada, and its production mix is 63% natural gas, 21% oil and 16% natural gas liquids.
Earnings for the second quarter declined by 68%, while total production increased by 3% due to an increase of 26% in oil production. The company has hedged its oil (85%) and gas (65%) production for the next two quarters of 2012.
The company intends to increase its liquid production and change its production mix to 48% gas, 32% oil and 20% natural gas liquids, which will be a positive for DVN.
The stock is trading at a forward P/E multiple of 16.8x and offers a dividend yield of 1.35%.
Range Resources Corp
RRC is an independent energy company involved in the exploration, drilling and production of oil, natural gas and natural gas liquids. The company has its operations in the Appalachian and Southwestern regions of the U.S., and has a production mix of 78% natural gas, 16% natural gas liquids and 6% oil.
The company reported second quarter EPS of $0.11, showing a decrease of 59% compared with the same period last year, and a deviation of 55.2% from mean EPS consensus of $0.06.
The company is expected to achieve 30%-35% organic growth in 2012, and 75% of its 2012 gas production is hedged at a floor of $4.45/mcf.