Rising Natural Gas Prices Will Hit Dow Chemical's Bottom Line

Oct.23.12 | About: Dow Chemical (DOW)

Weather is always a factor in natural gas prices. Last winter was equivalent to the warmest winter in U.S. recorded history, exacerbating a glut in natural gas from over production. The price of natural gas plunged to levels to encourage producers to shut-in production and lay down rigs drilling for dry natural gas. The result is storage for natural gas will finish close to last year's storage figures of 3,856 Bcf, erasing the glut. The natural gas rig count has dropped by over 500 rigs from a year ago, and according to Baker Hughes (NYSE:BHI) is now down to 427 rigs. Production of natural gas is now lower than a year ago and is falling. Because of the decline in new production A Colder Than Normal Winter Could Throw Natural Gas Into Backwardation. In this situation the spot price of natural gas will rise to higher prices than longer dated futures prices to encourage additional near term production. Just as natural gas spot prices dropped to well below break-even costs at $1.90 in April to discourage production, the price of natural gas will rise as high as necessary to encourage exploration and production companies like Chesapeake (NYSE:CHK) to place rigs back into dry gas fields like the Haynesville Shale and the Barnett Shale. In this situation chemical companies like Dow Chemical (NYSE:DOW) that use large amounts of natural gas will take a hit to earnings. It is estimated that close to 20% of Dow Chemical's production costs are made up of natural gas consumption.

Dow Chemical earned $1.69 billion before taxes in the first six months of 2012. Dow uses derivatives of crude oil and natural gas as a feedstock in its ethylene facilities. Year to date, the cost of purchased feedstocks and energy was down $881 million from the same period last year, a decrease of 8 percent. Dow spent approximately $10 billion on feedstocks and energy in the first 6 months of the year. Over half of this expense is directly tied to natural gas prices. Last year natural gas averaged $4 per mcf in the first half of the year and this year natural gas averaged $3.25 per mcf over the first half of the year. Prices have now risen back towards $4 per mcf for the first half of 2013. This will cause Dow Chemical to spend several hundred million dollars more on natural gas in 2013 than they spent in 2012. But if the winter is colder than normal, the price of natural gas could rise to $5 to $6 per mcf, or higher. And, if the winter is one of the colder ones over the last century, then fears of a storage shortfall the 2013-2014 winter could drive natural gas prices as high as $17 per mcf as discussed in this article.

North American natural gas prices are some of the lowest in the world. Currently, liquid natural gas transported on ships globally is trading for $10 in Europe and $13 in Asia. Natural gas produced in North America is stranded in North America. Cheniere Energy (NYSEMKT:LNG) is working on the Sabine Pass facility to liquefy natural gas for global shipping and estimates it will be able to export North American gas to other parts of the world in 2015. North American gas prices will remain lower than those in Asia on average due to the shale gas discoveries. However, breakeven costs to drill wells in the Haynesville Shale and Barnett Shale are near $5 per mcf. This does not include all-in finding costs or a return on investment. There is ample room for a rise in natural gas prices once the recent glut from weather and over production is worked off. A colder than normal winter could send natural gas storage below the 5-year average normalizing prices from recent depressed levels of the last couple of years.

A 50% rise in natural gas prices to $6 per mcf in the first half of 2013 would cost Dow an extra $2 to $4 billion in energy and feedstock costs versus the first half of 2012. That could wipe out all of Dow's profits if they are unable to pass costs along to consumers. Many products Dow producers have foreign competitors who will not be impacted by North American natural gas prices. There is no certainty Dow will be able to pass most of the potential increased costs along to its customers. Dow does have natural gas hedges in place for the next three years for a portion of its natural gas costs. But a rise of 50% rise or more in natural gas prices would raise costs substantially. Dow plans to spend $4 billion to expand its facilities in Freeport, TX to take advantage of lower North American natural gas prices. Dow is willing to trade off higher labor costs for lower energy costs. But but by the time the plant is expanded in 2017 North American natural gas prices could move closer to prices in other parts of the world. Investors in chemical companies like Dow need to keep a close eye on natural gas prices and be prepared to exit if the winter is colder than normal. Other chemical companies with large exposure to natural gas prices in North America include Dupont (NYSE:DD), Praxair (NYSE:PX), Air Products (NYSE:APD), and Huntsman (NYSE:HUN).

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.