Natural Gas Producers: Is There Profitless Prosperity Ahead?

by: Alan Brochstein, CFA

It's that time of the quarter again, when I review the transcripts of the quarterly conference calls of the natural gas producers to try to gain some insight into what's going on. Unfortunately, they haven't all reported yet, as it is year-end, but I feel compelled to address the issue now. This is my third installment, as I first addressed the topic in September (Natural Gas: Extreme Contango Suggests Caution) and then in November (Time to Bail on Shale). These posts have been very "well" received, with many clearly appreciating the argument I have been trying to convey. The stocks of the companies I have mentioned have been mixed. I would characterize them as generally higher in price and in line with the overall market, but, in some cases, better. There have been some major transactions, including the Exxon Mobil (NYSE:XOM) purchase announcement of XTO as well as Devon's (NYSE:DVN) new focus on resource plays. I should point out that the price of gas has soared since that first article, with spot doubling and the one-year forward price rallying over 30%, mainly in response to what has been a pretty cold winter.

Today I want to try to make the analogy to the semiconductor industry, which is one I have followed more closely over the years. Semiconductors have proliferated in recent years, with very strong unit growth in all segments. On top of very robust demand, the supply has gone up as well, and Moore's Law has continued to rule.

While it may surprise you, worldwide semiconductor billings are very near their all-time high, which is well above the bubble high from 2000. If you look at the earnings, though, in the industry, it is clear that only a handful of companies have been able to prosper. Most have endured what many have called a "profitless prosperity", where everyone is busy working but not making money. Here's a picture of what it looks like:

MU Sales and Earnings
It's not pretty, is it? The global market has grown 5.8% over the past 15 years, and this commodity manufacturer of DRAM has grown slightly faster, yet over the time-period, it has seen earnings per share fall and average pretty close to zero. Even a company in a much better position in terms of competition, like Intel (NASDAQ:INTC) has struggled over the long haul. I'll spare the chart, but here are the 15-year tallies: Sales up 7.3% and EPS up 7.5%. Looking at the 2000 peak, their sales today are higher, but their EPS are lower.

I know that most of you reading this probably don't care about the semiconductor industry, but I think it illustrates a great point: Just because demand for something is strong, it doesn't mean the suppliers can make money. Micron is the better example, as natural gas is about as much a commodity as one can imagine. So, yes, while I concur with the experts that the demand outlook is fantastic, we need to focus on supply. There, the game has changed recently, and rather dramatically. We now have these massive "resource plays", and their numbers just keep growing. Just recently, we learned of a massive discovery in the Gulf, the Davy Jones. If you are unfamiliar, you can read about it here. In any event, the landscape has changed, and with technological advances in both discovery and in production, we can expect sources like Haynesville, Granite Wash, Barnett, Bakken, Eagle Ford, Marcellus, etc. to transform gas availability to the equivalent of water.

Investors can quit looking at things the way they have historically. Traditionally, following the rig count gave a nice read into the future price, especially when it was depressed. After all, if producers cut supply, low prices will lift. Such is life for a commodity. Now, there are two dynamics that are driving very high supply despite "less drilling":

  • Higher production from wells in the resource plays
  • The availability of high forward prices

For now, the prices of the stocks aren't really reflecting the new reality of supply in my view due to artifically high forward prices that enable the companies to lock in very favorable pricing by hedging. I have hypothesized that the other side, stodgy utilities that aren't really paid to optimize their purchase price, is to blame. They keep buying expensive gas out in the future to smooth their costs. How long will they keep paying such a high premium?

The future I envision is one in which the price of gas is extremely low. I expect that the forward prices will weaken, but producers will keep producing. They have debt to service and capital investments to monetize. Before I share the highlights from the big gas producers, I wanted to highlight the forward and spot prices again. To strip out seasonality, I include the year-over-year change:

NatGasSince 1992
Several observations:

  • The contango, though less extreme than at Labor Day, persists
  • Gas bull market ended with a double top
  • Gas, which has appreciated since the end of the last major recession by 9% annualized, has outperformed the CRB index (1.3%)
  • The long-term "average" is close to $3
  • The rally in gas from depressed prices has been anemic relative to other commodities (CRB up 26% y-o-y)
  • This is interesting, as typically gas is MORE volatile than other commodities
  • The forward price of gas (panel 2) seems to have hit a wall (the lows of 2006-2007)

OK, now to what the guys who know a lot more than me are saying, with the caveat that Chesapeake (NYSE:CHK), which is ALWAYS bullish, hasn't reported. Late last year, they explained why they aren't hedging at all. Smart or just lucky? Southwestern (NYSE:SWN), Devon and XTO (XTO) haven't reported either. Devon is scheduled to report 2/17, and SWN will report 2/25. Here are some big players and others who have already reported:

Petrohawk (NYSE:HK) had an operational update on 2/1. Here is the transcript. Chairman and CEO Floyd Wilson eloquently stated what the company is all about:

Petrohawk and a handful of other independent producers are sitting on a lot of homegrown natural gas. Our plan and commitment to drill and hold these valuable leases and assets, particularly, in the Haynesville Shale has proven to be sound.

We hedge, we contract for certain materials and services, we make financing available and we drill to grow. Perhaps at a higher rate than some would choose in today’s natural gas price environment assuming that others would have hedged as much as we had, and of course, you have to own these types of assets to provide this kind of choice as the growth rate.

Recently promoted COO Stoneburner summarized the just stunning growth from last year and the plans for this year:

For all of 2009 we drilled a total of 626 wells, all of which were successful. 564 of those wells or 90% were drilled in the three Shale Plays. 135 of those wells were operated with all but three being located in the three Shale Plays.

The main driver for the Company during 2009 once again was the Haynesville Shale. During 2009, total of 64 wells were placed on production. With the exception of those wells that were purposefully had produced at restricted rates the average initial production rate was 17.8 million a day.

These wells were able to increase production almost 450% for the year, growing gross production from approximately 110 million a day at the beginning of the year to approximately 480 million a day at the end of the year. This growth was accomplished with a relatively modest drilling program that average slightly less than 11 rigs on average during 2009. During 2010 the Company intends to operate 17 rigs and drill between 110 and 120 operated wells.

On February 9th, Comstock Resources (NYSE:CRK), which is also focused on the Haynesville, reported. I recently added this stock to my watchlist and really like the CEO, Jay Allison, and his team. Here is the transcript, and some key comments: the fourth quarter of 2008, we were producing less than 2 million cubic feet of gas per day from the Haynesville. By the end of the fourth quarter in 2009, we were producing 84 million cubic feet of gas from the Haynesville. And we did that without buying anything. We did that through the drilling program.

"We expect to have 18% to 25% production growth this year driven by our Haynesville Shale program. Based on results we had in 2009, we think our Haynesville Shale program could add 400 Bcfe to 500 Bcfe proved reserves in 2010.

Big Dog in the Marcellus, EQT (EQT), reported on January 27th. Here is a link to the transcript, and here is what retiring CEO Gerber had to say:

...the headline statistic of course was of the nearly 20% growth in produced natural gas sales and as Phil mentioned at a lower capital costs with projecting sales of another 20% in 2010 at as he described lower cost this was all driven by aggressive horizontal air drilling in our Huron, Berea plant all with the drill bit. Significant progress in the development of the Marcellus also all with the drill bit is our sixth consecutive quarter of double digit natural gas sales growth...

On to EOG Resources (NYSE:EOG), which reported on February 10th. Here is a link to the transcript, and here is what CEO Papa had to say:

...we're bullish on oil and believe North American gas prices will be weak for the first half of this year and strengthen in the second half. Accordingly on a quarterly basis, our natural gas production profile is expected to increase sequentially this year. A majority of our gas growth will come from the Haynesville, Horn River and Marcellus plays while the liquids growth will emanate primarily from the Bakken, Barnett Combo and Westgate areas...

Now I switch to our natural gas play, starting with the Haynesville. The big news here is that our initial test in the Bossier was successful. The Bossier is a shale in about 200 feet above the Haynesville with similar rock properties. The Sustainable Forest 5 - No. 2 Alt well and DeSoto Parish blow tested at a 13 million cubic feet a day flow rate with 7625 PSI flowing cubic pressure.

Up surface frac and pressure analysis indicates this Bossier zone is separate from the underlying Haynesville zone. This means we have two valuable prorogates over a portion of a 160,000 total net acres were both zone in present. We plan to drill 70 grow Haynesville and Bossier wells this year and this area will be the largest single driver if our 2% year-over-year North American gas growth....

We have only a small amount of gas hedged through June and are un-hedged thereafter. Our overview continues to be that the 2010-12 NYMEX is reasonably reflective of future prices.

I hope that these comments give you a flavor of what's going on in gas production. It is clear to me that production will be soaring. While I know that some folks question the decline rates in these new wells, I would counter with declining costs, improving technology, new finds, and companies want to produce whether to grow EPS or cover interest expense. So, I envision profitless prosperity in the years ahead.

If you agree with me, you might want to avoid investing in companies without shale or other resource play assets, as they will be buried. Even the shale guys will probably have problems with their stocks, as many investors value the companies on the value of their reserves, which is based upon what I view as an inflated price (acknowledging that the new SEC rule made it less inflated). Finally, there are lots of companies that could benefit from lower gas prices, including restaurants and certainly energy-intensive industrial companies.

Disclosure: Author has no positions in any stocks mentioned.