Seeking Alpha

Natural Gas: It Is Not About The Weather Anymore

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Includes: APC, AR, BHP, BKR, BP, CHK, CNX, COG, COP, CVX, DGAZ, DVN, ECA, EQT, FNV, GS, HAL, HCR, KMI, LNG, MS, OXY, RRC, SLB, SLCA, SP500, SWN, TELL, UGAZ, UNG, WMB, WPX, XOM
by: KCI Research Ltd.
KCI Research Ltd.
Contrarian, Deep Value, long/short equity, portfolio strategy
Summary

Through a Darwinian survival winnowing funnel, natural gas investors have evolved to be hyper-focused on weather, attempting to capture short-term moves for profits.

The bigger picture has been relentlessly bearish, as U.S. dry natural gas prices have been trapped in an almost 14-year bear market.

Low prices have cured low prices, and dry natural gas production is on the precipice of declining materially, which many prognosticators are not modeling right now.

A 60:40 allocation to passive long-only equities and bonds has been a great proposition for the last 35 years …We are profoundly worried that this could be a risky allocation over the next 10." - Sanford C. Bernstein & Company Analysts (January 2017)

Bull markets are born on pessimism, grow on skepticism, mature on optimism, and die on euphoria" - Sir John Templeton

Life and investing are long ballgames." - Julian Robertson

Introduction

Commodities are trading at 100-year lows relative to the S&P 500 Index (SP500), and the most beleaguered of all commodities, dry natural gas prices, have been mired in an almost 14-year long domestic bear market.

With that backdrop, it is no surprise that long-term investment flows have vanished from natural gas equities, with many natural gas equities trading at all-time low market capitalizations and enterprise values.

Partly as a result of the anemic price action, nearly all market participants remaining in the sector have become traders, seeking to ply their fortunes on the back of short-term price moves in natural gas futures, which retail investors hold through the United States Natural Gas Fund (UNG), and triple leveraged ETFs and ETNs, notably the Velocity Shares 3x Inverse Natural Gas ETN (DGAZ), and the Velocity Shares 3x Long Natural Gas ETN (UGAZ).

More sophisticated investors are short the leveraged ETFs and ETNs, depending on their short-term bullish or bearish viewpoints; however, the point remains that almost all long-term capital has been eviscerated from this corner of the investment markets, and almost all remaining have become short-term traders. Short-term trading dominates, and that is an understandable outcome given the carnage that has happened.

The ongoing bear market in the energy sector has amplified the negative sentiment, yet something interesting is going on under the surface.

Specifically, production growth, which many view as a given, is set to hit a brick wall. Ironically, this is happening as structural demand growth for natural gas remains robust, setting the stage for an epic bull market.

Numerous false starts, which have encapsulated my attention and capital too, including a breakout in prices in 2018 above $4, have created one of the most pessimistic and skeptical backdrops that I have witnessed in my over two decade professional career. This negative sentiment, where very few believe in materially higher natural gas prices, is the reason the forthcoming bull market has the potential to be so dynamic.

Investment Thesis

Energy is the most loathed sector of the entire stock market, and within the energy sector, natural gas is even more scorned, despite robust structural demand gains, and this is setting the stage for a powerful secular bull market in natural gas prices, and in unloved, out-of-favor natural gas equities.

Production Growth Not As Robust As Thought

Perennial bears on natural gas prices, and natural gas equities cite runaway dry natural gas production growth.

There is some truth in this diagnosis, as domestic U.S. production has surged. However, domestic production growth over the last decade in dry natural gas has lagged, by a large degree, the more prolific production growth in crude oil and condensates.

To provide perspective, consider that the top 40 natural gas producers cumulatively produced 35,080 MMcf/day of dry natural gas production in the fourth quarter of 2012.

(Source: Natural Gas Supply Association)

Six years later, that 35,080 MMcf/day of production by the top 40 U.S. natural gas producers had grown, but only to 38,962 MMcf/day, for a cumulative production gain of 11.1%.

(Source: Natural Gas Supply Association)

Think about this for a minute. In the fourth quarter of 2012, there were not any active LNG export facilities, with Cheniere Energy (LNG) exporting their first cargoes in February of 2016.

Additionally, in the fourth quarter of 2012, coal was still the leading feed stock for electricity generation, a position it did not relinquish on a full calendar year basis until 2016, when natural gas took over the number one spot domestically.

Internationally, natural gas is still taking market share in electricity generation, with forecasts that it will overtake coal to become the world's second-largest energy source by 2030.

That glide path highlights the growth opportunity for natural gas, yet circling back to my pain point, despite this structural demand growth, dry natural gas production has underwhelmed what many people thought it has done, falling significantly under the production gains of liquids in the U.S. over the last decade.

Natural Gas Production Leaders Have Changed

Adding to the narrative, growth in the largest natural gas producers is even more underwhelming.

For reference, at year-end 2010, here were the top U.S. natural gas producers:

1. Exxon Mobil (XOM) - 3.9 Bcf/day

2. Chesapeake (CHK) - 2.6 Bcf/day

3. Anadarko (APC) - 2.4 Bcf/day

4. Devon Energy (DVN) - 2 Bcf/day

5. BP (BP) - 1.9 Bcf/day

6. Encana (ECA) - 1.8 Bcf/day

7. ConocoPhillips (COP) - 1.6 Bcf/day

8. Southwestern Energy (SWN) - 1.3 Bcf/day

9. Chevron (CVX) - 1.3 Bcf/day

10. Williams Energy (WPX) - 1.2 Bcf/day

(Source: Author, 10-Ks)

Williams Energy was actually ticker symbol "WMB," which is the Williams Companies (WMB) ticker, before Williams separated their pipeline and E&P businesses, and Williams Energy transformed from primarily a dry natural gas producer to primarily a liquids producer through a series of acquisitions and divestitures.

An additional note here; specifically, Chesapeake Energy and Southwestern Energy, which were both top-ten natural gas producers at year-end 2010, and in the list below (first quarter 2019), and top-three natural gas producers over the past decade, substantially moved their source of natural gas production, migrating from higher cost basins to lower cost basins.

The top-ten U.S. natural gas producers circa 2010 were dominated by the larger energy companies, and collectively, they produced 20.1 Bcf/day.

Range Resources (RRC) was the modern pioneer of Appalachia, and that discovery in 2004 grew into a behemoth by the end of 2019, with Appalachia-focused producers occupying 8 of the 10 slots of the largest U.S. natural gas producers.

Appalachia-focused natural gas producers are now 8 of the 10 largest U.S. producers, shown in the table above, with a couple of comments as follows:

1. EQT Corp. (EQT) - 4.0 Bcf/day - Appalachia-based producer, who produces roughly the same amount of gas as the leading producer in 2010, Exxon Mobil.

2. Exxon Mobil - 2.7 Bcf/day - Major integrated E&P sits in the number two spot, bolstered by its acquisition of XTO in 2009, though U.S. production is down since that time frame.

3. BP - 2.3 Bcf/day - In the number three spot after acquiring BHP Billiton's (BHP) onshore assets.

4. Cabot Oil & Gas (COG) - 2.3 Bcf/day - Appalachia-based Cabot is neck-and-neck with Antero and takes the number four spot in this ranking, as of the date of the list/data.

5. Antero Resources (AR) - 2.2 Bcf/day - Appalachia-based producer is poised to ascend to #2 spot in dry natural gas production, as they continue to execute on their growth plan and is the second-largest domestic producer of natural gas liquids, after the Occidental Petroleum (OXY)-Anadarko merger, holding roughly 40% of Appalachia's liquids rich acreage.

6. Chesapeake Energy - 2.0 Bcf/day - Appalachia leading Northeast producer, whose Appalachia dry gas assets are comparable to COG's, in my opinion. Total natural gas production is down for CHK year over year after selling their Utica assets. Chesapeake also gets substantial natural gas production from their Haynesville acreage (in addition to associated gas production from their oil related plays) which Tellurian (TELL) has made overtures to buy, but this is higher cost production compared to their Appalachia acreage position.

7. Ascent Resources Utica Holdings (Private Company) - 1.6 Bcf/day - Appalachia-based producer who was founded by Aubrey McClendon, the late former founder of Chesapeake Energy, in his next act after leaving CHK.

8. Southwestern Energy - 1.6 Bcf/day - Appalachia-focused producer who left behind their legacy Fayetteville founding assets to focus on the better economics of Appalachia. Owns assets in Northeast Appalachia, near COG and CHK, and is developing Southwestern Appalachia liquid assets.

9. Range Resources - 1.6 Bcf/day - Appalachia-based producer who is the founding modern Appalachia producer, drilling the first well in 2004, and who continues to own some of the best acreage in Appalachia today, from my perspective. Additionally, they have reduced debt over the last year, with overriding royalty interest sales, the latest to a group that included Franco-Nevada (FNV), pioneering a way, albeit an expensive way, for E&Ps to reduce debt. The silver lining is that FNV's implied valuation of RRC is much higher than the current share price today.

10. CNX Resources (CNX) - 1.4 Bcf/day - Appalachia-based former coal-focused company, has pivoted to become a top-ten U.S. natural gas producer.

Interestingly, the total cumulative production of the top-ten producers in the first quarter of 2019 was 21.7 Bcf/day, and the total natural gas production of the top-ten U.S. producers at the end of 2010 was 20.1 Bcf/day, as referenced earlier, so the cumulative production increase of the top-ten producers from 2010 to the first quarter of 2019, was 1.6 Bcf/day, or a total increase of just 8% in natural gas production for the top-ten producers.

Thus, the production profile is relatively the same. There has just been a wholesale change in the companies occupying the top-ten slots, with almost all the larger-cap producers vacating their production profiles, moving to a focus on liquids production, and ceding ground to Appalachia production, with Appalachia producers now occupying 8 of the top 10 slots, because Appalachia natural gas is the low-cost dry gas producer, outside of associated gas production.

Importantly, with dry natural gas prices averaging roughly $3.75 since 2009, and north of $4 over longer time frames, a return anywhere near these historical prices is going to lead to a boom in profits for the leading producers today, as their cost profiles are significantly lower than their peers of a decade ago.

Production Growth Set To Hit A Wall

We have established that dry natural gas production growth has been relatively muted among both top-40 and top-10 producers.

Having said that, total natural gas supply has consistently been ahead of demand, prompting a continuation of relatively lower natural gas prices.

(Source: Author, StockCharts.com)

A portion of the surplus in total supply can be attributed to the historically warm winters of 2015/2016, and 2016/2017, which left roughly 2,000 Bcf of dry natural gas unused in storage, negating what was a structural supply deficit during a majority of this time frame.

The winters of 2017/2018, and 2018/2019 offered no weather relief, as they were both slightly warmer than normal, with last year's winter being a cruel tease to bullish investors, starting out historically cold in November of 2018, before transitioning to historically warm in the heart of winter, specifically the last two weeks of December of 2018, and the entire month of January of 2019.

Thus, weather has played a role in total natural gas supplies exceeding total natural gas demand, suppressing natural gas prices.

However, production has also played a role too, notable with associated gas production, which almost all of those who are bearish on natural gas cite as the primary reason for the continued bear market in natural gas prices.

Against this backdrop, something interesting has started to happen.

Specifically, growth capital expenditure spending has dried up, and this has manifested itself in a free fall in rig counts and completion crews.

Natural gas directed drilling rigs are now down 33.5% year-over-year according to Baker Hughes (BKR) data, undercutting almost all expectations from both the sell-side, think Goldman Sachs (GS) and Morgan Stanley (MS), and buy-side research shops, who collectively saw an increase in drilling rigs in 2019, not the substantial decrease that has occurred.

(Source: Baker Hughes)

For those thinking that associated gas production from the Permian, SCOOP-STACK, the Bakken, or from the DJ-Niobrara is going to grow uninterrupted, there has been a significant pullback in capital expenditures, perhaps best expressed by Occidental Petroleum's significant cap-ex cutbacks, which are going to accelerate in 2020. This pullback in cap-ex has manifested itself in a sharp decline in rig counts in the liquids-rich unconventional basins too.

(Source: Natural Gas Intelligence)

Said another way, at today's prevailing oil prices, which are much more relatively attractive to the top oil producers than they are to the top natural gas producers, there is not going to be a flood of associated gas production that all the natural gas bears keep forecasting, because growth cap-ex in liquids production is being cut significantly too.

Far more likely is that associated gas production disappoints relative to robust expectations, something that seems more probable with Kinder Morgan's (KMI) decision to delay portions of their forthcoming natural gas pipeline takeaway capacity from the Permian due to insufficient customer interest.

Closing Thoughts - Low Prices Have Been The Cure For Low Prices

Recently I spent some time in Texas, and what I can tell you from boots on the ground due diligence, is that almost all energy service firms, from large integrated service firms, including Schlumberger (SLB), Halliburton (HAL), and Baker Hughes, to private frac sand providers that are undercutting U.S. Silica (SLCA) and Hi-Crush (HCR), is that collectively, these firms are cutting back, bracing for a continuation of the downward trend that has taken root in the second half of 2019.

Put simply, this is not a backdrop that is going to lead to production gains that shoot past estimates, as we saw from 2016-2019, especially with drilling productivity gains plateauing, which is a topic for a future article.

Actually, the opposite outcome is far more likely. Meaning that production is very likely to disappoint versus lofty expectations.

If this happens in an environment of continued demand growth, which is likely, given that too many have become too pessimistic on domestic and global economic growth, then the likelihood is that we will have significantly higher energy prices, led by the red headed stepchild of even the downtrodden, scorned energy sector, which is natural gas, and more specifically natural gas equities.

In closing, investors who can embrace shunned economically-sensitive assets, when almost all market participants are buying quality, and defensive assets, front running the passive and ETF flows, and preparing for a downturn, is perhaps the perfect storm of a contrarian opportunity. Adding to the narrative, almost all investors outside of the hallowed dividend growth favorites, have become traders, and this short attention span volatility is leading to significant opportunity.

Disclosure: I am/we are long AR, BHP, BP, CHK, CNX, COG, DVN, ECA, EQT, FNV, HAL, HCR, KMI, LNG, OXY, RRC, SLB, SWN, WMB, XOM. 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.

Additional disclosure: Every investor's situation is different. Positions can change at any time without warning. Please do your own due diligence and consult with your financial advisor, if you have one, before making any investment decisions. The author is not acting in an investment adviser capacity. The author's opinions expressed herein address only select aspects of potential investment in securities of the companies mentioned and cannot be a substitute for comprehensive investment analysis. The author recommends that potential and existing investors conduct thorough investment research of their own, including detailed review of the companies' SEC filings. Any opinions or estimates constitute the author's best judgment as of the date of publication, and are subject to change without notice.