- Natural gas E&Ps were hit hard last week, booking large hedging losses during a period of strength for the commodity.
- The degree of hedging between Q1 and Q2 caught many flat-footed, with short-term traders exiting positions.
- Longer term though, the story has not changed a lot for these firms. Cash flow visibility is healthy and looks quite attractive versus valuations.
- This idea was discussed in more depth with members of my private investing community, Energy Income Authority. Learn More »
Sentiment suddenly turned sour on natural gas E&Ps this week. With natural gas spot prices bumping through the $4.00 per mmbtu level recently and improvement existing throughout the forward futures curve, there has been a flood of (in my opinion) "tourist" capital into natural gas producers trying to leverage the seemingly imminent upside in earnings numbers. Color these folks surprised as big names like EQT Corporation (EQT), Range Resources (RRC), and Antero Resources (AR) all disclosed multi-hundred million hedge losses, muddying results. What is the deal with this, and more importantly, have these hedges derailed the outlook?
Analyzing The Impact
- EQT Corporation announced a loss of $1,300mm stemming from the company's NYMEX swaps and options due to increases in forward prices.
- Slightly smaller in scale, Range Resources reported negative GAAP earnings, primarily stemming from a $250mm derivative fair value loss due to increases in commodity prices.
- Antero Resources booked a $757mm hedging loss, one of the larger losses announced in Q2 relative to overall company size.
These are large losses, representing "what could have been" earnings if the companies had stayed unhedged into the summer surge. Anyone thinking that natural gas producers were in for stellar profits this quarter driven by that rise in pricing took this news hard, and clearly the market as a whole did not see this coming given the post earnings reaction. It's important to note that by and large, adjusted EBITDAX numbers for these companies were in line with Street expectations, so without a doubt the GAAP / hedge loss activity was the driver of most negative sentiment. Cabot Oil & Gas (COG) trading activity shows this dynamic at work as well. Unlike the other players above, Cabot Oil & Gas did not materially ramp its hedging activity and remains fully unhedged out into 2022. Whether that was due to management expertise or just dumb luck (Cimarex Energy (XEC) merger distractions), the company has been a material outperformer ever since earnings were announced relative to its natural gas peers.
Before I pin the blame entirely on traders playing the energy sector short term, even for analysts that follow company hedge books, these large losses are still somewhat of a surprise. As an example, from the end of the first quarter (with data reported within the 10-Q) to the end of the second quarter, Range Resources basically doubled their 2021 hedge book, capturing part of the move but really missing the biggest chunk of the upswing. Eager to lock in forwards, those running trade desks at these energy firms just simply locked in prices too early in the run up and to a larger degree than they usually do quarter to quarter.
Management being early in this way does have some connotations. Analysts have been cutting forward free cash flow estimates for 2021 and 2022 for many of these natural gas producers in the wake of these earnings reports, simply because there is less unhedged production available to leverage current strip prices than previously thought. While it's easy to hand wave off these losses as immaterial, at the end of the day it means less money in the pockets of the company. That means less cash flow available for debt paydown for companies that still need to so and less money to put in shareholder pockets via buybacks and / or dividends.
Why does a little delay matter? There is always the flow of capital between oil and natural gas producers. Quite frankly, the outflows of money out of the sector in recent years has often meant that what money does remain often gets shifted between areas that are cycling in and out of favor. Right now, oil companies as a whole have less hedge exposure in 2021, have better balance sheets overall, and are more likely to return capital to shareholders this year. Dollars continue to flow there, and it's likely that the oil sector does better over the next several quarters assuming current realities remain constant.
Realities Of Drilling, Why Companies Hedge
Bad news out of the way, I think it's important to note here that investors cannot have it both ways. Compared to oil producers in the aggregate, natural gas producers were lauded in the middle of 2020 for their hedging activity. When natural gas fell to $1.40 per mmbtu in June, pretty much the entire industry had hedged out most of 2020 production. Low prices just simply did not matter - at least as long as they did not stay that low forever.
Over the past decade, most of the industry have been net positive beneficiaries of hedging production, and it's something they've needed to have done to stay in business. Antero Resources - long a prolific hedger - noted that it's sitting on $6B in net cumulative profits over the past fifteen years in its conference call. Other producers, while not to that degree, hold extremely large gains over the life of their programs. Overall, investors should be happy that these producers have hedged the way they have.
It's largely a function of economic realities. The more risky a balance sheet, the more producers have to hedge to ensure the cash flow is there when they need it. Natural gas producers have carried far more leverage than their oil counterparts because pricing basically did nothing but go down for years. Unlike oil which did at least have some pops, natural gas directed drillers have been in a constant battle, fighting to lower costs to compete with emergence of associated gas capture. Investors in this space recall how close Antero Resources and Range Resources came to bankruptcy over the past few years. If they had run the business without a hedging program, both would have filed for bankruptcy at some point, equity owners wiped out. No question.
It's important to not forget the visibility that hedges give producers. EQT Management had this to say during the call:
To be more specific, our 2022 hedge position will keep our leverage closer to 1.5x, enabling us to retire debt, institute shareholder-friendly actions, and allow us to be more flexible in how we hedge in 2023 and beyond.
In other words, while all the hedges that they have added (particularly after the Alta acquisition) might have removed some upside in the recent run, the earnings visibility allows them a line of sight on leverage, allowing a resumption of cash returns to shareholders that would be tougher to get through given how volatile natural gas has been.
Were the large mark to market hedge losses this quarter expected? Absolutely, albeit not to the degree that some bore. Does it take away from the cash flow upside in 2021 and 2022 given that these hedges were entered into a bit early? Sure. But, most natural gas producers continue to trade at extremely depressed valuations. While a bit further behind some of their oil peers, current free cash flow yields and minimal maintenance capital expenditure programs should allow these firms to turn their eye to shareholder returns - much like the rest of the industry. It's a bump in the road for producers, but it does not disrupt the longer term outlook which remains constructive. While I think there is a case to be made that oil equities outperform natural gas over the coming quarters, both still have healthy outlooks - and it's important to remember natural gas is certainly going to have better demand duration as we get out into 2035, 2050, etc. In short, stay long - but for the right reasons.
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This article was written by
Michael Boyd is an energy specialist with a decade of experience in both the investment advisory and investment banking spaces, with stints in portfolio management, residential mortgage-backed securities, derivatives, and internal audit at various firms. Today, he is a full-time investor and "independent analyst for hire.”
Michael leads the Investing Group Energy Investing Authority. The service focuses on finding total return opportunities within the energy sector, ranging from upstream producers to pipelines to refineries. Features include: model portfolios, real time trade alerts, high quality research, and an active and vibrant chatroom of professional investors. Learn More.
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