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Natgas Companies and Contango

|Includes: Chesapeake Energy Corporation (CHK), GMXRQ, UNG
There is a lot of focus on cheap natural gas spot prices and thus on Natgas stocks. The sector has been an underperformer for some time. This is quiet understandable. Many companies could turn operational cash flow negative if they continue to sell at spot prices.

But one should note that Natgas has one of the steepest forward curves in the commodity market. Natgas companies have the option not to sell at spot prices but can have a rolling forward hedging program. This will enable their net sales price to be much higher than the spot prices enhancing their cash flows significantly.

This kind of rolling forward hedging is risk free as long as one has physical Natgas to deilver. For a natural gas producer this should not be an issue.

Currently the Nov 2011 futures is trading around 4.475, while the near month of Nov 2010 is trading around 3.33. That’s almost a 35% premium for 1Y.

This means Natgas producers by running a 1Y rolling hedging program can sell at significant premium to the spot prices, which taking much of risk. At these sale prices their cash flow is enhanced significantly.

Investors who have had bad experiences with UNG will be able to relate to this easily. While UNG bleeds because of the steep contango, a rolling hedging program will benefit from the same contango.

Of course one needs to drill down on each company to see their hedging programs. But the point i m trying to make valuing Natgas companies based on spot Natgas prices might be very conservative, as a simple low risk hedging program could make a lot of difference. I m quiet sure that many companies are doing this and this will have better cash flows in quarters to come even if the spot prices remain subdued. They will enjoy significant cash flows from hedging.

Disclosure: Long CHK, GMXR