February 20th, 2012 
Category: 
Natural gas prices have been trending lower on the back of increasing dry gas production in North America and reduced demand thanks to an unusually warm winter. Dry gas is landlocked in North America since there are no facilities to export it to world markets where in some cases can fetch prices upwards of $10/mcf compared to the $2 and change it currently sells for in North America. The supply build-up will only make things worse for natural gas weighted names and could potentially wreck havoc later this year among producers as they compete for depleting storage space. Canadian natural gas prices will suffer more pressure as they get bullied by rising US production competing for pipeline capacity. As of February 15, the EIA reported a decline of 19% in Canadian natural gas exports to the US compared to last year. Whether you’re a contrarian investor or a value investor looking for exposure to natural gas weighted producers, make sure you review the following variables.
too much supply, not enough demand!
Impact of Declining Gas Prices
The impact of declining natural gas prices is starting to be felt as natural gas weighted companies are forced to scale back capex programs which slows or reverses production per share growth. Companies that will fail to plan for a sustained level of price weakness will be lead to higher debt levels forcing dilution through potential equity financings or asset sales at what could be the low of the price cycle.
Wishful Price Decks
Many financial institutions and companies are still using pie in the sky average gas price estimates for 2012. As of last week, YTD average AECO Spot strip pricing has been $2.38/mcf and $2.60/mcf for Henry Hub Spot. Make sure you review what a company is budgeting for its natural gas production especially if it pays a dividend. A company’s cost structure is the key here, are they making any money at current prices? Are they even breaking even? Will they be able to break even if prices average $2 or less?
Plan B: Liquids
There’s no way to know where natural gas prices will settle this year or how long this depressed price environment will last, producers with a significant natural gas weighting should be shifting focus to oil or liquids production in order to strengthen cash flow. Failure to do so will result in a prolonged period of pain for shareholders or worse depending on the balance sheet health. Does the company have an inventory of low risk oil or liquids rich targets? Can the company achieve this shift within a contracting cash flow?
no surprise we have a glut...
Balance Sheet Health
Natural gas weighted companies that are currently drawn on their line of credit at levels higher than 70% or even less might be in for a nasty surprise. Banks will reduce their credit lines when current strip pricing is applied on their reserves resulting in more stress on operations and growth. This brings us to the balance sheet health, how much is the company drawn on its bank line and does it have a decent margin it could use to focus on increasing liquids production? Reducing capex and hunkering down until the storm passes neutralizes production growth which turns the company into dead money for investors.
Hedging
For a heavily weighted natural gas producer, having 10% or even 20% of natural gas production hedged at higher prices for the year is in my opinion useless as the impact of the remaining 80% will strangle cash flow. A company with significant hedges in place will still feel the impact of low natural gas prices if their reserves are weighted to natural gas since the bank lines might suffer. This year, producers were caught with their pants down as I believe they were waiting for strengthening prices this winter to lock in their hedges, a winter that turned out to be extremely disappointing.
Conclusion
Finally, if you’ve read this far, it is obvious that I am bearish on natural gas. There’s just no hope until we close in on operational export facilities or unless some unexpected event changes the fundamentals of this commodity (fracking ban for example). However, if you are a contrarian investor or a value investor looking for exposure to gas weighed names, remember to focus on companies with breakeven prices below current strip pricing without forgetting to take into account the remaining variables discussed above. These are the companies that will survive and prosper in the long run once the price cycle reverses. Keep in mind that it might get worse before it gets better, timing is everything and hindsight is 20/20.
What do you think of natural gas prices?
My DIY stock portfolio is overweight in Canadian oil producers for a reason. I believe Oil consumption is on the path of growth for the next decade and I intend to take every advantage possible of it:
In my opinion, a lot will depend upon the direction whichever administration comes to power with regards to tapping the large shale reserves here. (US perspective).
With easy availability of gas and less dependence on mid-east oil, the prices are bound to fall.
But if a decision drags on on how to regulate fracking, the prices could go up just on speculation and I don’t think the volatile situation in the mid-east is going to ease any time soon.
I don’t think the situation in the ME affects NG prices in North America in the short term. what we need in NA are export terminals or higher demand due to power generation or to transportation and so far this has been lacking on a large scale.
I think natural gas prices have to be reaching their lows soon. It is a market I’ve been looking to get into, but the companies that drill for it have been taking a beating due to the declining prices.
Watch out, timing the low is the trickiest part. I’d wait for the summer, if we don’t get a hot summer this year the back to back blows will push ng prices even lower!
Gas-fired gas plants will have an impact, just not in the short term. The FEED / permitting / construction cycle runs a few years, but that is certainly the trend. The combined cycle sector of the power gen industry is going nuts w/ new orders and projects. In the meantime, I’m with you on nat gas producers: hunker down and buy more on weakness.
I expect more pain before it gets better for producers, let’s see how the summer goes…
Picking the bottom of the price trough is always very tricky, if not near impossible.
That said, if I get some cash, I think in the next couple of months when NG hits a seasonal low, it might be the time to pick up some ECA for my portfolio. I don’t own any, yet.
No hurry Mark, there will be better prices ahead in my opinion.
MOA, as Mich points out, I wouldn’t rush in.
The price of ECA has nothing to do with seasonality and temperature changes anymore, its aobut NG supply. ECA has spent the last 2 years selling off its assets, becuase it has no revenue – its selling off its assets in order to produce revenue!
But there certainly is a value play here. All I can say is I am glad I sold ECA at $32 per share, and I think the price can still go lower. There will be a buy point soon, but who knowns when.
Cheers
The Dividend Ninja
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Mich Great post and sorry I missed it this week! I’ve made a note to include it on my next roundup.
There are two turn around scenarios I see for NG, but nothing happening anytime soon:
(1) Easy and cheap to produce NG from Shale Gas deposits is what is causing the current global oversupply. If you agree with that point, then any threat to that supply or method of extracting NG will cause an increase in prices.
I believe that threat is already present, in Shale Gas drilling being banned by various local governments. The problem of course is that shale deposits are closer to the surface and are part of the water table system. Quebec already started investigating and banning shale gas drilling last year (as I recall) and in the U.S. as well. Other countries I doubt will ban it anytime soon.
(2) I believe the second pressue for increasing NG demand will be from global demand for electircal power from NG plants. I think the Uranium meltdown in Japan sent ripples around the world with nucleur power generation. Seems like NG is a safer, cheaper, and plentiful alternative.
Thanks for letting me hijack your blog Mich!
Cheers
The Dividend Ninja
Hey DN, Great to hear your opinion.
In regards to Quebec, being a resident of this province I always find it too leftist with powerful tree hugger groups who succeeded in halting or killing a shale industry in its infancy. In Quebec, we are great at that, whine whine whine for more money from the government and whine more to stop creating new sources of income in the name of the environment. Too special in my opinion….
Having said that, a fracking ban in 1 shale play in the US will not make much of an impact since you have several producing basins. We are getting a lot of dry gas as a by-product of liquids rich targets. We will need a few bans to feel the impact.
As for global demand, NA natural gas has no access to the global market yet and won’t be having any until 2015 at the earliest.
I guess we are stuck with lower prices as a solution to low prices
You’re welcome to hijack my blog any-time DN!
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