Chesapeake Energy: A Groundhog for 2011 Natural gas prices?

Every year on February 2nd, weather watchers observe a groundhog emerging from its burrow. If the animal came out on a sunny day, it would be scared by its own shadow and would return to its hibernation, thus indicating six more weeks of winter. If, however, the animal emerged on a cloudy day, it would see no shadow and therefore would remain outside its burrow, thus heralding an early spring.

What does that have to do with Chesapeake Energy? Well it looks like the company is seeing the shadow of low natural gas prices for the year as it hedged 96% of its natural gas production in 2011. Why should you care about what CHK does? It’s because CHK is the second biggest natural gas producer in the USA with total company production of almost 3bcfe/d. It’s interesting to note that CHK only hedged 5% of its oil production for 2011.

CHK is not the only one to have hedged the majority of its gas production for the year; Range Resources hedged 85% of its 2011 gas production. It looks like natural gas prices will be wiping the floor yet again for a second consecutive year. Talk about prices getting worse in 2011 compared to 2010 but would that be really a surprise? I don’t think so and here’s why:

Natural Gas Rigs

According to Baker Hughes, an oil field services provider, 899 rigs were drilling for gas in the US this week. That’s 53% of the total rig count with 75% of Horizontal rigs targeting natural gas. Horizontal drilling technology has increased production and reserves substantially from shale plays across the US and Canada. Barclays Capital analysts estimate the rig count for gas should fall down to 800 rigs before natural gas production declines.  We have a good 100 rigs to go before we hit this milestone.

EIA Estimates

The EIA estimates consumption will remain flat vs. 2010 but production will be increasing by 0.8% in 2011. The forecast for Henry Hub 2011 cash price is expected down 7% at $4.10 vs. 2010. For the Canadian producers who mainly export to the US and are paid discounted AECO prices (substantially lower than Henry Hub) they have to watch for a falling US dollar through 2011 because it will add to the pain and impact their bottom line. Many of them no longer have any hedging in place.

Final Thoughts

I feel sorry for the Canadian weighted natural gas juniors as they will be abused once again this year in my opinion especially if their production is not liquid rich. With production going up, what will it take for demand to follow? Well, one can pray for a very hot summer or bet on a couple of hurricanes when the season comes but that’s not really “investing” anymore, it’s more like playing roulette at the casino. The turmoil in the Middle East and North Africa might also make it worse by destroying industrial demand if a fragile economic recovery is neutralized.

Even though I will not be investing in NG weighted juniors for most of 2011, I do believe there will be opportunities to exploit when the juniors are in their darkest hours. If one looks ahead to 2012 with a close eye on company fundamentals, armed with patience and ready for a decent holding period, it might potentially turn into a very profitable investment.

Statisticians observing the groundhog have found its “predictions” to be wrong about 70% of the time. However, in the case of CHK, I think there’s at least a 70% chance they were right with their hedging move.

What’s your take on natural gas prices? Are you currently holding any NG weighted stocks and why?