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Bust times for U.S. natural gas producers and boom times for U.S. oil producers could go on for quite a while--here's how to reflect that in your portfolio
01/27/2012 8:30 am EST
And I think the energy position in your portfolio ought to reflect that U.S. oil stocks and natural gas stocks are headed in opposing directions. The underlying fundamentals of liquid hydrocarbons are so different from those of gaseous hydrocarbons in the U.S. market that the odds are that 2012 will bring higher share prices for U.S.-oriented oil producers and stagnant prices for U.S. natural gas producers.
And unfortunately for bottom fishers, I think the trends that have put natural gas in an energy deep freeze are set to last for a while.
This all has repercussions that extend well beyond the stocks of oil and gas producers because the conditions in these two energy sub-industries will have a huge effect on drilling and service companies and on chemical producers.
Here are two deals from Monday, January 23, that sum it all up.
Chesapeake Energy (CHK) announced that it would cut the number of rigs drilling for natural gas to 24 rigs by the second quarter of 2012. That would be a 50% drop from the current rig count and a 67% decrease from the average rig count in 2011.
But Chesapeake isn’t just cutting its exploration and development activity—it’s actually going to cut natural gas production by approximately 0.5 billion cubic feet per day. That’s a decrease of 8% of the company’s current natural gas production and equals about 9% of total U.S. natural gas production. If prices don’t rebound from current levels at $2.61 per thousand cubic feet at the Henry Hub for natural gas, the company is prepared to take another 0.5 billion cubic feet a day out of production.
Contrast that to this story out of Apache (APA) on the same day. Apache will pay $2.85 billion to buy Cordillera Energy, a company with oil and natural gas reserves in Oklahoma and Texas. Oil and natural gas liquids make up 53% of Cordillera’s production. In the deal Apache will acquire 254,000 net acres of drilling rights and proved reserves of 71.5 million barrels of oil and natural gas equivalents and another 234.5 million barrels of probable or possible reserves.
Why did Apache buy at a time when Chesapeake is shutting production? Here’s the simple math, according to Apache: The value the production of a dry gas well, that is one without liquids, is about $3 per thousand cubic feet. A natural gas well with liquids would yield products worth roughly $7 per thousand cubic feet.
Other oil and natural gas producers in the United States basically confirm this math with their actions. When ConocoPhillips (COP) reported fourth quarter earnings on January 25, it told analysts that it will shut 100 million cubic feet per day of natural gas production out of its total U.S. and Canada production of 2.5 billion cubic feet per day. The reason, CFO Jeff Sheets told analysts and investors is that the price of natural gas hit a 10-year low in January and may remain soft for another year or two. Gas prices need to rise to $5 or $6 per thousand cubic feet to generate long-term supply, he added.
Nevertheless ConocoPhillips reported earnings per share (excluding one-time gains) of $20.02 a share for the quarter—22 cents a share above the Wall Street consensus—on increasing oil production. ConocoPhillips’ oil production in the United States will keep climbing, too, the company said as its production of liquids from its shale reserves in the Bakken, Permian, and Eagle Ford formations rise from the current 120,000 barrels per day toward 270,000 barrels per day.
Conoco Phillips CFO Sheets may be a bit optimistic about how long natural gas prices will remain depressed. The U.S. Energy Information Administration recently raised its estimate for growth in natural gas production through 2035, despite the current deep slump in gas prices, by 7%. Natural gas prices will remain below $5 per thousand cubic feet on average over the next 10 years.
From a simple supply and demand perspective, increasing production growth when prices are so low doesn’t make any sense. But there’s really nothing simple about natural gas supply and demand. In the rush to stake a claim to the most acres of potential natural gas production in the new gas shale regions, such as the Marcellus shale, natural gas companies have wound up with a huge back log of drill or lose ‘em leases. Under the terms of these leases, if the natural gas company doesn’t show evidence of trying to develop the lease with some period—usually five years—then the lease rights lapse. Don’t drill? Lose the lease. Drill and don’t produce any natural gas? Then you can’t afford to finance your development activity.
And then there’s the problem that natural gas is a “by-product” of producing oil. Conoco Phillips, for example, figures that bout two-thirds of its natural gas is a by-product from wells producing oil or natural gas liquids. Unless you want to flare off the gas or stop producing oil, company can’t reduce natural gas production beyond certain physical limits.
It’s only the most deep pocketed of natural gas producers (such as Conoco Phillips) or those that have sold off substantial lease acreage when prices for such deals were solid (such as Chesapeake) that can afford to cut back on production. For example, Cabot Oil and Gas (COG) hasn’t yet curtailed either production or its drilling program. The company is counting on cash flow to fund its $850 million to $900 million drilling program in 20121 that would add more than 100 wells and raise production by as much as 55% this year, by company estimates. Wall Street analysts have recently questioned Cabot’s math, saying the company looks about $75 million short of funding that capital plan. The company disputes those calculations.
There are two things that could quickly turn around the price of natural gas.
First, growth in the U.S. economy could accelerate, driving up demand. That would be a good thing for lots of reasons but it basically makes the natural gas companies captive to economic growth. From this perspective, as an investment the sector resembles the housing sector—investors who can call the turn will do well.
Second, the skeptics about the longevity of shale-based natural gas production could turn out to be right. Estimates of the production curve with time of a natural gas well in a shale formation are based on an analogy with the production curve of traditional gas wells. But no one really knows, the skeptics point out, how quickly peak production from a shale well will decline. There could be less gas in the industry’s future than most natural gas companies now project. (In a related development, in its annual outlook the Energy Information Agency cut its estimate for unproved technically discoverable natural gas reserves in the Marcellus shale formation by 65%. That reduced total estimates for all U.S. shale natural gas reserves by 41%. I don’t know if the new or old estimate is more accurate. The production history of these formations is so short that estimates are likely to remain volatile for quite a while.
So how does this play out of investors?
Favor companies with U.S-based liquid production over natural gas production. The U.S. gas glut is so difficult to reduce because exporting gas from the United States requires a huge investment in pipelines and liquefied natural gas terminals. On the other hand, U.S. oil producers are in the business of replacing imported oil with domestically produced oil—and seeing the price of domestic oil supported by a global market that seems to be set at $100 a barrel—and that spikes above that every time an oil producer threatens to reduce oil supplies. The Energy Information Agency projects oil imports will fall from 49% of total consumption in 2010 to 36% in 2020. I’ve repeatedly posted about some of the U.S producers that benefit from being liquids heavy (see my post http://jubakpicks.com/ ) and on January 13 I added one Pioneer Natural Resources (PXD) to my long-term Jubak Picks 50 portfolio http://jubakpicks.com// so enough said on that angle.
Look at U.S.-based chemical companies that will benefit from the low prices on one of their key raw materials, natural gas. I’ve got DuPont (DD) in my Jubak’s Picks portfolio (http://jubakpicks.com/ ) but other chemical companies such as Ashland (ASH), Cytec Industries (CYT), and FMC (FMC) all are picked by Wall Street to grow earnings in 2012 by 16% or better.
And finally, favor oil drilling and service companies that are focused on shallow and deep water drilling over those with big exposure to U.S. land-based drilling. Any slowdown in drilling activity would hurt these companies more and evidence from recent earnings reports show falling North American margins as these companies pay to shift rigs from natural gas drilling regions to liquid-heavy regions where drilling activity is still expanding. The playing field is tilted even more by recent evidence that lease rates for ocean-based jackup drilling rigs have rebounded from a three-year low. For example, Noble (NE)—and don’t get it confused with Noble Energy (NBL) recently signed a contract to leave a jackup rig in the North Sea at a day rate of $122,000, up from a prior contract at $91,000 a day. Deepwater rig day rates, which never fell as hard as the jackup market, remain relatively stable. So I’d emphasize drillers with big jackup exposure such as Noble, Ensco International (ESV) and Rowan (RDC) over drillers with heavy North American land exposure such as Halliburton (HAL) and Baker Hughes (BHI)
You might want to wait for some of the euphoria to wear off over strong U.S. fourth quarter GDP growth before adding any of these stocks to your portfolio. The Federal Reserve, which on January 25 said it would extend exceptionally low interest rates of 0% to 0.25% until the end of 2014 (instead of just the middle of 2013) doesn’t think fourth quarter growth rates will carry over into 2012. I don’t either.
Full disclosure: I don’t own shares of any of the companies mentioned in this post in my personal portfolio. The mutual fund I manage, Jubak Global Equity Fund http://jubakfund.com/ , may or may not now own positions in any stock mentioned in this post. The fund owned shares of DuPont and Pioneer Natural Resources as of the end of September. For a full list of the stocks in the fund as of the end of September see the fund’s portfolio at http://jubakfund.com/about-the-fund/holdings/
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