Why Not Drill for Natural Gas?
01/27/2012 10:00 am EST
For all the talk of energy independence and with oil prices ready to spike higher, natural gas production is being cut. Here’s why, and what it means for energy investors.
It is the best of industries, it is the worst of industries.
And I think the energy position in your portfolio ought to reflect that US oil stocks and natural-gas stocks are headed in opposite directions. The underlying fundamentals of liquid hydrocarbons are so different from those of gaseous hydrocarbons in the US market that the odds are that 2012 will bring higher share prices for US-oriented oil producers and stagnant prices for US natural-gas producers.
And unfortunately for bottom fishers, I think the trends that have put natural gas in a deep freeze are set to last for a while.
This 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.
A Tale of 2 Directions
Here are two deals from Monday, January 23, that sum it all up.
First, Chesapeake Energy (CHK) announced that it would cut the number of rigs drilling for natural gas to 24 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 cutting only its exploration and development activity. It’s going to cut natural-gas production by approximately 500 million cubic feet per day. That’s a decrease of 8% of the company’s current natural-gas production, and equals about 9% of total US 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 500 million 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 Partners, 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, with proven reserves of 71.5 million barrels of oil and natural-gas equivalents, and an additional 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 of 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.
ConocoPhillips Cool to Gas, Too
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 announced it would shut 100 million cubic feet per day of natural-gas production out of its total US 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 ten-year low in January, and may remain soft for the next year or two. 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 $2.02 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 will rise from the current 120,000 barrels per day toward 270,000 barrels per day.
ConocoPhillips CFO Sheets may be a bit optimistic about how long natural-gas prices will remain depressed. The US 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%.
However, natural-gas prices will remain below $5 per thousand cubic feet on average over the next ten years.
To Drill or Not to Drill?
From a simple supply-and-demand perspective, increasing production growth when prices are so low doesn’t make 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 formation in the Northeast, natural-gas companies have wound up with a huge backlog of drill-’em-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 in 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.
Only the most deep-pocketed of natural-gas producers (such as ConocoPhillips) or those that have sold off substantial lease acreage when prices for such deals were solid (such as Chesapeake) 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 2012 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.
Could Prices Move Higher?
There are two things that could quickly turn around the price of natural gas.
First, growth in the US 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 housing—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 over 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 Administration cut its estimate for unproved technically discoverable natural-gas reserves in the Marcellus shale formation by 65%. That reduced total estimates for all US shale natural-gas reserves by 41%. I don’t know which 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 for Investors?
Favor companies with US-based liquid production over natural-gas production.
The US gas glut is 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, US 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.
The price spikes above that every time an oil producer threatens to reduce oil supplies. The Energy Information Administration projects oil imports will fall from 49% of total consumption in 2010 to 36% in 2020.
I’ve repeatedly posted about some of the US producers that benefit from being liquids-heavy. (See this post from October 21, for example.) And on January 13, I added one of them, Pioneer Natural Resources (PXD), to my long-term Jubak Picks 50 portfolio . So enough said on that angle.
Look also at US-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 , and chemical companies 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 companies that are focused on shallow- and deepwater drilling over those with big exposure to US 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 jack-up 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.
Deep-water rig day rates, which never fell as hard as the jack-up market, remain relatively stable. So I’d emphasize drillers with big jack-up 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 also might want to wait for some of the euphoria to wear off over strong US fourth-quarter growth before adding any of these stocks to your portfolio.
The Federal Reserve, which Wednesday 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 economic growth rates will carry over into 2012. I don’t, either.