Around Labor Day, I noted that the relationship between near-term and future natural gas prices was off the chart, literally. Here is the chart I shared in that article suggesting caution on Gas E&P companies:
Since then, spot prices have shot up (perhaps seasonal), but, more importantly, the one-year out price has fallen sharply after trying to rally (and remains in a downtrend). You can see this divergence in the top two panels in this chart:
At an 18% premium, the forward gas is still somewhat expensive to spot gas historically, but it is certainly a more normal relationship now. With every asset up in value over the past year, why is gas lower? More importantly, is there potentially a disconnect that will allow investors to potentially profit (or avoid losses)?
Gas bulls will tell you that it's only a matter of time before gas goes up. We are working off the excess of supply that came onto the market in the bubble at the same time as industrial demand has plunged. All one has to do is to look at the rig count to see that supply will be curtailed. What they miss, as I pointed out in that prior article, is that we are learning that supply is much higher than ever imagined due to major discoveries in shale formations. In that last article, I discussed how several leading companies are cranking out production despite the plunge in gas. They are doing this because they have been able to sell forward. Call me cynical, but I believe that the recent hit to forward prices took place as companies prepared to update investors following Q3 results and wanted to show themselves as being even more hedged than they had been previously (except for Cheasapeake (CHK)).
As far as a disconnect, let me try to connect the dots. The leading natural gas producers rallied sharply with spot, but have been pulling back lately. A few of them are actually lower in price today than when I wrote about them in early September (despite the big rally in spot). I believe that their valuation should tie more closely to future prices, and that is why I am concerned. It's not surprising that the future price of gas has stayed high, but can these companies continue to count on hedging gains to fuel their profitability? The buyer forward is most likely a regulated utility. How long is it that regulators and consumers will tolerate gas prices well above market prices? I expect over time, as spot prices remain well below the spike levels of 2008, there will be less willingness to lock into longer term purchases, but the producers, who have made very large investments in their leases and who have reasonable debt to service (and pay down), will continue to put pressure on the forward price.
I want to share some comments from the industry about what's going on in terms of shale developments. All of these come from Seeking Alpha transcripts from Q3 conference calls, with links back for the reader to investigate further:
First up is Devon Energy (DVN), which likes shale so much it is divesting other assets to concentrate:
We are currently adding drilling rigs in our major shale development plays and will continue to do so in 2010. The step up in activity for the remainder of the year will move us outside the range of our previous 2009 E&P capital guidance. link
Chesapeake (CHK), as usual, offered all sorts of things to think about. They are not one of the companies hedging, as they have a publicly stated view that gas prices are going higher per their model. This will make them rich, of course, as they intend to crank out production:
On the operational side our daily production hit a new quarterly record for production at a daily rate of 2.483 Bcfe. In October, our net production has already been as high as 2.6 Bcfe. So we are on track to continue capturing gas production market share in the months and years ahead. By year-end 2010, we expect our daily net production to exceed 2.8 Bcfe and by year-end 2011 we expect our daily net production to exceed 3.1 Bcfe, which would be an increase of 25% from our third quarter 2009 average daily production. These production increases continue to be led by growth from our Big 4 shale and Granite Wash play. link
Next, let's hear from XTO, which is increasing production despite a massive cut in rigs:
Great quarter for us from a production standpoint, from the fact that we were running 100 rigs last year, down to 47 rigs in this quarter. So, less than half the rigs we started this year with about a 14% growth target 4% organic. We’re going to end the year with a 23% growth target and 13% organic for the drill bit...
As released today the company has approximately 55% on 2010, anticipated production hedged at $9.62. We will see that for 2010, we have begun to selectively lock in pricing that will continue to propel the company in value and reserve... link
Southwestern Energy (SWN) is cranking it out:
During the third quarter of 2009, we produced 73.2 Bcfe, up 38% from third quarter of 2008. Our Fayetteville Shale production was 58.8 Bcf, 60% greater than the 37.2, we produced in the third quarter of 2008.
They are a hedger just above the market price:
The hedges we put on in 2011 were in the mid $6, and then we have got one right around the $7 range, and that kind of tells what you we're targeting for overall prices. As we see those, you will see us work up hedges in both years. link
EOG (EOG) is not optimistic on gas in general (targeting just 3% growth due to weak prices in the first part of the year - must not use the CHK model!), but they are excited about the Haynesville:
We plan to run 10 Haynesville rigs in 2010 and increase our Haynesville net gas production from the current 40 million cubic feet a day to 200 million cubic feet a day by year-end 2010. The Haynesville will be the primary driver of our 2010 North American gas production increase. Link
Finally, Petrohawk (HK) is probably the single most leveraged shale play.
Our development and drilling programs in our core shale place have outperformed our expansion in the Haynesville and Eagle Ford has been collectively executed by the land team and our geoscience professionals. And we have developed new and better ways of analyzing the explosion of data now available in both of these areas... Production growth drives this conversion and with today's announcement we are on track to grow production 75% over last year and we have set 2010 guidance at 43% over this year. link
An interesting aside and a lead-in to a future article regarding ways to invest in the move towards these shale plays is a drill bit that was mentioned by HK. President Stoneburner stated:
The use of rotary steerable systems in certain applications has shown benefit as well as rotating case in the bottom. However, the most single significant factor has been the development of a PDC bit by our staff-drilling engineers that to this point has only been utilized by Petrohawk.
This bit has shown to increase the rate of penetration in the lateral dramatically. An example of the improved penetration rate is evidenced by the number of days that we have drilled more than 800 feet in a lateral.
In June and July, we only had three days with greater than 800 feet drilled. But during August and September, we had 20 of those days. More recently a 4500-foot lateral was drilled in five days and over 3200-feet of lateral was drilled in three successive days.
I believe that the mystery manufacturer is Ceradyne (CRDN), which stated in its recent Q3 Earnings press release:
A recently completed successful oil and gas drilling event in which Ceradyne’s proprietary ceramic bearing allowed the drilling of a directional hole through a difficult
CRDN can use a little help, so hopefully my deduction is correct. While Carbo Ceramic (CRR) is clearly a huge beneficiary of increased shale production, there must be other plays.
It's a very interesting dynamic. Higher prices will seemingly bring on an infinite supply of gas. What happens with lower prices? Already conventional production has plunged, as reflected in the rig count, but the highly productive shale wells have been gushing away. These companies all have reasonable debt loads and typically generate negative free cash flow. Plus, they have sold their story to growth investors who are counting on them to continue to crank out production. With demand unlikely to rise substantially due to a tepid economy and supply likely to increase, it seems as though the price in the future will be pressured. The shale producers have all rebounded sharply from a year ago despite gas prices continuing to fall. Thus far, their hedging activities appear to have cushioned the blow, but, looking ahead, their realization is unlikely to be as high. After participating in the recovery by investing in names like Carbo Ceramic (CRR), Chevron (CVX), Contango (MCF), Lufkin (LUFK) and Tidewater (TDW) earlier this year in a portfolio I manage as well as my model portfolios, I am sitting it out now.
Disclosure: No position in any stocks mentioned except Ceradyne (CRDN), which is in the Top 20 Model portfolio as well as in a foundation I manage for a family member.