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Although I Know Better, I’m Getting Interested In Natural Gas Related Equities

Canadian Value

CanadianValue

210 followers
As an investor you have to get to know who your enemies are. It takes a while to figure it out. When you first start learning about investing you will concern yourself with “the shorts”. Then you might decide that your enemy as an investor is Bernanke or the Democratic Party. But eventually you will figure out that hands down, no contest your main enemy as an investor is yourself. And he or she is one tough SOB to fight because just when you think you have won your mind creates a new battle for you.

I will admit that after years of work I seem to be able to slow down that itchy trigger finger of mine that is always too eager to buy a stock. I repeat over and over to myself that today won’t be the best price that Mr. Market will offer me for company XYZ, so save some cash to buy more tomorrow. But today I’m battling my mind as it seems to think that it knows that natural gas prices are going to start to improve fairly soon.

And this of course is very strange considering that all of 10 days ago I wrote about how predicting natural gas prices is far beyond my circle of competence:

http://valueinvestorcanada.blogspot.com/search/label/Natural%20Gas

Do you see what I mean ? 10 days is all it took for me to once again have to fight my mind over whether or not I have a clue as to predicting natural gas prices. A relentless enemy indeed my mind is.

Here is what my mind thinks it knows:

1) Natural gas companies are going into next year with only 30% of production hedged. And you can bet those hedge prices are on average less than they were in 2010 and 2009 when more production was hedged at higher prices. This lack of hedging is without question going to reduce cash flow for gas producers who are now selling gas at $4 spot prices rather than $6 to $8 hedged prices. That means a lot less capital available for capex and that means a lot less drilling in 2011. And of course less drilling means less production.



Here is a link to an article discussing the decrease in hedging:



http://www.bloomberg.com/news/2010-12-17/hedging-gas-tumbles-to-30-of-production-as-prices-slump-energy-markets.html



2) Anyone who can shift capital spending towards oil and liquids and away from natural gas is doing so. So not only do companies have less cash flow to invest in drilling, they also are steering that cash flow to oil drilling instead of natural gas drilling.



There is no better example of this than Chesapeake Energy who is the most active natural gas driller in the United States. Consider these comments from their most recent conference call:



“If you're on our website or go to it at some point, note Slide 17, which is a projected CapEx budget over the next, well, I guess, three years going out to 2012. And in 2010, we'll spend 31% of our money on liquids CapEx, 2011 that should be 45%. And by 2012, we'll be spending almost 2/3 of our capital on liquids plays. So I suspect that people really don't appreciate that impact when we start replacing $3 and $4 Mcf with $13 and $14 Mcf. On a similar cost basis, you really see a huge move in per-unit value creation, and that will drive some numbers in 2012 and beyond and I think most people are not currently not modeling for. So that will remain a focus of the company. Of course, if gas prices, for some reason, were to come back at higher levels, we can always pick our gas drilling back up. But at this point, our goal is to go from 90% natural gas CapEx in 2009 to go to 35% gas CapEx in 2012.”



So that is the most active natural gas driller going from 90% of its spending on natural gas in 2009 to only 35% in 2012. That is going to make a difference. Especially when you consider that every other company is making the same move if they have oil to drill for.



3) Number 1 mentioned the fact that cash flows and thus capex will be reduced by the amount available. Number 2 mentioned that natural gas capex will be reduced by choice. And now number 3 is that much of the natural gas drilling that has been forced on companies as they have to HBP acreage is also going to be reduced. Much of the leasing of the big shale plays in the Haynesville and the Fayetteville was done in 2007 and 2008 with a three year window to HBP the acreage. In other words if you don’t drill it you lose it. That incentive for drilling is going to end in 2011 for many companies as they will have HBP’d what they needed to because the time window is ending.



I’m sure many people have had the same thoughts about a turn in natural gas for the same reasons. How can you not. Cash available to drill is going to go way down as the 2008 and prior hedges have run out. Nobody who can drill for oil would drill for natural gas if they have a choice. And those who were forced to drill for natural gas to HBP acreage will in 2011 be relieved of that burden.



The problem of course is being able to predict when the turn will come and I don’t think a person can do that very accurately. I’m inclined to think that the end of 2011 might be a good bet for some real tightening in the natural gas market but I am very aware that is not much better than a guess.



The move for a true value investor would be to buy equities who will benefit in a big way from a turn in natural gas, but will also do ok if that turn is further in the future than expected. My preferred vehicle is still Chesapeake as I really think their move to oil is not being appreciated enough by the market. But my mind and I are still fighting on that one. I’ll let you know if someone wins. A more prudent play would be something with a better balance sheet.



Oh, and if getting your head around natural gas isn’t hard enough, a person interested in many gas producers will also have to try and figure out how likely it is that there will be some kind of ban on fracking. You forgot about that one didn't you mind ?

About the author:

CanadianValue
http://valueinvestorcanada.blogspot.com/

Rating: 4.0/5 (9 votes)

Comments

vgm
Vgm - 3 years ago
Canadian Value

Your posts on natural gas and CHK are informative and are appreciated.

But it seems to me you are trying to make a macro call on the future of natural gas - both price and utilization - and this results in your (continuing) inability to decide to buy with conviction. I think we can be certain that nat gas will be important in the future, but the timing is the elephant in the room.

There are two ways out: either take Buffett and Munger's advice and put it on the "too hard pile" and move on, or decide on CHK by a bottoms-up analysis, which of course would also be a Buffett/Munger approach.

vgm
LwC
LwC - 3 years ago
This morning I ate breakfast with someone who is active in the oil & gas business, and FWIW his opinion is that large companies are beginning to divest relatively small gas properties that are difficult for them to make an adequate IRR at current gas prices due to their high overhead cost allocations; and that small companies are able to buy those properties from them at a price that gives a high probability of achieving an acceptable ROIC at current gas market prices, and ensures a very large ROIC if and when gas prices increase. He gave a specific example of certain gas properties that ConocoPhillips recently divested to a small independent.

If one is interested in pursuing an equity investment strategy based on that kind of assumption, one could attempt to identify small companies that are known to be pursuing those kinds of gas property acquisitions and invest in their shares if the equity price provides an adequate margin of safety.

He also gave an example of the kind of leverage that can be realized with right priced acquisition of such properties by describing a gas property that is owned by his company (though not a recently acquired one): a one dollar increase in the price of gas at the wellhead from today's price could increase the net profit from the sale of produced gas by something approaching 100%.

Good luck.

Vjklander
Vjklander - 3 years ago
My investments in gas are LINE and WMB. I've been happy with the results in both. Though truth to tell, I've got tight notifications and right now I'm ready to sell all on a hair trigger.

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