There Are Still Investing Opportunities Created by Natural Gas Collapse

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Jul 26, 2011
From October 2010 to July 2011, Robert Raymond has appeared several times on NBC’s The Strategy Session. The main topic of the interviews has been the collapse of the natural gas price and the investment opportunities that this event has created. Robert Raymond is the principal and founder of RCH Energy, a hedge fund specialized in the energy sector with approximately $605 million assets under management.


Following are the notes I took from these interviews along with some basic research on the industry — personal comments are in italics.


Natural gas oversupply — how did it happen?


· The natural gas market is structurally oversupplied. The horizontal drilling and completion technology, introduced to this commodity over the last decade has shifted the supply curve materially higher (I would say lower), while the demand curve has failed to keep up.


· Over the course of the last 36 months, supply has overwhelmed demand.


· As precedents, in the 80s, the oil and gold industries faced similar disruptive technologies which precipitated 10 – 20 year unbalances. Offshore drilling for oil and cyanide leaching for gold.


· After new technology is applied to commodities, supply and demand rebalance is measured in half decades and decades. We are in year two or three of the natural gas price capitulation. Thus, this can go on for a long time.


· Producers with drilling rights continue to drill and oversupply the market, which seems irrational. In order for managements to be more reasonable with their capital expending, the price will need to go lower.


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Rebalancing supply and demand


Some of the events that would hike demand or constrict supply are:


· The collapsing market will bring about some consolidations and bankruptcies.


· The natural gas production of the big integrated companies like: BP (BP, Financial), Exxon (XOM, Financial), ConocoPhillips (COP, Financial) and so forth, have seen their natural gas reserves in the US shrink. Ultimately, they will have to restore them, basically through M&A.


· During 2011, M&A activity in the natural gas industry has been very high. Raymond thinks it will continue to some extent, but will be very asset specific. This is a sign of an oversupplied market.


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· Apparently, this trend will continue until producers not only do not make a profit drilling new wells, but lose money on their existing operations. That could happen at a around $2 (Robert Raymond did not specify the price units; $2 per thousand cubic feet and $2 per million BTUs are similar though).


· When new drillings drastically ebb, the cycle will start to change.


· During 2008 and 2009, producers hedged a significant proportion of their output at attractive prices, from $6 to $8. In 2011, natural gas withdrawals are relatively unhedged, so we are living in a world with depressed natural gas prices which will be reflected in cash flows and will create a credit issue for

some of these companies.


· Substitution of oil by natural gas in some usages like power generation, a possible increase in demand for automobiles powered by natural gas, would add to the demand for this commodity. However, these changes would take time.


The new natural gas industry


The collapsing market has changed the rules in the industry. Some of the more important are:


· There is a distinction before the oversupply crisis and now:
o Before, unproven reserves and lease holds were highly valuable in the market.


o Now, cash flow and rate of return are the standards to value a company. Some managers have understood this and are positioning their companies to survive in this new world; some others have not and will be impaired.
· The next generation of hydrocarbons in the US will be unconventional in nature, very capital intensive, will take a long time to develop.


Investment opportunities


Three years after the latest natural gas price collapse began, there are still some opportunities, per Robert Raymond:


· The hedge fund is shorting the commodity through the ETF and directly in the commodities markets.


· The large cap energy stocks are not considered a good option. Stocks are way ahead of the commodity now because managers have been forced to buy these equities. The markets are discounting these stocks at a price for natural gas around $5.5 to $6. On July 2011 is trading around $4.3.


· MLPs (Master Limited Partnerships)1.
o The Alerian MLP Index is fairly valued. Therefore, it is not a good alternative for considerable price appreciation. It is important to be more selective.


o A common mistake investors make is to treat all MLPs as if they are homogenous. It is crucial to understand the underlying assets of each MLP. Raymond thinks that there is a lot of value in some specific set of assets in certain producing markets of the country like:


o A basin that has liquid associated, not dry natural gas, but some crude oil to condensate. Located where the new technologies can be applied.


o The crude oil storage and transportation MLPs.


o The midstream MLPs like Copano2 are good alternatives. Copano (CPNO, Financial) will have the largest natural gas processing plant in Texas later this year.


o Another way to realize value is in through the M&A activity. The entire place is going to consolidate. The Petrohawk Energy acquisition by BHP paid a high premium (around 65 percent. Prior to announcing the acquisition, Petrohawk closed at $23.49 on July 14, 2011; the acquisition price is $38.75).
Conclusions and remarks


· I am not an advocate of short selling anything, in spite of the fact of being being right in the analysis, an investor may be forced to close the position at a great loss.


· The following figure shows a 12-month moving average for gross withdrawals (production) and consumption. The lines show that withdrawals and consumption had a steady increase from the beginning of 2007 until mid-2008. At that point, withdrawals continued to grow (at a slightly lesser slope) while consumption decreased for a year until mid-2009. From mid-2009 until the latest available data (April 2011) withdrawals and consumption have grown at a rather parallel rate, although the gap between them is greater.


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· The next figure shows the 12-month moving average difference between withdrawals and consumption (left vertical axis) and the 12-month moving average price for natural gas (right vertical axis). It is interesting to note than during the first six months of 2008, the difference and the price increased as a result of strong global demand. When the crisis and recession began in earnest, the 12-month moving average price fell from $8.2 in September 2008 to $3.70 in December 2009. The price recovered a little and has been around $4. The difference (surplus) remains at around 250 billion cubic feet, which seems to prevent the price from reaching and maintaining higher levels. By the end of July 2011, the US Energy Information Administration will release new data. If the difference and the price remain at their same levels, it might be unwise to short natural gas.


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· The MLPs seem to be a good place to start searching for and analyzing opportunities. Natural gas is a cyclical industry. If the new technology disruption is serious, as stated by Robert Raymond, we would better consider current price levels to value the entities.


· The middle size MLPs with high quality assets and/or midstream facilities (gathering, transmission, processing, fractionation, etc.) might be the most suitable targets for an acquisition. If a reader finds value there, it could be a great opportunity.


· The analysis should take into account that the natural gas industry is global. Consequently, global consideration of supply and demand is important.


Readers must do their research and analysis and reach their OWN conclusions and decisions. All the contents of this article are for informational purposes only. If any reader decides to trade in stocks or any other investment vehicle, they agree to do it at solely (his/her) own risk. None of the material presented here should be interpreted as a recommendation or solicitation to buy and/or sale any security. The reader agrees to assume full responsibility for any and all gains and losses, financial, emotional or otherwise, experienced, suffered or incurred.


1) A Master Limited Partnership is a limited partnership that is publicly traded. The limited partners provide the capital and receive periodic income distributions from the MLP’s cash flows. The general partner is responsible for managing the MLP and receives compensation that is performance linked. To be classified as a legal MLP, the partnership must derive most of its cash flows (about 90 percent or more) from real estate, natural resources and commodities. The tax advantage is that MLPs do not pay profit taxes; money is taxed only when limited partners receive distributions.


2) Copano Energy is not an MLP; it is registered as a public LLC (limited liability company).


First Interview




Third Interview


The Post-Strategy Session