Saturday, August 22, 2009

Has natural gas hit bottom? Not yet


Some companies will eventually make a killing from the recent collapse in natural-gas prices. But when? And which companies?

Value investors usually need only identify a bargain, then hang on until the rest of the stock market catches up with their thinking. But the plunge in natural-gas prices has been so severe and could last so long that some companies with the best natural-gas assets may not survive the shakeout.

Balance sheets are at this moment more important than geology.

Prices are the beginning of the problem. Benchmark Henry Hub natural gas for September delivery closed at $3.163 per million British thermal units Aug. 17. That's a 44% decline in price since the beginning of 2009 and the lowest price since September 2002.

Natural gas in storage, meanwhile, climbed 63 billion cubic feet in the week that ended Aug. 7. That pushed inventories 592 billion cubic feet higher than they were at the same time a year ago.

Supply up, demand down

The problem is supply and demand.

U.S. natural-gas producers continue to increase supply. Much of the new gas is coming from what were once called "unconventional" sources, such as the gas shales of Texas, Utah and Wyoming. Natural-gas production was up almost 2% in the first five months of 2009 compared with the same period in 2008, according to the U.S. Department of Energy.

That increase in supply has come as demand has crumbled. Consumption fell 4.2% in the first five months of 2009. Factories, chemical plants and steel mills account for 29% of U.S. consumption. With the recession, many of those customers are running at less than full speed. Demand from industrial customers fell 13% in the first five months of the year.

The worst of the crunch is still ahead. (For another way to judge when the oil and gas sector has bottomed, see my post "Next week it's oil, oil and more oil earnings," on using capital budgets as a leading indicator.)

Natural-gas producers with big debt loads and high interest payments haven't yet cut production. In the second quarter, companies such as Chesapeake Energy (CHK, news, msgs) have instead used higher production to beat Wall Street's earnings projections.

And producers that had the smarts or good luck to lock in higher prices with hedges haven't cut production either. XTO Energy (XTO, news, msgs), Devon Energy (DVN, news, msgs) and Ultra Petroleum (UPL, news, msgs), companies with hedges that cover a good portion of their production, all reported an increase in production, big profits from their hedges or both. XTO, for example, reported it had received an average price of $7.08 per million Btu in the second quarter because of its hedging....MORE