Looking Beyond $2.71 Natural Gas

Natural Gas prices have been declining for years. The shale gas boom has been great for servicers and consumers, but drillers have been producing so much natural gas that they’re almost giving it away. The Wall Street Journal has an article highlighting the steady increase in domestic production (up around 50% since 2005) and the sliding price. Spot Natural Gas dropped to $2.71 yesterday and there are forecasts that the price may drop as low as $2.

The stocks have reacted predictably, with Comstock Resources (CRK) and Southwestern Energy (SWN) both falling sharply. To be sure there is no end in sight for the weak pricing environment. Natural gas is starting to replace coal as the fuel of choice for new electricity generation, and low prices will create their own demand. But this all takes time, and for traders who rely on pictures, the charts certainly look ugly for these and other names.

However, it’s worth remembering the recent M&A activity that’s been taking place. Sinopec, a large Chinese oil company, invested $2.2BN in a joint venture with Devon Energy (DVN) in oil and gas fields it’s developing. Access to cheap, secure U.S. energy resources is attractive to China. France’s Total invested $2.3BN alongside Chesapeake Energy (CHK) and Spain’s Repsol put in $1BN to partner in a field alongside Sand Hill Energy. This week, Bloomberg highlighted the record prices shale acreage is receiving from international buyers.  Last Summer BHP Billiton acquired Petrohawk at a 60% premium to the then current price. Floyd Wilson, Petrohawk’s CEO, no doubt had sublime timing. But there’s little doubt that the major E&P companies recognize the long term role natural gas will play in U.S. energy consumption. Exxon Mobil (XOM) publishes “The Outlook for Energy: A View to 2040” which provides some insight into their thinking. It’s worth reading. They expect gas and electricity (which is increasingly produced by using natural gas) to meet a growing share of total energy demand. Natural gas is far cleaner than coal, far cheaper than oil and provides energy security in the U.S. While in the near term it is supplanting coal as a source of electricity, it’s likely to make some inroads to transportation. And those northeasterners who burn oil for heat will see the economics of shifting to natural gas.

None of this makes for a trade. But natural gas E&P names with low debt and production costs provide the staying power to hold as an investment while M&A activity continues and demand reacts to low prices. And there’s always the potential upside from instability in the Middle East. We continue to own DVN, whose proved reserves alone are worth around $60 per share. We like CRK, which owns assets similar to those Petrohawk sold at a high price last year and is steadily adding higher-margin natural gas liquids and oil to its output. Yesterday we bought back into Range Resources (RRC) which represents a concentrated bet on the Marcellus Shale but has very low production costs and in our opinion solid management. Although its proved reserves put a floor value far below the current stock price, we think the company is highly confident about its ability to de-risk much of its acreage but FASB rules require that proved reserves be extracted within five years and RRC need not start the clock ticking on everything. We had exited RRC in the Fall as takeover speculation drove the price up. We think at current levels it’s an attractively priced investment. They estimate up to 50 Trillion Cubic Feet (TCFE) of resource potential which, even if it only generated a realized $0.50 per MCF of cashflow would generate $25BN. The company expects to fund all capex from cashflow by next year.

There is a huge divergence in what large long term focused companies are willing to pay for these E&Ps hydrocarbons and what market participants are willing to bid for their stocks today.   In the near term, expect these stocks to be volatile.

Disclosure: Author is Long DVN, RRC, CRK, SWN