US natural gas
A variety of factors has led to US natural gas prices that are significantly below worldwide replacement costs. The natural gas price appears to be heading higher. Any such rise would likely benefit gas exploration and production companies.
The Henry Hub natural gas price reached multi-decade lows in 2015 and is still far below long-term averages. Adjusting for inflation makes current natural gas prices in the US even more extreme.
Improvements in fracking technology in the 2000s led to a rate race of trying to get hold of the best shale oil assets in the country. The total gas rigs in the country increased from 600 in 2003 to 1600 by the end of 2008.
The first drop in rig count in 2009 was driven by the global financial crisis. The second hit came in 2011 after shale gas field production really took off in 2010.
So far it follows the template for a typical capital cycle. Demand shock bring up commodity prices, inflow of new capital into the industry, and eventual overcapacity, which brings down returns.
So why has the price continued to slump? Given a full well replacement cycle for shale gas of only 125 days, you would think that supply should correct quickly and price stabilize. I can think of six reasons why the supply has continued to boom and price has continued to go down:
- Distorted incentives
The US oil & gas industry is special in that leases for blocks of land only last for 5-10 years. But if you discover oil or gas, the company gets to keep the land for the life of the well, which could be up to 40 years. This provides an incentive to explore for gas, even though commodity prices do not justify the costs involved in exploration and production. The government is incentivized to maximize production as well, given that it gets 12-18% of production value in royalty fees over the life of a well. Proved natural gas reserves in the United States are now the highest ever.
- Improvements in technology
It is possible that improvements in technology have brought down the cost curve for natural gas. Let’s observe the following two charts. The first one is from 2010, indicating a break-even for most US shale gas fields of $3.5-4.5/mmbtu.
The next chart from 2015 has figures that are practically unchanged. A lot of the cost savings over the last few years has been in the costs of service providers, but they are cyclical and not substantial.
- Natural gas is a by-product of oil production
A part of natural gas from oil production is flared off, but the rest is added sold on the market. US oil production took off in 2012 and may have contributed to the natural gas lows of 2012.
- Opportunity cost vs coal
Chinese coal production boomed from 2003 onwards putting pressure on global coal prices. As power plants can be reconfigured to run on coal instead of natural gas, you would expect natural gas prices to be somewhat dependent on coal prices. Yet if you look at the electricity generation mix by fuel type, natural gas has gained at the expense of coal in almost every year over the past decade, despite peaks and valleys in the natural gas price. Natural gas being cleaner may be part of the reason why demand has stayed so strong.
- Import/export constraints
A lot of prior imports of natural gas has now been substituted for much cheaper domestic shale gas. Imports have fallen dramatically. It is only natural that Henry Hub prices should fall as well.
2009, 2012 and 2015 were El Niño years, which is a weather phenomenon associated with warmer than average sea surface temperatures in the Pacific Ocean. Higher sea surface temperatures tends to lead to warm winters and therefore low heating demand using natural gas. All three of these years were associated with short-term falls in the natural gas price.
Shale gas is only part of the total supply picture, but the factor that is the most volatile. 40% of dry gas comes from shale, 15% from associated gases, 10% from higher cost coal bed methane, 5% from offshore and 30% from conventional onshore wells.
The cost curve indicates long-term natural gas prices of $3-3.5/mmbtu. If such estimates are true, then given the current Henry Hub price of roughly $2.0, then rig counts should be falling quickly. The natural gas equivalent rig count (natural gas + 0.25 oil rig count) is going down quickly since starting to drop in 2014.
Shale gas production has now peaked and is starting to fall, much thanks to the lower oil price since late 2014.
Year-on-year production levels are accelerating on the downside, including for Marcellus shale which had been driving production growth until now.
Due to the (initially) warm winter of 2015, heating demand has been weak and inventory levels therefore elevated.
But weather phenomenon are cyclical. By early February 2016, stockpiles of fuel fell to near-average levels for this time of the year. And much points to the fact that we will see a colder winter by the end of 2016 thanks to it being a La Niña-year.
The switch of power generation demand from coal to natural gas is continuing. Over the last year to 1Q2016, total coal-fired power plant retirements will be around 16GW and natural gas additions about 8GW.
LNG export growth has started to accelerate. The Sabine Pass export terminal is starting up, and another four export terminals will be up and running by 2019.
Exports have started to surge in February and are likely to continue. For reference, 9 Bcf/day corresponds to 13% of average 2015 production levels for the US of 72 Bcf/day.
Pipelines into Mexico are also ramping up, and may become as much of a demand driver as exports of LNG.
Longer term, it is possible that we might see new applications for natural gas, including for use in vehicles such as trucks. Although the numbers are small for the United States so far, the potential is there. At an oil price of $30/bbl, using oil-natural gas equivalency of 6x, the natural gas price would have to rise to $5/bbl for natural gas to lose its edge over oil.
Speculators are short natural gas futures on an unprecedented level, which is likely to lead to a short-squeeze once the improving fundamentals are recognized among the general public.
Source: Jason Goepfert at sentimentrader.com
Bottom line: as long as demand stays strong, supply will continue to contract at these prices. A colder winter next year and a low oil price will ensure much tighter supply and much higher natural gas prices by the end of 2016. Given large proven shale gas reserves, it is unlikely that Henry Hub prices will move much above replacement costs. Most likely scenario is a natural gas price hovering around $3/mmbtu and foreign coal demand staying around $6-7/mmbtu.
It is not as easy to find actionable ideas. Natural gas futures for January 2017 delivery trade at $2.7/mmbtu, already pricing in a fair amount of recovery. Natural gas ETF’s such as UNG are constantly rolling over futures contracts so if the futures curve is characterized by contango, buyers of the ETF must pay for a negative roll yield. Natural gas exploration and production companies are all leveraged and perhaps poor stewards of capital, but I think a basket approach of natural gas companies may be sensible.
Brief overview of US natural gas companies: Southwestern Energy Company (SWN), Cabot Oil (COG), Range Resources (RRC), EQT Corporation (EQT) and Antero Resources (AR):
Southwestern Energy, Cabot Oil and Range Resources all have exposure to the Marcellus basin, where natural gas prices are lower than in Louisia. Pipelines are being built and excess capacity are likely to bring the price differential between Henry Hub and Marcellus prices down significantly by end of 2017. Right now the Marcellus natural gas price is $1.7/mmbtu, so there is upside in both Henry Hub prices and the basis differential.
Valuing the companies with any precision is difficult due to uncertainty in decline curves and assumptions about future natural gas prices. Assuming roughly $1/mmbtu in maintenance capex and $1.5/mmbtu in opex (rough numbers), you are left with $2.5/mmbtu in total costs to break even. At $3/mmbtu and a EV/(EBITDA-MCX) multiple of 10x most of the stocks should at double. At $3.5/mmbtu most of the stocks should go up by multiples.
Another approach is to value proved and probable reserves and discount profits accordingly. SWN, RRC and AR offer PV-10 estimates, which is a non-GAAP measure of the present value of future drilling. PV-10 estimates may unreliable due to their design: issues include not adjusting properly for probable reserves obtained through horizontal drilling, a 10% discount rate may not be the right number to use and it is also sensitive to management assumptions. A lot of the value comes from probable reserves that do not show up in traditional valuation metrics.
Income statement numbers may suffer from another pitfall in full cost accounting, whereby the company capitalizes all exploration costs and impairs them from time to time when the efforts are proven unsuccessful. This boosts earnings in good years and creates rafts of impairments when natural gas prices go down. This is well understood by the market.
Debt levels appear to be on the high side, but all of these companies have liquidity several years out to take them through short-term pressures. At today’s prices, debt is covered by current wells although it would take many years to produce out. Base declines are high the first few years but then stabilize – maintenance capex should therefore also fall somewhat over time now that production being pulled back.
Any valuation will be somewhat arbitrary because of uncertainties in the inputs that go into the formulas. The biggest factor will be the natural gas price, feeding through to EV/EBITDA multiples which tend to mean revert to 8-10x. My edge is not valuing individual energy stocks and I therefore favour a basket approach. When you buy a basket of stocks in commoditized industries you simply want:
- The least leveraged company; with
- The best capital allocation; and
- The lowest replacement cost;
- At the lowest EV/assets;
- All the while supply is shrinking rapidly.
Range Resources have the lowest leverage of the group, but then again the upside may lower than the rest. Southwestern Energy and Range Resources hold fantastic assets in Marcellus, one of the lowest cost gas fields in the United States. As above cost curve showed, US shale is one of the lowest cost sources of natural gas in the world. Only when production starts dropping substantially will we see what normalized profitability in the natural gas sector looks like.
I am long a diversified basket of US natural gas companies, the biggest positions being the ones mentioned above.
Thanks to @pradeeepk for supplying me with ideas and charts for this post.