We believe that this is an extremely significant event as the typical U.S. E&P hedges more than 50% of their coming year’s production in advance, often telling investors that they are “trying to be conservative” and reduce risk.
The reality is that they are utilizing the forward curve to improve earnings and cash flows. The hedging programs in place at natural gas E&Ps have contributed as much as 50% of their operating cash flows over the past five years, making gas E&Ps equal parts hedge funds and natural gas producers.
The current five year average contango between the 12 month forward natural gas price and the spot price is 21.93% (ie, on average over the past five years, the 12 month natural gas futures contract has been priced 21.93% above the spot price).
Prior to 2005, the 12 month forward futures price was, on average, equal to the spot price, as the following chart, depicting the % contango between the 12 month natural gas futures price and the spot price going back to 1991 shows (the pink line is the five year average):
We believe that the natural gas forward curve will continue to flatten, as the forward curve represents investor sentiment toward long-term gas prices and sentiment has finally become fairly bearish (although not yet as bearish as reality).
This will make life very difficult for natural gas E&Ps as we move through 2012 and they work their way through the majority of their remaining hedge books put in place when 12-month forward gas prices were 20%+ above spot prices.
As you can see on the above chart, the current contango between the 12-month natural gas forward price and the spot price is 11.73% and falling…
Investment Conclusions
While it is tempting to run out and short a basket of U.S. E&Ps, there are a few complications that must be addressed.
The first is that with the current 27.2:1 ratio of spot oil to spot natural gas prices, even a relatively small amount of liquids production can substantially change the economics of a “gas producer.”
For example, Chesapeake Energy (CHK) produces 83% of their BOEs from dry gas, yet generates 52% of their revenue from dry gas at current spot prices.
Cabot Oil and Gas (COG) generates 95% of their BOEs from dry gas, but only 81% of their revenues at current spot pricing.
This substantially narrows the number of “gas” E&Ps. In addition, some E&Ps (Sandridge, in particular) have taken to creating Royalty Trust/MLP vehicles –- carving out gassy assets and selling them to retail investors at absurd valuations, raising substantial amounts of cash.
This game will continue into 2012.
Lastly, some E&Ps are rapidly switching their production from gas to oil.
Chesapeake, for example, has decreased the percentage of their production that comes from dry gas from 90% in Q3 2010 to 83% in the most recent quarter.
The following table lists the major U.S. E&P’s, sorted by the percentage of their production (in BOEs) that currently comes from natural gas (from least to most). It also shows their production mix a year ago (Q3 2010) to allow for comparison, as well as the percentage of revenues based on current production that would come from natural gas using $3.50 natural gas price realizations and $94 WTI crude realizations.
- Nathan Weiss
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