With new technologies like hydraulic fracturing and horizontal
drilling unlocking natural gas from shale basins that were
previously inaccessible, gas prices have plummeted over the past
few years. Since 2008, the price of gas has fallen from a high
above $13 per thousand cubic feet (Mcf) to today's price of $2.75
... a 78% decline in a little more than four years.
That sell-off has been a thorn in the side of energy
companies.
Aside from the effect on day-to-day profits, many companies have
also been forced to make downward adjustments on thebalance sheet .
Just last quarter,
BHP Billiton (NYSE:
BHP
)
took a $2.8 billionimpairment charge for gas assets in the
Fayetteville Shale...
BP plc (NYSE:
BP
)
had to write off $2.11 billion... and the largest gas producer in
Canada --
Encana Corp. (NYSE:
ECA
)
-- had to write down $1.7 billion.
But I've found one energy company that is prospering, despite
low natural gas prices. In fact, this company has navigated the
difficult pricing environment so well that despite gas prices
trading at a third of where they were back in 2007... its stock
price is actually up 81% in the past five years.
What's behind this company's success? In short, it's the
company'shedging strategy...
For those of you who are unfamiliar, ahedge is a lot like taking
out an insurance policy on your home... You hope to never have to
use it, but just in case something goes wrong, you're still
able to protect your bigger investment.
Much like homeowners insurance, hedge contracts are essentially
financial tools that enable you to pay a little to preserve a
lot.
For example, an oil company might enter into contracts to sell
50% of its oil at $100 per barrel. If oil drops to $90, $80, or
even lower, then the company is still guaranteed at least $100 a
barrel on half of its oil production.
Sometimes, a small hedge can minimize the damage or completely
save a much larger bet that goes sour. That's why energy producers
use them to safeguard against a drop in either crude or natural gas
prices.
One company that has been actively taking advantage of hedges
lately is
Linn Energy (Nasdaq:
LINE
)
. Thanks to hedging, Linn is able to sell 100% of its natural gas
for significantly more than the currentmarket rate.
Let me explain...
Linn Energy is a rare breed. The company is one of less than a
dozen upstream master limited partnerships (MLPs). It owns roughly
15,000 active oil and gas wells from the Permian Basin of west
Texas to the Bakken Shale of North Dakota.
But Linn Energy isn't like most oil and gas companies... It
doesn't dispatch exploration teams to remote areas such as the
South China Sea in search of new discoveries, nor does it pay
billions to develop them.
It lets traditional oil companies do the heavy lifting. Once
those properties are mature and gushing, then Linn comes forward
with anacquisition offer (giving the seller fresh cash to repeat
the process somewhere else).
Because it doesn't have to shell out money to explore and
develop new land, Linn has plenty of cash on hand for acquisitions
-- and this empire builder is an avid shopper. In total, Linn has
invested $5.6 billion during the past few years to close 29
acquisitions.
When scouting for potential targets, Linn looks for established
fields with stable production, long-lived reserves and relatively
little need for capital investment.
The acquisition of BP's assets in the Hugoton Basin of Kansas is
a perfect example. Back in March, Linn paid $1.2 billion for 2,400
wells that are producing 110 million cubic feet of gas and liquids
per day.
Now, anyone who has been paying attention to the gas market
might be puzzled why Linn would be interested in thisreal estate
when natural gas prices are languishing near historic lows.
Well, consider this: the firm immediately used hedges to lock in
Hugoton's output at $4 per Mcf, and it only costs $1.50 per Mcf in
"lifting costs" to get this gas out of the ground.
This leaves a healthyprofit margin of $2.50 -- and this is the
worst-case scenario.
If gas is stuck in neutral for the next few years, or even if it
falls further, then Linn will pocket no less than $4 per Mcf. So
there is no downsidecommodity exposure.
Linn's hedging strategy effectively converts every last drop of
oil and gas into predictable cash almost immediately. That has
allowed it to raise itsdividend an incredible 81% in the past six
years.
The company's natural gas production is 100% sheltered clear
through 2017. Meanwhile, its crude oil output is 100% hedged at
prices north of $90 per barrel through 2016.
By contrast, the average exploration and production company has
hedged 44% of production in 2012, 22% in 2013, and just 4% in 2014.
As a result, if gas prices stay low, then Linn will be one of the
industry's most profitable players.
Risks to Consider:
Of course with investing, nothing is 100% certain. Linn's
hedges work best in a flat or declining price environment. If gas
rebounds too far, too fast, then the company will leave some money
on the table.
Action to Take -- >
But thanks to Linn, investors don't have to wait for oil and gas
prices to turn around. This unique business is already capturing
above market rates today, with almost none of the downside
commodityprice risk that other firms face.
-- Nathan Slaughter
P.S. -- There is an energy crisis looming in the United States.
In case you haven't heard, in six months a major event will take
place that could cause 10% of America's electric energy supply to
dry up. As the country scrambles to react, one company could shoot
up by hundreds of percent. For more information on how to profit
from the coming crisis, click here.
Nathan Slaughter does not personally hold positions in any
securities mentioned in this article. StreetAuthority LLC does not
hold positions in any securities mentioned in this article.