Millions of Americans suffered through a brutal heating
season, and the bills are now coming due.
Yet a quick glance at the natural gas futures market suggests
the most brutal winter in recent history will soon be a distant
memory. Gas for delivery in the summer 2015 and 2016 remains
around $4 per thousand cubic feet (Mcf). Futures traders figure
that our nation's drillers will simply pump enough gas out of
wells to rebuild depleted inventories, and the market will soon
be well supplied.
But is such a rosy view justified? After all, the number of
domestic gas drilling rigs in service is far lower than a year
ago, and this industry is no longer hell-bent for growth like it
once was. According to Baker Hughes, the number of domestic gas
rigs in service fell from more than 400 a year ago to a recent
#-ad_banner-#The conventional wisdom holds that drillers have
kept only the most productive rigs in service, idling less
productive rigs, which means that industry output would be fairly
constant despite the smaller rig count. Yet that logic ignores
the depletion rigs being experienced at our nation's best shale
Many of the wells that have been tapped over the past two to
three years are at their peak of production right now but will
likely start to deliver diminished output soon. This is known in
the industry as the Red Queen syndrome,
as discussed in this Businessweek article
To be sure, the rig count can be boosted to offset depletion
rates, but the notion that natural gas production can be sharply
boosted at the flip of a switch ignores decades of history
regarding depletion rates.
Yet it is the demand side of the equation that is also being
overlooked. Even ignoring the fact that natural gas is
increasingly being used as a transportation fuel source, and may
eventually be exported in vast quantities in liquefied form;
demand from power plants is likely to keep growing rapidly.
In recent years, a number of electric utilities have switched
from dirty coal to cleaner gas in their power plants in a process
known as C2G (coal-to-gas). In response to the recent rebound in
gas prices, some suggest that the trend will reverse. That
ignores the fact that 8% of our nation's coal plants are set to
close in the next few years,
according to U.S. Energy Information
, and another 16% may be mothballed as well.
Meanwhile, gas producers not only need to meet rising demand
from existing powerplants, but they also need to replenish
badly-depleted storage supplies. At this time of year, there are
typically 1.8 billion cubic feet of gas in storage, though the
supplies are currently at half that total
The futures market, anticipating a move back to $4 natural
gas, simply shrugs off that concern. But it's looking less likely
that gas inventories will be rebuilt before next winter, unless
drillers go on an all-out pumping spree, which as noted by the
Baker Hughes rig count, simply isn't in evidence.
This means that it's time to start think about how gas drillers
would be affected if
settled later this year closer to that $5 mark. Analysts at BMO
Capital have already done the exercise with driller
Southwestern Energy (NYSE:
. The analysts noted that SWN would generate $90 million in
quarterly free cash flow (
) if gas prices were at $5 per Mcf, compared to just $20 million
in FCF if gas was $4 per Mcf.
The analysts rate SWN as "outperform" simply based on expected
output growth. Higher prices only help. "Not only do we view the
shares as inexpensively priced in the context of what is a growth
profile that's more visible (and predictable) than what most
other producers can possibly generate, but we believe the
risk/reward is especially attractive when put in the context of
potentially greater free cash flow."
Analysts at Citigroup are bullish on
Cabot Oil & Gas (NYSE:
, which has lost more than $2.5 billion in market value since a
fourth-quarter report highlighted a lack of distribution
capabilities for gas transport in its key regions.
Still, as key pipelines come online, Cabot's gas production
will have an easier time getting to market, and the company will
realize better prices by being connected to the national
distribution grid. These analysts also see a surge in output,
which should take Cabot's revenue from $1.75 billion in 2013 to
more than $4 billion by 2016, by which time the company should be
generating more than $2 billion in operating profits. The
scenario of firming
, as outlined earlier, would simply boost those figures.
Citigroup's current $45 target price would likely also get a
Risks to Consider:
Weather remains a big wild card for this energy source. If we
get an unusually cool summer, then air-conditioning demand may be
so weak that gas storage levels can rebuild at a faster than
Action to Take -->
Natural gas producers, especially those that haven't locked in
all of their output at current prices, have a huge amount of
operating leverage to higher gas prices. Southwestern Energy, for
example, would see free cash flow rise more than 300% on just a
25% jump in gas price assumptions. This is a good time to
re-visit other gas producers, to see which ones have similar
operating leverage to higher prices. If gas storage levels don't
start to rapidly rebuild in the next few months, then many on
Wall Street will be talking about $5 gas for next winter.
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