The New Pressure on Natural Gas
August 16, 2010
For natural-gas producers, even a hurricane would seem like a breath of fresh air.
Overworked air conditioners fueling demand for gas-fired electricity raised gas prices earlier this summer, when futures for the coming winter rallied past $6 per million British thermal units. It didn't last: Now they are under $5. There are implications not just for exploration and production (E&P) firms, but electricity generators. Chemical-stocks investors should also take note.
Exploitation of unconventional resources such as shale gas has pushed U.S. reserves and production back up to levels not seen since the early 1970s. Barring hurricanes and an exceptionally cold winter, prices look set to stay weak.
Usually, the cure for a low gas price is a low gas price, which spurs demand and discourages drilling. Announcing second-quarter results, however, most producers said output would continue rising. One reason is "use it or lose it" clauses on land leases signed by E&P companies. Some $76 billion was spent on shale gas acquisitions from 2005-09, says IHS Herold -- a lot of sunk capital to walk away from.
The Fed's zero rate policy facilitates this drilling habit by pushing investors toward riskier assets. Last week, Chesapeake Energy raised $2 billion of debt, $400 million more than it wanted originally. Overall, the sector has raised $23.5 billion in mostly high-yield debt so far this year, according to Jonathan Wolff at Credit Suisse, almost as much as for all of 2009. He estimates gas-focused producers will reinvest 165% of cash flow this year.
High spending, fueling cost inflation and excess supply, will squeeze profits. Investors should target those E&P companies producing more oil and natural gas liquids (NGL), which command higher prices relative to gas. Newfield Exploration, for one, is shifting investment toward liquid.
Beyond the E&P sector, low gas prices spell trouble for merchant electricity generators: Witness Dynegy's decision to sell out to Blackstone Group on Friday. Because gas-fired generation sets the electricity price in most U.S. regions, electricity revenues follow gas prices down even as costs of fuel like coal remain stable. Of the group, Calpine offers shelter since its power stations are mostly gas-fired, so revenue and costs move together, protecting margins.
One group that stands to benefit: U.S. chemicals producers. Ethane is a dominant form of NGL used to make ethylene, a chemical building block. As gas producers target more liquids production, so the price of NGLs has fallen. This gives the likes of Dow Chemical and Westlake Chemical a cost advantage on Asian and European peers. It is of little comfort to E&P companies right now, but their predicament has a silver lining for an important constituency: their customers.
Source: The Wall Street Journal
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