The New York Times has been running a series of articles on natural gas. Named “Drilling Down” and written by Ian Urbina, they are well researched and rely on internal memos, e-mails and other confidential information from companies and the government agencies that regulate them.
Shale drilling for natural gas has led to dramatic upward revisions in estimated ultimately recoverable (EUR) reserves in the U.S. and has lent support to the idea that natural gas could begin to replace coal as a source of electricity and even take the place of diesel in powering trucks.
We’ve read the articles with interest because we are invested in a handful of natural gas E&P names. We do believe that it’s in the long term interests of the U.S. to rely more on domestically produced fuel that has a lower carbon footprint than coal or oil. We think that investing in the sector is attractive because we think demand for natural gas will increase. The NY Times has questioned how clean natural gas really is since the hydraulic fracturing process by which the gas is released from the rock formations in which it resides uses vast amounts of water in combination with some nasty sounding chemicals. We think increased government oversight of the environmental effects can only be in everyone’s interest, and believe the companies we’re following as well as no doubt many others recognise their own commercial interests in not damaging the environment.
This weekend and today the New York Times ran two additional articles in the series. Yesterday’s questioned the reserve forecasts and ultimate profitability of much of this activity, and characterised the market as looking like a bubble. We can’t add much to the debate on ultimate reserves, although natural gas prices remain weak because of the continued drilling success the industry enjoys.
The only disappointment about today’s supply is its abundance. In fact, a little less natural gas would probably be good for most E&P names. Today’s challenge is earning a decent return when there’s just so much of the stuff available. But we disagree with the idea that there is currently a bubble. While there have been some acquisitions of plays by majors such as Exxon Mobil (XOM), what’s happened so far hardly looks like a mad rush by price-insensitive buyers. There haven’t been any IPOs of natural gas E&P names which would be one component of a bubble. Getting buy in from the retail investor would be a sure sign the top is approaching, but we’re not seeing any of that activity.
The bubbles are currently elsewhere on Wall street, in social networking websites (LinkedIn, Groupon) and treasury bonds, but not in natural gas E&P names. In fact there continues to be plenty of scepticism around ultimate profitability for many companies. Most plow their cashflow straight back into more drilling, and announced cap ex plans are routinely scrutinized for the need to issue more equity. The stock of Comstock Resources (CRK) continues to reflect some concern that they’ll need to revisit the capital markets to fund their plans.
The New York Times makes available hundreds of e-mails and other documents in support of their series, showing how deeply researched it is. Page 385 highlights a March 2011 research report from Argus on Chesapeake in which the analyst Philip Weiss criticises the company’s aggressive accounting policies. He notes the level of derivatives activity is large relative to its levels of production when compared with its peer group. The analyst even equates CHK to a combination of hedge fund and E&P company. He notes that CHK uses derivatives to keep some of its borrowing off its accounting books, by using Volumetric Production Payments (VPPs). In exchange for upfront cash CHK commits to provide certain quantities of gas in the future.
Briefly reviewing CHK’s financials, it’s unclear where these transactions are accounted. They certainly list derivatives on their balance sheet, a $2.38 BN liability as of March 2011. But their balance sheet is more leveraged than other companies we follow, as shown below. CHK has operated with a higher risk profile than some other names in the industry, and for that reason we’ve avoided them. The Argus research cited by the New York Times would seem to be worthy of further research and probably greater disclosure by the company. Meanwhile we prefer the other names listed below, in part because of their more conservative leverage.
Leverage for Selected Natural Gas E&P Names
Net Debt ($MM)
Mkt Cap ($MM)
Disclosure: Author is long RRC, DVN, SWN, CRK, HK
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