Is your exploration and production company prepared for a nuclear winter in the commodity markets? It's important to be prepared, especially if there's a further collapse in natural gas prices. Though there are some possible scenarios where natural gas rebounds, it looks like a natural gas bear market in the near future. (Before reading this article you might want to check out Oil And Gas Industry Primer.)
There are a number of reasons that many investors are more bearish on natural gas than on oil. Storage for natural gas is currently far above last year's level and the five-year average. Natural gas stocks in underground storage were at 1,674 as of April 3, 2009, which is 438 Bcf (billion cubic feet) higher than April 2008, and 310 Bcf above the 5-year average according to the Energy Information Administration (EIA). This excess storage will weigh down prices over the next few months.
Domestic natural gas production has been rising for several years despite years of industry and sell side assurances that this would never happen due to higher depletion rates on new wells. Unfortunately, at the same time that production is rising, industrial demand is falling due to the recession.
Imports of liquefied natural gas (LNG) into the U.S. is expected to grow in 2009 according to Steve Johnson, president of Waterborne Energy, due to a combination of excess supply and reduced demand outside the U.S.
The nightmare scenario for energy investors is a situation where storage becomes full and there's nowhere left for gas to be piped. This is more of a theoretical fear, as no one is completely sure of the actual total storage capacity.
If you own exploration and production stocks, it might be wise to check how much of its production is hedged in 2009. This guaranteed price for production will protect earnings if fears are realized.
IN PICTURES: Top 10 Forex Trading Rules
EOG Resources (NYSE:EOG) is one of the largest independents in North America. In 2009, 88% of EOG's production was natural gas, and the company has 36% of it hedged at higher prices. This is low for the industry and possibly indicates management's more bullish view of natural gas prices going forward.
Two companies on the opposite end of the spectrum are Chesapeake Energy (NYSE:CHK) and Quicksilver Resources (NYSE:KWK). Production for these companies is mostly from natural gas, and 82% and 88% of that production hedged for 2009, respectively. This makes sense as both companies were in active discussion with lenders over the last few months, and a strong hedging program may have been a requirement of continued lending.
There are some companies without hedges at all. As of April 6, 2009, Kodiak Oil & Gas Corp. (NYSE:KOG) and W&T Offshore (NYSE:WTI) had no production hedged for 2009 - for both oil and natural gas. This situation can exist because management feels bullish on future commodity prices and wants to capture all of an upside move, or a management team that is philosophically opposed to hedging in any situation. It can also result from a company monetizing a hedge position that is in the money, and receiving a cash payment for it. (Find out how to stay on top of data reports that could cause volatility in these markets, read Become An Oil And Gas Futures Detective.)
There are some things that might save the natural gas markets from this bearish scenario. We could have a brutally hot summer that boosts demand, or an active hurricane season that shuts in production of natural gas. Either would help balance the market in the short term.
The Bottom Line
Exploration and production companies are one of the few industries with an active derivatives market for its end products, and can hedge production out several years at a time. Investors thinking of investing here might be wise to own these hedged companies in case the bear case in energy is realized.