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

Hedging Companies
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.

Non-Hedging Companies
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.

Related Articles
  1. Stock Analysis

    3 Stocks that Are Top Bets for Retirement

    These three stocks are resilient, fundamentally sound and also pay generous dividends.
  2. Investing News

    Are Stocks Cheap Now? Nope. And Here's Why

    Are stocks cheap right now? Be wary of those who are telling you what you want to hear. Here's why.
  3. Investing News

    4 Value Stocks Worth Your Immediate Attention

    Here are four stocks that offer good value and will likely outperform the majority of stocks throughout the broader market over the next several years.
  4. Investing News

    These 3 High-Quality Stocks Are Dividend Royalty

    Here are three resilient, dividend-paying companies that may mitigate some worry in an uncertain investing environment.
  5. Stock Analysis

    An Auto Stock Alternative to Ford and GM

    If you're not sure where Ford and General Motors are going, you might want to look at this auto investment option instead.
  6. Mutual Funds & ETFs

    The 4 Best Buy-and-Hold ETFs

    Explore detailed analyses of the top buy-and-hold exchange traded funds, and learn about their characteristics, statistics and suitability.
  7. Professionals

    How to Protect Your Portfolio from a Market Crash

    Although market crashes are usually bad news for your portfolio, there are several ways to minimize losses or even profit outright from market movement.
  8. Mutual Funds & ETFs

    What Exactly Are Arbitrage Mutual Funds?

    Learn about arbitrage funds and how this type of investment generates profits by taking advantage of price differentials between the cash and futures markets.
  9. Investing News

    Ferrari’s IPO: Ready to Roll or Poor Timing?

    Will Ferrari's shares move fast off the line only to sputter later?
  10. Investing Basics

    What Does Plain Vanilla Mean?

    Plain vanilla is a term used in investing to describe the most basic types of financial instruments.
  1. What are the risks of annuities in a recession?

    Annuities come in several forms, the two most common being fixed annuities and variable annuities. During a recession, variable ... Read Full Answer >>
  2. Can mutual funds invest in options and futures?

    Mutual funds invest in not only stocks and fixed-income securities but also options and futures. There exists a separate ... Read Full Answer >>
  3. How do dividends affect retained earnings?

    When a company issues a cash dividend to its shareholders, the retained earnings listed on the balance sheet are reduced ... Read Full Answer >>
  4. What is the difference between called-up share capital and paid-up share capital?

    The difference between called-up share capital and paid-up share capital is investors have already paid in full for paid-up ... Read Full Answer >>
  5. How do futures contracts roll over?

    Traders roll over futures contracts to switch from the front month contract that is close to expiration to another contract ... Read Full Answer >>
  6. Why would a corporation issue convertible bonds?

    A convertible bond represents a hybrid security that has bond and equity features; this type of bond allows the conversion ... Read Full Answer >>

You May Also Like

Trading Center
You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!