Cold Comfort for a Natural Gas Bull
Last winter saw the largest and fastest withdrawal of natural gas from storage in U.S. history. We ended the withdrawal season at the lowest natural gas inventory levels in more than a decade. Inventories were about 50% below normal at the end of the winter withdrawal season.
Withdrawal season ends roughly in mid-April and is followed by injection season through mid-November. Injection season is a period of lower natural gas demand used to rebuild supplies depleted over the winter.
My feeling was that low inventories would affect the natural gas markets in the following ways. Year-over-year natural gas prices were likely to be higher than the previous year because supplies were lower. Natural gas producers would need to produce at high rates to replenish the inventories, and since I believed they would be getting better prices for the natural gas, profits would be up for most producers. This, naturally, would cause the share prices of natural gas producers to rise.
But markets can behave irrationally. You can be right on all the details, and still have the market go against you. This is one reason I don’t short stocks. I have seen the market cap of a $500 million company that I thought was worth less than $100 million rise above $1 billion before beginning its decline. So your investment thesis may be sound, but you could still lose money.
Going long is different in that I can exercise more patience if I am not leveraged. I believe that a number of drivers (e.g., the phase-out of coal, the beginning of LNG exports) will push natural gas prices higher over the long term. But the short-term natural gas markets are far more weather driven. Over time those weather events will even out, so if I am correct on the long-term thesis I can ride out the short-term moves.
Last winter, natural gas inventories were depleted by the coldest weather we have had in many years. This is one of those short-term weather events that lined up with my long-term thesis on natural gas. Natural gas prices would surely rise.
But short-term weather events can go both directions. A mild summer moderates natural gas demand from utilities because of reduced use of air conditioning. On the other hand, a hot or even a normal summer, combined with the severely depleted inventories, had the potential to cause much higher natural gas prices.
How often do we have a mild summer? Not often in recent years. So it was a pretty good bet that there would be upward pressure on natural gas prices through the summer.
But we did in fact have a mild summer this year. As shown in the graph below, natural gas demand from electric utilities was lower this summer than in the previous two summers (although only modestly below last year’s demand).
Meanwhile, natural gas producers did produce at the highest levels in history. Last year’s record production was surpassed.
The net result was that natural gas inventories were refilled much faster than normal this year:
Last week saw the first decline of natural gas inventories since spring, so this marks the beginning of withdrawal season. We started this year’s withdrawal season only 6.4% below the five-year average for this time of year, and only 5.3% below last year’s level. If we have a winter like last winter, we are going into it in slightly worse shape than a year ago. But because of the mild summer, we are in much better shape than we might have been.
So how did all of this impact my short-term natural gas thesis? Natural gas prices were in fact consistently higher than they were a year ago:
Natural gas producers, as shown in the previous graphic, produced at their highest levels ever. So we had higher prices and higher production. This did in fact translate into higher year-over-year profits for most natural gas producers.
But the mild summer and the speed at which inventories were refilled kept the share prices of most of these producers in check. Some major natural gas producers that are also significant oil producers, like Devon Energy (NYSE: DVN) and ConocoPhillips (NYSE: COP), had very impressive returns up until the oil price correction that started in July (and both are still up year-to-date). Others, like the Cabot Oil and Gas (NYSE: COG), saw their share price decline even though profits surged.
Conclusions
Ultimately, the long-term thesis on natural gas remains the same: I am bullish. But I am much more neutral on the short-term, because inventories are near normal and I can’t predict the weather. Even so, given the same conditions that we saw in the spring, I would make the same short-term bet. Most of the time it should work out better than it did, but this year a mild summer tempered returns.
(Follow Robert Rapier on Twitter, LinkedIn, or Facebook.)
Portfolio Update
Seadrill Deep-Sixes the Dividend
We’ve been clear throughout this ordeal of a year for Seadrill (NYSE: SDRL), and for offshore drillers in general, that we view it as a long-term holding with a high risk of further losses in the near term. We’ve also argued that given a dividend yield in the teens the market wasn’t putting much store in management warranties about the security of the payout this year.
Now there are no more warranties to trust, because in reporting quarterly results that were no weaker than expected Seadrill abruptly suspended its payout. The CEO cited “significant deterioration in the broader offshore drilling and financing markets over the past quarter.”
The share price is down 22% on the news as the income crowd bails out at any cost, which at this point means below book value. Selling offers the relief of getting this stinker off the books, but that’s an option we’re not recommending because the relief that could carry a significant long-term price.
The truth of the matter is that the dividend elimination significantly strengthens the balance sheet. It will save the company some $2 billion a year, enough to cover the unfunded yard installments for the six floater and eight jackup rig newbuilds set to be delivered in 2015-16. Then it will just be a matter of finding employment for these, amid a drilling downturn and rig glut, before Seadrill’s debt maturities increase dramatically in 2017-19.
The good news is that management has navigated these rough waters before, and we expect Seadrill to emerge a long-term winner once again. The bad news is that this could take quite a while, even longer that it will take all the dividend chasers to sell out to speculators looking for a tradable bottom.
There’s significantly more value here than today’s share price would indicate, but don’t expect that to be realized next year. Profiting from SeaDrill’s rebound will require the patience of a true bottom-dweller. If that sounds like you, continue to hold SDRL.
— Igor Greenwald
Stock Talk
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