A Low-Risk, High-Yield Bet on Natural Gas

Although US natural gas prices have surged more than 60 percent from their April 2012 low, investors must put these recent gains into context: this rally is from a 10-year low, and the commodity is still down 30 percent from year-ago levels.

We expect US natural gas prices to remain depressed for at least the next two to three years. The current volume of natural gas storage exceeds the five-year average for this time of year by about 20 percent–a major near-term headwind.


Source: Energy Information Administration

But the summer heat wave has driven record demand for electricity. At this point in the summer, New York City has logged a total of 509 cooling degree days (CDD), a metric that’s calculated by subtracting 65 degrees Fahrenheit from the day’s mean temperature. Historically, New York City has averaged about 345 CDDs over the same period. Chicago has fared even worse, with its total CDDs exceeding the historical average by more than 100 percent.

Meanwhile, ultra-depressed prices have prompted utilities to switch their feedstock to natural gas from coal. The Energy Information Administration (EIA) estimates that natural gas-fired plants will generate 30.8 percent of US electricity in 2012, compared to 24.8 percent in 2011 and about 20 percent in 2006. Accordingly, the EIA’s forecast also calls for coal’s share of US generation to 36.7 percent, down from 42.2 percent in 2011.

Three factors have catalyzed the recent rally in US natural gas prices.

The unusually warm 2011-12 winter eroded demand for natural gas and elevated inventories; some of the snapback reflects improving sentiment toward the commodity now that this seasonal headwind has abated. Moreover, the recent heat wave has bolstered electricity demand, leading to an uptick in natural gas consumption. Finally, the ultra-depressed price of natural gas has prompted a wave of fuel switching among utilities with the flexibility to change feedstock.

However, all three tailwinds will prove transitory. In three months, warm weather won’t boost natural gas demand. And when natural gas exceeds $3 per million British thermal units (mmBtu), coal sourced from the Powder River Basin will become more attractive to utilities. In other words, a recovery in US natural gas prices could cause the current wave of fuel switching to reverse.

More important, none of these short-term improvements address the heart of the problem: an upsurge in natural gas production.


Source: Energy Information Administration

Although producers have scaled back drilling activity in fields that produce primarily natural gas, almost one-quarter of domestic output comes from wells that target oil. Moreover, the industry has shifted its focus to fields that also contain natural gas liquids (NGL), a family of heavier hydrocarbons such as butane, ethane and propane that fetch higher prices and improve wellhead economics. In short, drilling activity isn’t as sensitive to gas prices as some investors suppose.

If natural gas were to eclipse $3.50 per mmBtu, producers would likely increase output to take advantage of higher prices. Only an upsurge in domestic consumption or exports would produce a sustainable rally in the price of natural gas.

High Income in Gas

Although ultra-low natural gas prices may be a problem for Chesapeake Energy Corp (NYSE: CHK) and other producers, the current environment affords ample opportunity for well-capitalized operators to pick up gas-rich acreage at huge discounts.

Many exploration and production firms have sought to divest gas-focused assets to fund aggressive, and expensive, development programs in liquids-rich plays that offer superior economics.

Publicly traded partnerships such as Linn Energy LLC (NSDQ: LINE) have moved quickly to acquire gas-rich acreage at valuations and hedge future production at prices that guarantee a reasonable rate of return.

Linn Energy and other savvy publicly traded partnerships are buying gas-producing properties at low prices and locking in favorable prices on expected output through futures contracts. 

Although the August 2012 natural gas futures that trade on the New York Mercantile Exchange fetch almost $3 per mmBtu, contracts expiring in January 2013 trade for more than $3.50 per mmBtu. Natural gas for delivery in late 2014 goes for almost $4 per mmBtu. Even if natural gas prices were to plummet to less than $2 per mmBtu, a company that has fully hedged its output wouldn’t suffer from the pullback.

If natural gas prices remain depressed for an extended period, these acquirers can cut their costs to the bone by performing only basic well-maintenance work. If natural gas prices rally after 2015, these companies can ramp up drilling activity to boost production and take advantage of higher prices.

On March 30, 2012, Linn Energy completed the $1.2 billion acquisition of 600,000 net acres and 2,400 wells in the Hugoton Basin of Kansas from energy giant BP (LSE: BP, NYSE: BP). These wells currently generate 110 million cubic feet of natural gas equivalent per day, roughly 63 percent of which is natural gas and 37 percent of which are NGLs.

Linn Energy hedged 100 percent of its expected natural gas output from these wells over the next five years. The purchased acreage also contains an identified drilling inventory of 800 additional sites, providing plenty of upside if natural gas prices rally.

Management notes that that deal will be immediately accretive to the Linn Energy’s distributable cash flow, enabling the firm to boost its quarterly payout to unitholders while maintaining a comfortable coverage ratio.

Linn Energy followed up this transaction with another deal with BP, spending $1 billion on 12,500 net acres and 750 producing wells in Wyoming’s Jonah Field. This acreage flows about 145 million cubic feet of natural gas equivalent per day, about three-quarters of which is natural gas, 23 percent of which are NGLs and 2 percent of which is crude oil. Linn Energy also hedged all its anticipated production from this field through the end of 2017, limiting its exposure to fluctuations in commodity prices and locking in favorable profit margins.

Thus far in 2012, Linn Energy has completed almost $2.8 billion worth of acquisitions, compared to less than $1.5 billion in all of 2011 and $1.35 billion in 2010.

The upstream operator has grown its distribution by roughly 10 percent over the last year, and these latest deals should give the company the scope to increase its quarterly payout by another 10 percent to 15 percent in the next 12 months.

Around the Portfolios

Aggressive Portfolio holding SeaDrill (NYSE: SDRL), on July 3 issued a press release disclosing that its wholly owned subsidiary SeaDrill Partners LLC had confidentially submitted the first draft of its registration statement to the SEC. The new publicly traded partnership’s assets would include an interest in two semisubmersible drilling rigs, one drillship and one semi-tender rig that are currently in its parent’s fleet. SeaDrill will use the proceeds from the initial public offering of the master limiter partnership to fund its plans to expand its fleet of ultra-deepwater drilling rigs. Buy SeaDrill up to 45.

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