The Pressure on Natural Gas

Source: WSJ

For America's natural-gas producers, even a hurricane would seem like a breath of fresh air.

Overworked air conditioners fueling demand for gas-fired electricity raised gas prices earlier this summer, when futures for the coming winter rallied above $6 per million British thermal units. It didn't last: Now they are under $5. There are implications not just for exploration and production (E&P) companies, but also electricity generators. Investors in chemicals stocks should also take note.

The exploitation of unconventional resources such as shale gas has pushed U.S. reserves and production back up to levels not seen since the early 1970s. Barring hurricanes and an exceptionally cold winter, prices look set to stay weak.

.Usually, the cure for a low gas price is a low gas price, which spurs demand and discourages drilling. Announcing second-quarter results, however, most producers said output would continue rising.

One reason is "use it or lose it" clauses on land leases signed by E&P companies. Some $76 billion was spent on shale gas acquisitions between 2005 and 2009, according to IHS Herold. That is a lot of sunk capital to walk away from.

The Federal Reserve's zero rate policy facilitates this drilling habit by pushing investors toward riskier assets. (I thought zero rate policy is pushing investors toward less risky assets. But now corporate can definitely sell more junk bond. Maybe that's what it meant -- riskier asset) Just last week, for example, Chesapeake Energy raised $2 billion of debt, $400 million more than it wanted originally. Overall, the sector has raised $23.5 billion in mostly high-yield debt so far this year, according to Jonathan Wolff at Credit Suisse, almost as much as for all of 2009. He estimates gas-focused producers will reinvest 165% of cash flow this year.

High spending, fueling cost inflation and excess supply, will squeeze profits. Investors should target those E&P companies producing more oil and natural gas liquids (NGL), which command higher prices relative to gas. Newfield Exploration, for example, is shifting investment towards liquid and, helped by price hedging, is not outspending its cash flow.

Beyond the E&P sector, low gas prices spell trouble for merchant electricity generators: Witness Dynegy's decision to sell out to Blackstone Group on Friday, rather than soldier on. Because gas-fired generation sets the electricity price in most U.S. regions, electricity revenues follow gas prices down even as costs of fuel like coal remain stable. Of the group, Calpine offers some shelter because its power stations are mostly gas-fired, meaning revenues and costs move together, thereby protecting margins .

One group that stands to benefit from low gas prices are U.S. chemicals producers. Ethane is a dominant form of NGL used to make ethylene, a basic chemical building block. As gas producers target more liquids production, so the price of NGLs has fallen and should stay low.

This gives the likes of Dow Chemical and Westlake Chemical a cost advantage versus Asian and European peers that use more-expensive oil-based naphtha as a feedstock. It is of little comfort to E&P companies right now, but their predicament has a silver lining for one important constituency: their customers.