Wednesday, December 19, 2012

Betting on a Natural Gas Rebound

I'll start off by saying I'm not an oil & gas industry expert, probably just the opposite, so the majority of this post will be qualitative in nature, but I think any investor with a long term outlook could agree that natural gas prices must come up over time.  New fracking and horizontal drilling technologies have made previously unattainable resources accessable creating a booming supply of domestic natural gas in the United States.  The 2011-2012 mild winter didn't help the situation, it was the 4th warmest on record.  Since one of the primary uses for natural gas is heating homes in the winter, supplies remained elevated and prices dropped to below $2 per bcfe as the winter ended. 

Natural gas prices have rebounded to $3.34 per bcfe, but very few natural gas producers can turn a profit at these prices, and those that can are limiting their new investments in additional resources.  The old saying is the cure for low prices, is low prices, it causes producers to stop or slow production, and it encourages new sources of demand.  Low natural gas has increased demand in three main ways:
  • Electricity utilities are switching from aging coal plants to gas as its become cheaper, cleaner, more politically agreeable
  • Encouraging discussion and investment in exporting liquified natural gas to exploit the large spread between natural gas prices in the US and elsewhere in the world 
  • Spurring on the natural gas as a transportation fuel trend, especially for commercial vehicles
On the supply side, producers have reduced the rig count by 50% compared to last year, it's a bit of a leading indicator so it's yet to show up in natural gas supplies.

These are two good data points to keep bookmarked to keep updated on the supply side:
Last winter/spring (in hindsight too early) I started searching for a way to go long natural gas, I passed on the poorly put together yet surprisingly popular natural gas ETF UNG and stumbled on Ultra Petroleum based out of Texas.  Despite the name, Ultra is almost exclusively a producer of natural gas, and pretty much the lowest cost producer.  They operate in two main areas, the Pinedale and Jonah fields in Wyoming and then in the Marcellus Shale region of Pennsylvania (through JV partners in the Marcellus).  Below are two slides that Ultra provides on a regular basis showing their cost structure compared to peers and their breakeven points for net income and cashflow, clearly they have structured their operations in such as way where they can survive in a low price environment and thrive in a more normalized one.


The major concern with any smaller independent explorer is the balance sheet and their ability to meet the high capital expenditure costs.  Ultra has been proactive about improving the liquidity position as evidenced by their recent sale of mid-stream assets for $225 million.  In 2012, Ultra will spend a net $600 million on capex compared to $1.5 billion in 2011, while only modestly increasing debt.  Its clear if you listen to recent conference calls that management is not willing to spend more money than necessary in this environment and is more focused on long term profitability over short term growth in assets, just the type of management I like.

In summary, Ultra Petroleum is a great way to invest in the eventual rise in natural gas prices.  It does experience a lot of daily volatility, so have a strong stomach before jumping in and be prepared to hold it through the cycle, although it seems reasonable to assume we've seen the low in natural gas prices.

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