Follow the Money Before You Lose Yours Part 2

Robert is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

The Universal Law of Holes states that if you find yourself in one, stop digging. The US natural gas industry has found itself in a bit of a hole.  Production of natural gas expanded beyond belief or consumption.  No surprise, then, that prices for natural gas dropped to their lowest point in years.  Yet producers keep on producing away.  What gives?

A recent report in the New York Times gives a big clue: some natural gas producers must keep drilling and adding more gas to an overloaded market because they are contractually obligated to.  Companies like Chesapeake Energy (NYSE: CHK), EXCO Resources (NYSE: XCO) and Quicksilver Resources signed onto financing agreements that mandated ongoing natural gas production without regard to profitability.  When natural gas prices were high, this wasn’t a problem.  These companies had valuable natural gas resources but not the financing to exploit them.  Borrowing money with these terms seemed reasonable.  Today, prices are so low, extracting natural gas usually loses money.  Even giant ExxonMobil is losing money on its natural gas operations.  Further, leasing agreements typically mandate a company must drill for natural gas or lose its lease.

Mention should be made of an interesting theory put forth by The Business Insider two years ago.  Foreign companies have invested in shale gas exploration and production.  Even though US natural gas prices crimp profits, experience gained by ongoing exploration could pay off for these foreign firms when they start looking for shale gas in other parts of the world.

Whatever the reason for ongoing but unprofitable production, stock prices and earnings suffered predictably.

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Chart courtesy of The Motley Fool

EXCO, for example, has seen its revenues and earnings steadily decline in the past 12 months.  So far this fiscal year, the company has lost $3.64 per share.  Quicksilver hasn’t done much better, losing $4.31 per share.  Chesapeake has held up better on the earnings/revenue front, but compared to previous years, FY2012 and FY2013 earnings projections clearly will disappoint shareholders. Chesapeake needed to sell assets to cover an emergency loan and the board of directors was shaken up and the CEO removed after his personal stake in company wells and other questionable activities came to light.

 So what’s an investor to do? First, watch out for those companies mentioned in the NY Times article.  Carrizo Oil and Gas (NASDAQ: CRZO) was also named as a firm with similar financial terms as Chesapeake or EXCO.  However, Carrizo survived the drop in natural gas prices better than Chesapeake or EXCO and is projected to earn almost twice in FY2013 than its projected earnings in FY2012.  Second, look for companies that have a significant oil production operations to offset any natural gas weakness.  Linn Energy (NASDAQ: LINE) exemplifies this.  The company produces both crude oil and natural gas and has shifted operations towards oil production over natural gas.  Linn has slowly appreciated over the past year while paying a nearly 7% dividend.  Third, consider investing in companies that extract natural gas from Marcellus Shale.  The production costs in this shale formation are significantly cheaper than in Texas or Louisiana.  Cabot Oil and Gas (NYSE: COG) just announced great earnings that propelled the stock upward 10% in one day.  One big reason: low production costs for Marcellus shale gas allow for profitable extraction even when natural gas prices are low.

Before dumping Chesapeake, consider one of its innovative efforts to return to greater profitability.  Chesapeake is a financial backer of Oxford Catalysts Group (London: OCG), a company that makes diesel, gasoline or jet fuel from natural gas.  Using proven technology, Oxford claims it produces premium diesel oil from natural gas for $1.57/gal assuming a natural gas price of $4/Mcf.  Making transportation fuel from natural gas may tantalize investors, but the technology is controversial and may have a significant environmental impact.  These environmental considerations may slow plans to build a plant in Pennsylvania to produce transportation fuels from natural gas.  Also consider that Oxford has lost about a third of its value since 2008, although it has staged a recent rally on the London Exchange.  Royal Dutch Shell (RDS.A) is successfully producing aviation fuel from natural gas in the country of Qatar; hopefully Oxford and Chesapeake can succeed in the US.

Bottom Line:

The boom in natural gas production made fortunes for many.  However, in hindsight, the debt incurred by some exploration firms left them vulnerable to low natural gas prices.  Their earnings and share prices later suffered when natural gas prices fell.  Examination of a company’s debt never hurt and in this case, could have been a financial lifesaver.  There’s still money to be made in natural gas; just watch what you invest in.  The combination of low debt and a well hedged balance between oil and natural gas could be a formula for financial success.

If you haven't already, be sure to read Matt DiLallo's analysis and personal experiences with natural gas companies in Part 1 of Follow the Money Before You Lose Yours.

dylan588 has a position in Cabot oil & Gas. The Motley Fool owns shares of ExxonMobil and has the following options: long JAN 2013 $16.00 calls on Chesapeake Energy, short JAN 2014 $15.00 puts on Chesapeake Energy, long JAN 2014 $20.00 calls on Chesapeake Energy, and long JAN 2014 $30.00 calls on Chesapeake Energy. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.If you have questions about this post or the Fool’s blog network, click here for information.

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