Southwestern Energy: The Best Way To Play Natural Gas
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As commodity markets absorb the impact of the never ending flow of news, oil recently ended at about $84 per barrel for West Texas Crude. Natural gas closed at about $2.80 per mmBTU, though a few days earlier it had touched $3 per mmBTU for the first time since January 2012. The potential reemergence of natural gas prices has profound consequences for the domestic economy on many different levels. I wanted to look at some large gas producers to see how they might fare in a higher gas priced environment.
What we have seen in recent months is a reduction in natural gas drilling, as many companies have moved away from dry gas in pursuit of more profitable plays in liquids such as oils. At the same time, more and more of America's energy needs are being met by natural gas. It was simply a matter of time before demand would catch up with supply, boosting the price of gas.
One company that has fared rather well in this environment is Southwestern Energy (NYSE: SWN). It did not have a successful first quarter with profits of $0.31 per share, some 21% below the first quarter of 2011's $0.39 per share. But what natural gas company did all that well in the first quarter? What I like about Southwestern Energy is its hedging program. According to the company's first quarter report, it has hedged 200 Bcf for 2012 at an average price of $5.16, and 185 Bcf at an average price of $5.03 for 2013. These hedged amounts account for roughly 35% to 40% of Southwestern's expected natural gas output those two years.
It was due to successful hedging that Southwestern obtained an average realized price in the first quarter of $3.49 per mmBTU, with about $1.25 of this from hedging activities. While I see an upward trend in natural gas pricing in the next 12 to 18 months, I doubt we will see anything approaching $5 per mmBTU for several years. Therefore, these hedges give Southwestern a powerful weapon in profitability.
Southwestern is regarded as a low cost producer of natural gas, and the first quarter did not disappoint in that regard, with an average recovery cost of $1.31 mcf in the first quarter. And the company's large interest in the Fayetteville shale all but guarantees continued growth. In the first quarter Southwestern's output rose 16% from the first quarter of 2011.
At today's level, Southwestern is trading at a 5 year PEG of over 3, indicative of an overvalued state. But I do not believe analysts have properly taken into account the full impact of Southwestern's hedging, nor the apparent bullish run by natural gas prices. There is long term price support in place for natural gas from a macroeconomic perspective. I believe natural gas will be more expensive next month, and next year, than it is today.
Southwestern's balance sheet is in fine shape, with long term debt representing some 27% of capitalization. It does not pay a dividend, but if you believe, like I do, that there is far more upside in natural gas than there is downside at the moment, there are no better plays in my opinion than Southwestern.
Talisman Energy (NYSE: TLM) shows what I believe is a dangerous trend among oil and gas companies. As dry gas prices have fallen over the past few years, Talisman has been selling gas related assets into a weak market and reinvesting the proceeds into its now core liquids. Now that the price of oil is off some 20% and dry gas prices have surged nearly 40% so far this year, this does not look like the brightest move at this time.
At an investor presentation this month, Talisman noted that it has 40% of its anticipated second half 2012 oil production hedged with a floor and ceiling of $90 and $150, respectively. On May 1, the company announced a $250 million write down on the value of its North Sea properties, and also disclosed it would be spending only $200 million of capital during the balance of the year on dry gas projects. Of course, gas was selling far closer to $2 per mmBTU than $3 per mmBTU on May 1, and I do wonder, as Talisman continues to struggle in Europe, if the company might rethink that capital commitment if gas prices continue to trend upward.
I am not about to endorse Talisman, but it is a company, if it can get its act together in the North Sea, with capital appreciation potential, and it does offer a market average 2.4% yield.
The west's largest gas company, after Exxon Mobil, is Chesapeake (NYSE: CHK). Owing to a cash crunch, it took on $4 billion of debt, and then sold another $4 billion of midstream assets during the second quarter. The sale of the pipeline assets leaves Chesapeake more exposed than ever to dry gas prices, the type of product that Chesapeake is most involved in. In May, Chesapeake stated it would be profitable this year if gas prices averaged $3 per mmBTU, and that is just about what I am expecting during the second half of this year.
Chesapeake's stock has risen by about 50% from its 52 week low, set in early May. The bad news is that the company is no longer as undervalued as it clearly was two months ago. I view it as unlikely Chesapeake will report second quarter earnings of more than two cents a share, and for the year, perhaps $0.25 to $0.30 per share. The company and its stock price still have substantial leverage for the long haul, but for here and now, with its 5 year PEG of 7, this is not the stock for the faint of heart, nor for that matter, any value oriented investor.
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