Natural gas producers in the US are faced with tough choices. Advances in drilling technology have made low cost production from shale resources viable on a large scale, and the industry has been in a race to lay claim to the most valuable properties and to capture a competitive advantage in mastering the technology. But at the very same time, the price of natural gas has collapsed, erasing profits. This has pinched budgets and forced companies to be creative in finding fresh sources of capital. It has also forced companies to re-evaluate development plans and resource acquisitions.
The price of natural gas in the US has been falling almost continuously since mid-2008 when it peaked at over $13/mmBtu. It now lies just above $2/mmBtu.
Despite the falling price, natural gas production in the US has continued to climb. According to data from the EIA, between July 2008 and January 2012 US production increased 17%. Companies have been slow to adjust their expansion plans to the falling price. Finally, in late 2011 and early 2012, companies have begun to adjust their capital expenditures to the current low natural gas price reality. Gregory Myers has reported on this in the Financial Times, citing decisions at Chesapeake Energy and ConocoPhillips. In 2011, Encana Corp finally confronted reality and abandoned its 2008 pledge to double production.
Even as capital budgets are cutback, companies still face a need to raise new cash. The new technologies can also be applied to production of unconventional oil resources, like the tight oil in North Dakota’s Bakken Shale or Texas’ Eagle Ford Shale, as well as to development of liquid rich gas fields. Since the price of oil remains high, it can pay to develop these resources. But many natural gas companies with experience in the new technologies find themselves cash poor due to the low operating profits on their gas properties. Cash poor, and prospect rich.
These companies are selling their traditional gas assets to buy higher value shale deposits. Equity issuance is also at historically high levels. Dealogic estimates that share issuance by the sector represents one-fifth of all the US equity raised this year.
A more interesting development is to get cash from accrued gains with pre-existing hedges as reported by Ajay Makan in the FT. An example would be of a company which had entered in 2009 into short positions in forward/futures natural gas contracts for the next six years, until 2015. Right now, in March 2012, the company has on its books gas contracts with maturities varying from June 2012 to 2015. Since the gas yield curve back in 2009 when the company initiated the positions was significantly higher than the current gas yield curve, the company is sitting on significant unrealized gains. Consider just one of its many futures positions: 1000 contracts sold in 2009 with maturity March 2014. The price in 2009 of a March 2014 contract was around $4. Now the same 2014 futures price is around $3.4. Since each contract is for 10,000 mmBTU, the company can close the position and make a profit of 10,000 mmBTU x ($4-$3.4) = $6,000 per contract, for a total of $6 million.
The companies can close out these contracts in order to cash in on the gains.
A couple of questions are in order:
1. Why would the companies want to do that?
2. If the companies sold the hedges wouldn’t they become unhedged and exposed to greater risks?
The answer to the first question lies in the fact that with low gas prices, companies are not able to generate enough cash from operations to fund investment in land, drilling and exploration of shale gas fields, when the industry faces a lot of competition to own such assets. Faced with an operating cash squeeze, the companies are tapping their reservoir of gains generated by pre-existing hedges.
But, going forward, won’t the companies be much more vulnerable to price gyrations if they liquidate their hedges?
The companies can immediately lock into new forward contracts at the prevailing forward price. The companies are simply realizing past gains on their outstanding contracts in order to plough the money back into their businesses. Unrealized gains are a wasted resource. The companies are free to establish new hedges. Analysts who claim that companies are taking on more risk to avoid cutting back on investment are just wrong. There is not a conflict between cashing in on unrealized gains from past hedges and being hedged going forward.