April 9, 2012

Chesapeake Energy: Naked Risk Management

By EconMatters

As discussed in our previous post, Chesapeake Energy is one natural gas producer taken the road less traveled by entering 2012 "naked" with none of its gas volumes hedged, betting that gas prices would rise.  Exiting the positions was profitable, but could prove to be short-sighted and misguided by over-confidence as it essentially left the company fully exposed to the languishing commodity price, while aggravating its already tight liquidity ratios (both current and quick ratios stood at 0.4x as of Dec. 31, 2011).  In contrast, other natural gas companies, like Encana, Linn Energy, Venoco and Range Resources  have hedged at least 75% of their 2012 production.

Henry Hub natural gas price has tanked 48% to a 10-year low in the past twelve months closing at $2.11 per mcf as of Monday, April 9.  Record production from new shale plays aided by new technology such as horizontal drilling and hydraulic fracturing ("fracking"), a sluggish U.S. economy, and a much-warmer-than-normal winter have all conspired to depress the the price the natural gas since 2009.

Chart Source: FT.com, April 9. 2012

The situation could get even worse this year.

The latest data from EIA showed that working gas in storage rose by 42 billion cubic feet (Bcf) to 2,479 Bcf as of Friday, March 30, 2012 hitting an all time high for March month for the week ended March 30, 2012.  This is 56% higher than last year at this time, and 60% or 934 Bcf above the 5-year average of 1,545 Bcf (see chart below).


NOAA announced that March 2012 is already the warmest March on record for the contiguous United States, a record that dates back to 1895 (See Map Below).  A warm winter does not necessarily guarantee a very hot summer, which is one way to burn off some of the gas inventory glut.


Analysts at Barclays estimate the average cost of drilling for domestic natural gas is roughly $4, but may be as low as $2.50 or so in easier-to-drill plays like the Marcellus Shale in the Appalachian region.  That suggests  almost all the new drilling of unconventional plays are under-water at the current Henry Hub price level.

Producers are feeling the pain.  Companies including ConocoPhillips, Chesapeake Energy, Encana, Ultra Petroleum, Talisman Energy have shut in production and/or cut their 2012 capital budget.  However, these planned curtailments most likely will not be enough to balance out the massively over-supplied market.

In its March 2012 Short-term Energy Outlook, EIA now expects inventory levels at the end of October in both 2012 and 2013 will set new record highs as well.  At this rate, some analysts are projecting storage capacity could be close to max out by October of this year.  In an extreme case, with no storage space available, some produced natural gas may get dumped on the spot market, and we could see natural gas breaking below the $2 mark this year.

Chart Source: Yahoo Finance, April 9, 2012

In this challenging commodity price environment, producers with the better risk and portfolio management skill would likely weather the storm better than peers, while companies like Chesapeake Energy may have to bite its time as well as bullet.  Chesapeake Energy stocks have dropped about 37% in the past 12 months vs. +4.07% of S&P 500 in the same period (see chart above).

Further Reading: Natural Gas: Will The Recent Rally Change The Bear Course?

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