Contributor: Ken Snyder, Gulf Energy Development. Over the past couple of years, much has been written and said about natural gas producers shifting to rich gas and crude oil plays. It is hard to find a recent producer presentation that doesn’t prominently feature their plans for oil and liquids with multiple graphics and bullet points.
It was early 2010 when the strategy really started to get traction. Here are some quotes out of some of the Q2 conference calls that year:
- Chesapeake: “We continue to focus primarily on oil and liquids rich areas. That's where the money is these days…..For now, we are disclosing just 12 liquids rich plays, but there are more on the way.”
- Devon: “Oil and NGL are the focus now. Most of 2010 is focused on oil and liquids-rich plays”
- Petrohawk: “2,000 drill sites in the Eagle Ford should be crude oil and liquids rich. While crude oil and natural gas liquids are a small part of our production today, we can grow it quickly...”
The strategy made a lot of sense. Gas prices were at about $4.25/MMbtu. Crude was $75.00/bbl. So the crude/gas ratio was at an ‘astronomical ‘ 18X. Rates of return from crude oil and liquids-rich gas wells were multiples of gas well returns. At that point the big concern was how long such a gravy train for the natural gas processors would last. Today we know that 18X was just a preview of things to come. In 2012 the ratio has hit 45X and will probably flirt with 50X in the not too distant future. What was a perfectly rational strategy in 2010 has become a prerequisite to survival in 2012.
That’s because it takes time and a lot of money to shift a producer’s drilling activity from gas to liquids. New plays must be developed. Drilling and fracking technologies proven for gas must be adapted for crude oil. New infrastructure to handle crude and liquids must be put into place. With gas prices at $2.50, there is less money to do all of those things. And that means producers funding the transition have less time. For some it will be a race to stay alive.
Consider a few of the downgrades issued since mid-January:
- S&P affirmed Chesapeake’s BB+ rating but revised its outlook from stable to negative.
- S&P lowered its natural gas pricing view and that resulted in “a negative impact” on Comstock Resources' estimated profitability and cash flows. Its corporate credit rating dropped to 'B+' and the rating on Comstock’s senior unsecured debt declined to 'B'.
- EnCana was downgraded by Bank of America to an “underperform” rating.
- EXCO Resources was downgraded by TheStreet Ratings from hold to sell.
I don’t mean to imply that any of these companies is a survival risk. But gas prices are clearly having an impact on their financial situation. Expect to see more of these downgrades as the reality of sub $3.00 gas prices work their way through the P&L statements of companies with heavy exposure to dry gas prices. Some will have a problem.
One of the best summaries of the current market situation can be found in S&Ps revised outlook for Chesapeake, issued a couple of days ago. The video, featuring S&P Managing Director Scott Sprinzen can be seen at Chesapeake Energy: Weak Natural Gas Prices Fuel Standard & Poor's Negative Outlook. Here are some of the highlights:
- Chesapeake has been on a tremendous growth trajectory in recent years. In fact, they are responsible for 20% of the overall increase in natural gas production in the U.S. over the past five years. They now account for about 9% of U.S. natural gas production.
- But the technology that has enabled Chesapeake to increase its production has been implemented by others as well, such that there has been the development of excess production in the U.S market which coupled with a fairly mild winter has led to depressed natural gas prices. And that’s undermined the value of Chesapeake’s large investment in natural gas.
- It has also led to the company being in a substantial negative free cash flow position. That is, their investments are outstripping their internal cash generation.
- That is something that had been expected in any event given the company’s growth goals, but it has become much more severe that we believed a year ago.
- One reason why there is such a cash flow deficit at this juncture is that Chesapeake is in the midst of a transition to more of a focus on crude oil than natural gas – with crude oil having much brighter pricing prospects than natural gas at this point.
- ….So we think there is now more of a gap between cash inflows and cash outflows, and this will be a challenge to the company especially when they are expecting to reduce total debt at the same time.
- This is an asset rich company. They have the ability to sell assets, enter into JVs, do volumetric production payments, royalty trusts…. All of which they have done over the past year. Their ability to do that in a cost effective manner is very much dependent on capital market conditions.
- ….If coverage metrics become too weak, the rating would be in jeopardy.
So the bottom line – To stay alive, producers with heavy exposure to natural gas prices need to use all the tricks of the trade to stay ahead of gas price induced cash flow shortfalls.
