Chesapeake, XTO, Sandridge, others, looking over their shoulders

Implications: Anna Driver (Reuters) reported in the August 28 issue of the International Herald Tribune that concerns about a potential over supply of natural gas in the U.S. may limit investor interest in the independent natural gas exploration and production companies. Production is growing at double-digit rates from gas shale fields such as north Louisiana’s Haynesville operated by Chesapeake Energy and others. High prices and interest in gas shales resulted in many 2008 budget increases. Natural gas futures are down 40% from their July peak. Share values of Anadarko Petroleum and XTO energy have dropped significantly. They are trading at five times 2009 cash flow. Short-term risk is high. Valuations are compelling but uncertainty about the trends in prices keep investors cautious. Investor confidence could return if companies stopped expanding production plans and started buying back stock (as Anadarko recently announced). Some analysts believe natural gas prices will not fall much further.

Analysis:  As a group, the independent natural gas producers are a mixed bag. Anadarko has a broader asset base but over $11 billion of long term debt. Apache has a more balanced reserve base but $4 billion of long-term debt. Chesapeake energy is disadvantaged by almost $11 billion of debt coupled with the fact that its portfolio of assets contain a high percentage of unconventional shale gas reservoirs. XTO energy has over $6 billion of debt. Highly leveraged companies are forced to hedge substantial fractions of their production to pay off interest as it comes due. This lessens their profit potential in times of rising natural gas prices. The sector as a whole took full advantage of easy credit earlier in the cycle and increased drilling budgets accordingly. Today gas prices are static to down-trending. Range Resources with $1.1 billion of debt has a number of shut in natual gas producers in the Marcellus play of Appalachia. These wells, waiting on gas processing plants and pipeline connections will not begin producing revenue until 2009. Looming on the horizon is increased flows of liquefied natural gas (LNG) into the U.S. market. August 15th netbacks of $7.19/million but at Everett, Massachusetts and $5.22 at lake Charles, Louisiana are not reassuring for the economic future of the independents, particularly leveraged companies that produce mainly shale gas. Another problematic company is Sandridge Energy which has the dubious distinction of having the largest low heating value (btu) natural gas field in the U.S. (Pinion field in the West Texas Overthrust zone). Neither compelling asset values nor net leased acreage positions are accurate predictors of performance. The ability to meet future interest payments is paramount.