Natural Gas Thesis Broken?
Board: Special Ops Ultra Petroleum
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To address these arguments on the high-level, I’d start by employing a frame that is essential to most any demand-driven argument: Low prices are the cure for low prices. When and if prices drift to a level where it is economically preferable to substitute natural gas, they’ll move higher. If they move too high, switching will pull the pendulum in the opposite direction. That as backdrop, I believe there are some powerful demand-driven arguments for increased natural gas consumption (which I’ll detail below). Assuming that economics rule across the long-run, there’s also an argument—which we’ve detailed at length—around a returns-driven argument.
In that regard, storage levels matter in the near-term, to the extent that they determine prices, near-term returns on equity, and for balance sheet constrained players, affect their fortunes from a liquidity/solvency perspective. But in the long-run, they matter much less. In the domestic arena, and this presupposes there aren’t meaningful forced shutdowns of coal-driven capacity, it makes economic sense for power producers to substitute natural gas for coal during shoulder seasons at $3.50-4/mcf, dependent upon the coal basin and costs of transportation. So, it logically follows that a near-term floor on natural gas prices should settle around that threshold. The markets, for their sometime short-sightedness, have supported this price.
Taking a longer-view, and this assumes some variety of carbon tax (which, in my opinion, seems a debated likely to take a less partisan posture in years to come), that figure notches ever-higher. It’ll be gradual, but I wouldn’t rule it out. Then there’s the export argument. In many areas of Asia and Europe, natural gas prices are linked to oil. By that, I mean natural gas is priced according to energy equivalency. The widely accepted rule of thumb is 6 mcf provide the same amount of energy as 1 barrel of oil. So, even though it doesn’t make a great deal of economic sense, producers price natural gas this way. So, at $100 oil, natural gas prices can be as high as $15/mcf in places like Japan. If the U.S. is able to build and secure contracts for export capacity approximating 10-20% of U.S. production, which seems possible, that could provide an addition $0.50-1.50/mcf uplift to prices. In short, I can still make a reasonable argument for $4.50-5/mcf natural gas in the long run.
Now, let’s zoom out to address another element of the argument, which TK has touched upon. That is the idea of improving production efficiencies driving the cost of extraction ever-lower, and/or producers flooding the market as prices improve. On the matter of improving productive efficiencies, there are two views. The first is that UPL was early to the party, and incremental cost reductions will be harder to come by. In turn, its returns on equity and capital will decline as others catch up. That’s possible, but as I noted above, there’s still a good argument for a $3.50-4/mcf floor on nat gas prices. To that end, I’d estimate that UPL can earn about 10% returns on equity at that price threshold, which I’d call a market clearing rate of return (i.e.—the minimum return a producer will accept for undertaking a project). All of this makes sense, if we’re to examine producers’ current estimated all-in costs on a per unit basis, where the least economic plays clock in around $5.50-6/mcf. That’ll change, but the truth is, demand should support a supply threshold
There’s another rung to this argument, which is that UPL will consistently be a top-decile, or even top-quartile, player on costs and returns, because management is good at what they do. In that case, catch-up from the industry will not come at cost its ability to earn good returns on capital. On the matter of industry producers continuously behaving irrationally—flooding markets with new supply as prices turn higher—I think it’s a valid concern. I’d counter with a few arguments. First is as I said above, low prices are the cure for low prices. When you look at competing fossil fuels, from a demand standpoint, $3.50-4/mcf looks like a reasonable downside to me. And on that basis, UPL shares are modestly undervalued. If we’re to give effect to what the entire industry requires to earn a decent return on capital now, it’s more like $5-6/mcf.
As for whether they’ll take heed of that argument, I see a few factors at work. First and foremost, and I realize it’s dangerous to invoke history, while the industry’s seen watershed changes over the past five years, this is a relationship that’s held for all of the fossil fuel era. Prices converge on a rate that allows producers to make a good return. When they aren’t there, supply is withdrawn. In that sense, demand and supply have a way of converging on each other. There are two other variables in play.
First, where natural gas was the new-new thing a few years back, many producers drilling decisions have an opportunity cost element that did not exist then. Oil shales have emerged as a viable drilling option, which should limit the extent of natural gas rig additions even as prices recover. Second, JV capital—which Watford noted last quarter—is less abundant than previously. JVs, in particular, have contributed to drilling at uneconomic rates in the past few years. For the time, that breed of activity is much-less prominent. Last, the industry-drilling dynamic, and motivator, is somewhat different. Where previously, producers had drilled to secure rights to their leaseholds, that’s now a less significant motivation. They’ve locked up their leaseholds, and are on to the next shiny toy, oil shales and deepwater. In short, these factors also will work to natural gas producers’ benefit.
Does that mean prices won’t languish if storage levels balloon? No clue. But I don’t really worry about it, in the case of UPL. Hope this helps. Questions and comments appreciated.