Friday, October 1, 2010

Keith Schaefer: My #1 Question....When Should I Invest in Natural Gas?

A Contrarian View of the Gas Market....and 4 Questions To Ask Yourself

It is, by a longshot, the most frequently asked question among OGIB readers over the last two years....“When should I buy natural gas? And should I buy ETFs? Future contracts? Natural gas producer stocks? I’ll tell you my thoughts, and I’ll also give investors four questions to ask the management teams of their natural gas producers that could help you protect your investment. The culprit of these low prices is the highly profitable shale gas plays that have grown very quickly all over North America. Shale gas wells often pay out very quickly, on an operating cost basis. The team writing the energy daily letter at National Bank in Canada had an interesting take on gas yesterday that mirrored my thoughts.

“Finally, the conventional wisdom that appears to be growing in the gas market is that the market is poised for a significant rally because of the overwhelmingly bearish mood and the fact that there are no buyers anymore out there for gas. “We would agree if in fact there were no buyers out there for gas. “But there are buyers, ETF investors (in a big way at these low prices), Reliance Industries, Mitsui, KoGas, Statoil, China National Petroleum Corporation, BG Group and Shell to name a few. Once these capital injections cease, the time will be right to become very bullish on gas. The key is to be the first one to recognize this phenomenon…or at least not the last.” The companies they named are large foreign producers who have paid big money to farm into shale plays just to learn the technology.

In 2009, the investment bankers were able to raise money for even the junior gas companies that were unhedged. Raising money for senior or intermediate producers was even easier. And just as the buy side institutions that bought those financings became wary of a long time of low gas prices, the industry was able to get capital from these international players.

Until all these sources of capital dry up and natural gas producers are feeling more forced to curtail production, gas prices could remain this low or lower. The good news is that with these low prices, producers can’t hedge good prices for 2011, like they could last year for their 2010 production.

So what does this mean for retail investors, how can we use that information to protect or increase the value of our portfolio? The answer is, know your investments, and here are four questions to ask management. Investors in the junior gas weighted stocks, in both Canada and the US, should be very cautious now.

First investors should check if their company’s are near their debt ceiling, and there are lots who are, because these companies can’t raise money (equity; or issue shares) now. They only have their debt line and cash flow. And net cash flow right now is very low for these producers.

Second, investors should ask management if they would have to take any reserve writedowns if the independent evaluators came in to do their calculations at today’s prices. A company’s reserves are their assets from which they can secure lending against. If those reserves were economic last December 31, they might not be this year at these lower prices, we have yet to see any meaningful rally in gas prices this fall, compared to last year. And reserves are This which would mean they may have to suddenly sell assets or do very dilutive financings at very low share price just to stay alive.

Third, investors should also be checking if their natural gas weighted investments are reducing production, which is good for preserving cash but generally not for the stock price. The market pays for growth, not contraction.

Energy consultants Ziff Energy recently said that junior producers should not be spending any money, in order to preserve capital during this time when full cycle costs, where you amortize everything into your costs of production, are almost twice what the current gas price is in Canada, and 50% higher than current spot price in the US.

Fourth, ask management what their plan is to survive an even longer period of low natural gas prices if they are unhedged. It’s your company and it’s your money.

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