With the EIA forecasting an average price of $3.41 and $3.63 per million British thermal units (MMBtu) in 2013 and 2014, respectively, is the financial health of exploration companies with weak hedge books, such as Comstock Resources (CRK) and Ultra Petroleum Corp. (UPL) vulnerable to a reversal in energy prices?
Freezing winter weather combined with increased demand for gas-fired replacement power (due to higher than expected nuclear power outages) have worked to drive stocks of natural gas lower. The Henry Hub spot price hit a recent high of $4.38 MMBtu, its highest level since September 2011.
Comstock Resources derived about 85% of production and reserves from natural gas in 2012. The company posted a year-on-year operating loss of $100.1 million in 2012, compared with a loss of $33.5 million during the prior year, mostly due to weaker natural gas prices and asset impairments. Average hydrocarbon selling prices in the fourth quarter were $3.05 for natural gas (compared with $3.40 in 2011) and $101.56 per barrel of oil.
Management expects gas prices to remain weak and is moving to higher oil production, with efforts focused on the Eagle Ford Shale play in South Texas. However, this transition is proving costly, as Comstock continues to outspend cash from operations: In 2012, the balance sheet bled more than $121.5 million in free cash.
Given what might be peak pricing, it’s hard to fathom why management has chosen not to lock in more contracted natural gas hedges, especially with oil projected to total no more than 20% of production by year’s end: Each $0.10 change in the price of natural gas could affect cash flow by approximately $600,000 per quarter.
With little liquidity, a borrowing base of just $130 million and a projected capital budget of about $422 million for 2013, management recently infused the balance sheet with about $768 million from the recent sale of West Texas assets to Rosetta Resources (ROSE).
Comstock sells at a premium price-to-sales ratio compared to integrated major E&P companies like Exxon Mobil (XOM) and Chevron Corp. (CVX). Ergo, should drilling and commodity risks continue to pressure profitability prospects over the next few years, Comstock’s stock price could underperform its E&P peer group.
Unlike Comstock and many of its natural gas peers, Ultra Petroleum’s business strategy remains focused on further development of its long-life dry gas reserves located in the Green River Basin of Wyoming and emerging Marcellus Shale opportunities in Pennsylvania.
Management hedged 184 Bcfe, or 70%, of 2012 annual production at an average price realization of $4.01 per Mcf. Without the predictable cash flow generated from forward hedges, cash from operations would have declined 57.3% last year to $573.8 million – more than negating the $100 million generated in free cash flow.
For 2013, only 65 Bcfe, or 26%, of the Houston-based producer’s projected output is locked in (at an average price of $3.63 per Mcf). Notwithstanding that Ultra is one of the lowest-cost pure-play U.S. natural gas producers, swaps and futures contracts made little economic sense to this management: Of the 11.2 Tcfe in proved and probable reserves, only 36% are economic to extract at prices ranging from $3 to $4 per Mcf, according to regulatory filings.
Due to depressed natural gas prices, the company incurred a total of $3 billion in asset impairment charges in 2012.
“Right now we don’t want to encourage any more natural gas development,” CEO Michael Watford commented on the recent earnings call. “We think it’s the wrong answer and [we] don’t understand why anyone is growing natural gas production.”
Activity in the Marcellus has literally ground to a halt, with Watford telling analysts that it wouldn’t be profitable to spud wells at any price below $5.00 per Mcf. Even in the prolific Green River Basin, where expiring competitor leases (once-valued at $4,000 - $5,000 an acre) are now selling for $1,000 - $1,500 an acre, the company has flatly stated it has no interest, at present, to acquire bolt-on positions.
Management is unwilling to engage in hedging activities because it opines “there is more upside than downside there”: insider consensus is that longer-term outlook (out to 2016) will become more favorable; with forward pricing curves of at least $4.25. At those kind of prices, Ultra expects it can profitably grow production and cash flow 40% and 100% (not CAGR numbers).
However, given management’s agnostic view toward commodity contracting and a drilling and CapEx budget only one-third the $1.1 billion spend of just two years ago, hitting its internal goals of $500 million in operating cash and $100 million in free cash flow this year could prove problematic – especially given base production of 257 Bcfe is expected to show sequential declines of up to 26% this year and 14% in 2014. In addition, this financial model is founded on an average realized price of $3.50 per Mcf, too.
Management can ill-afford to bet wrong on the future direction of gas prices: Although trailing-twelve month EBITDA/Interest Coverage ratio was a comfortable 6.8 x and little of its $1.8 billion in outstanding debt comes due before 2016, liquidity on-hand was comprised mostly of revolver credit totaling $723 million. Should gas prices head south again, Ultra’s ability to expand its Rockies output and grow cash flow could flounder – higher leverage and an inability to replace depleted reserves would likely endanger the company’s ability to continue as a going concern, too.
Though natural gas price hedging can limit upside profitability, in a falling market, such forward thinking can increase cash flow certainty – and longer-term survival too.
David J. Phillips, a contributing editor at YCharts, is a former equity analyst. His journalism has appeared in Bloomberg BusinessWeek, Forbes, and Kiplinger's Personal Finance. From 2008 to 2011, David was a reporter for CBS News Interactive. He can be reached at firstname.lastname@example.org.
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