Saturday, January 12, 2013

The US Natural Gas Industry is a Colloseum

The Colloseum is an ancient Rome amphitheatre where gladiators fight against each other until only a few strongest ones stand till the last.

In a sense, the US natural gas (UNG) sector is now a colloseum. There are too many players in this sector. They just have to kill each other, until there are only a few left at the end. I guess that happens to all economic sectors where there are too many players. Competition always do the job of eliminating too many players.

In the beginning of 2012, as decade low natural gas prices hurt producers, we heard a lot of producers vowed to curtail production to bring supply/demand to balance. By the end of 2012, we found that few NG producers actually did what they promised and curtailed their production, or postponed bringing new wells to production. Only one who actually curtained any production is Chesapeake Energy (CHK) who claimed that they ended the curtailment of about 0.2 BCF/day production as of end of Q2 of 2012. Why were producers eager to claim they were going to curtail production but were reluctant to do it?

If you go to investor presentation made by each individual producers, you heard the same story repeated: They all boast to investors how fast their productions have been growing, and how they project they will continue to grow.

Do you see the irony here? If every one keeps growing, the market will be more over-supplied, and the prices will continue to be killed, and it ultimately leads to the demise of their own industry. They understand it. They understand that the whole industry as a whole, they must keep production checked. They can not continue to grow recklessly. But as individual company, they want to see their own to continue to grow and expand. Because that is how they win the competition and get ahead of their competitors in attracting investment capitals.

It is a do or die situation. The shale oil and gas industry is a very capital intensive industry. They must spend large sum of capital money to drill and develop wells. So far the revenue stream is only a fraction of the capital spending. They can not sustain well drilling from cash flow from the business, they need continued injection of money from capital investment and from debt borrowing, in order to continue to drill wells. But the more wells they drill, the more they drive down the price and the more money they lose, which means they have to borrow more and beg the market for more capital investment money.

But then, it means they must continue to pitch an ever rosier pictures and try to portrait their business as rapidly growing, in order to make a case to continue to attract investment money and bank loan. Imagine the alternative. If the producers tell the truth that current NG prices are deeply non-profitable, and that they can not sustain their business from cash flow from revenue, and that they have no money to drill more wells, and that their production will fall and thus revenue stream will decline, and all that, and then they tell the banks and investors: please give up some more money so we can continue to drill more.

Imagine they say that to the banks and investors. Do they expect to get a dime of new loans or new investment capitals afterwards? No! They can not do that. Admitting facts and admitting failure will mean effective end of their business. Their competitors will win if they do so.

So that's why shale gas producers are getting bolder in projecting ever higher EUR (Estimated Ultimate Recovery) of their wells. That's why Cabot Oil & Gas (COG) claims that they are profitable even at current gas prices. They are not profitable. They cannot sustain their business if bank loans and new market capital injection stops, and they are unable to rise cash by selling assets. A profitable business should be able to sustain its own business operation from revenue cash flow. A profitable business does not need to continue to borrow money or sell assets just to make it through another day.

I see a big Ponzi Scheme here which will collapse soon, leading to collapse of US natural gas supply. It will be a big bonanza for the US coal sector. So I am holding my coal stocks firm: James River Coal (JRCC), Alpha Natural Resources (ANR), Arch Coal Inc. (ACI), Peabody Energy (BTU).

In the next few posts I will analyze COG's business to show whether they are really making a profit as they claimed. Stay tuned!

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