Natural Gas 301

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Welcome to our Natural Gas series aimed at introducing investors to the fundamentals of the industry. We've already covered the production basics, and horizontal drilling and hydraulic fracturing, so today we dive into numbers -- introducing the metrics that can be important in evaluating individual companies and the industry at large.

Though investors may certainly apply a slew of popular ratios (P/E, EPS, debt-equity, etc.) to natural gas producers, the most relevant ones for the industry are unrelated to the balance sheet or income statement. A gas producer's primary assets are its reserves, and they aren't listed on the balance sheet.

Instead, investors should flip to the "Proved Reserves" table in the company's 10-K. We'll use Anadarko (NYSE: APC  ) for these exercises, its table is below:

Source: Annual report.

Source: Annual report.

Now that we have our data, let's learn how to get it to say what we want to hear.

Reserve life index
The reserve life index, or the reserves-to-production ratio, measures how long reserves would last if there were no new discoveries or acquisitions.

Anadarko's reserve life index is 11 years. Intuitively, it is easy to assume that the higher the RLI the better. In reality though, a high RLI, say 25 years, could mean that a particular company is unable to develop its reserves which could illuminate a more serious problem (no money!).

It's also important to note, after a merger or acquisition it is possible for this number to be high simply because the parent company has not yet had the opportunity to develop those reserves.

Reserve replacement ratio
This is a simple ratio that indicates whether a company is replacing or depleting its reserves year over year.

Anadarko's reserve replacement ratio is 150%, which means the company does in fact replace reserves from year to year.

Gas companies can replace reserves in two ways. "Through the drill bit" refers to reserves replaced through exploration. "Bought" refers to increased reserves through acquisition. Through the drill bit is the preferred method because it implies firsthand knowledge of the new gas and reinforces a company's claim to technical prowess.

While these ratios seem pretty straightforward, this wouldn't be the natural gas industry – heck, this wouldn't be investing – without some sort of discrepancy in the way companies account for and report reserves.

The industry
In 2008, the SEC bowed to industry pressure and loosened the requirements for reporting reserve estimates; consequently, estimates increased and so did stock value. Natural gas has boomed since then and, depending on the crowd you run with, you have likely heard reserves described as "enough gas to last a century" or "Ponzi scheme."

Reserves are the major assets of any oil and gas company, but they only get paid for what they pull out of the ground and it's important to keep that in mind at all times.

Breaking even
Another issue in the industry right now is the depressed price of natural gas in the U.S. Over the past three years production has boomed and the price has tanked.

Source: Energy Information Administration.

The domestic price of natural gas is now so low that companies are almost guaranteed to lose money if they don't operate efficiently. Here are the most recent break even points for 10 natural-gas-producing companies:

Company Break Even Price
Southwestern Energy (NYSE: SWN  ) $3.50
Range Resources (NYSE: RRC  ) $5.00
EV Energy Partners (Nasdaq: EVEP  ) $5.10
Quicksilver Resources (NYSE: KWK  ) $6.01
Carrizo Oil & Gas (Nasdaq: CRZO  ) $6.05
Chesapeake Energy (NYSE: CHK  ) $6.10
PetroQuest Energy (NYSE: PQ  ) $6.50
EXCO Resources (NYSE: XCO  ) $6.95
Forest Oil (NYSE: FST  ) $7.00
Continental Resources (NYSE: CLR  ) $7.10

Source: Bank of America Merrill Lynch.

Though it seems that most of these companies are in terrible trouble with gas prices hovering around $4.00, there is another factor that comes into play here. First, natural gas liquids, or NGLs, track the West Texas Intermediate and generally sell for about 50% of the price of a barrel of oil. So, while production typically yields much more methane, often times there are enough NGLs in the mix to make drilling worthwhile. Additionally, companies may opt to pursue other gas plays that are rich in oil and NGLs, and avoid the areas that contain mostly dry gas.

For example, drillers have recently left the Barnett Shale to pursue other plays in Texas that are rich in oil and NGL. At the peak of 2008, there were 203 active drilling rigs in the Barnett. Now there are only 53, as companies have made off for the Permian basin and the Eagle Ford shale in search of the more lucrative commodities. It is the first time in 16 years that more rigs are drilling for oil than gas in the U.S. When the price of gas climbs again, the drillers will return to the Barnett.

Never stop learning
There is always plenty more to learn out there. For industry news and updates, load up My Watchlist with the energy companies above, and consider following trade publications like @plattsgas and amazing writers like @TMFDuffy on Twitter.

Can't get enough natural gas? Click here to check out the Motley Fool's special free report "One Stock to Own Before Nat Gas Act 2011 Becomes Law."

Fool contributor Aimee Duffy doesn't own shares of the companies mentioned in this article. If you have the energy, check out what she's keeping an eye on by following her on Twitter, where she goes by @TMFDuffy.

Motley Fool newsletter services have recommended buying shares of Range Resources, Southwestern Energy, and Chesapeake Energy. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

Read/Post Comments (6) | Recommend This Article (19)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On November 01, 2011, at 12:50 AM, canadacomments wrote:

    Will MF create a report containing all your articles on natural gas? It would be very informative.

  • Report this Comment On November 01, 2011, at 9:11 PM, Shawnerz wrote:

    I'm reading "Twilight In The Desert" by Matthew Simmons and this article fits right in. Thanks for the series of articles!

  • Report this Comment On November 02, 2011, at 8:47 PM, Shawnerz wrote:

    OK, I'll ask the dumb question: where did the 2663 and the 235 come from? I don't see those numbers on the Proved Reserves list at all.

    Another question: what's the difference between "proved" reserves and "proven" reserves?


  • Report this Comment On November 03, 2011, at 11:18 AM, XMFAimeeD wrote:

    @Shawnerz - That's not a dumb question at all, I've added another chart from the annual report that clarifies those numbers.

    There is no difference between 'proved' and 'proven' reserves.

    I typically avoid books with "Twilight" in the title, but I will make an exception this time. Thanks for the suggestion.

    Fool on,


  • Report this Comment On November 13, 2011, at 11:27 AM, shruggered wrote:

    Thank you for this series on natural gas, great job!

  • Report this Comment On November 13, 2011, at 2:34 PM, billdzy wrote:

    Aimee, great info. Since nat gas is a commodity, why not buy an ETF like UNG, since the price of nat gas is so low and hold out until it trades higher. I am new at this.


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