Ready for Falling Oil Prices?

The latest estimates from the EIA point to falling oil prices and rising natural gas prices. Diversified producers like Statoil have little to worry about, but smaller producers like Kodiak and Continental Resources may suffer.

Jan 22, 2014 at 10:32AM

The American Energy Information Agency's latest Short-Term Energy Outlook projects falling oil prices and rising natural gas prices over the next two years. This is quite a change from recent times when natural gas prices have suffered while crude oil prices remained strong. With anemic U.S. crude consumption, there are many reasons to start weighting your portfolio toward natural gas.

It is time to bet on natural gas
New U.S. environmental regulations are pushing utilities away from coal and toward natural gas. At the same time, the world's LNG trade is growing at an alarming pace. Together big fundamental changes are pushing natural gas forward.

Crude oil is in a different situation. Refined crude oil products are not going to fall off the face of the earth, but U.S. demand for gasoline is expected to fall slightly from 2013 to 2015. More efficient vehicles and conservative driving habits are putting a lid on America's oil consumption.

One company worth considering
Statoil (NYSE:STO) is a great example of a company with interests in the natural gas and oil markets. In Europe it is able to fetch more than $8 per MMBtu for its natural gas -- far above U.S. rates.

In the first three quarters of 2013, its production was pretty evenly split between natural gas and crude oil. Statoil produced 815,000 barrels of oil equivalent per day of natural gas and 1,124 mboepd of crude oil. It is running a very successful upstream exploration program, finding the biggest conventional volumes in the world for the third year in a row. In North America it is active in the Marcellus region and produced 100.9 mboepd of natural gas in the third quarter of 2013.

Another great reason to consider Statoil is its valuation. It trades with a reasonable price-to-earnings ratio of around 12. Its dividend yield of 3.5% should not be overlooked. Based on 20-year rolling time frames between 1940 and 2011, dividends are estimated to provide more than half of the S&P 500 index's total return. Statoil's dividend points to positive shareholder returns in the decades to come.

The in-between play
Chesapeake Energy (NYSE:CHK) is heavily invested in natural gas, but it is killing its natural gas production in favor of liquids. In Q3 2013, its crude oil production grew 23% year over year, its NGL production grew 31% year over year, and its natural gas production fell 10% year over year. In the same time-frame it managed to boost liquids production from 21% of total production to 27% of total production. 

Hopefully management will realize that natural gas is a good long-term market. Right now natural gas is not sexy, but its demand is expected to grow consistently over the coming decades. Stronger natural gas prices will help boost Chesapeake's bottom line and pay down its $12.7 billion in long-term debt.

Expensive oil plays
Small exploration and production, or E&P, companies like Kodiak Oil & Gas (NYSE:KOG) and Continental Resources (NYSE:CLR) offer huge growth at a price. These companies are heavily oriented toward crude oil. 86% of Kodiak's reserves are crude oil. Continental's recent quarterly earnings show that oil production accounted for 88% of its revenue.

The danger is that Kodiak and Continental are putting too much money into oil production. Soft oil prices may eventually force these companies to cut back their capital expenditures, leaving them with big debt loads and unsustainable balance sheets. Kodiak's production grew from 1.3 mboepd in 2010 to an estimated 29.2 mboepd in 2013. Continental grew its annual production from slightly less than 15 mmboe in 2010 to 36.3 mmboe as of Q3 2013. Such massive growth rates are only sustainable for a limited amount of time. A company can only double its production for so many years before it runs out of acreage.

Apart from these issues Kodiak and Continental are expensive. Kodiak is trading around 23 times trailing earnings, and Continental is trading around 27 times trailing earnings. These companies are high-margin companies with high growth rates, but oil prices continue to soften, and demand growth remains low.

Final thoughts
The Energy Information Agency sees softening oil prices and rising natural gas prices over the next couple years. Cheaply priced companies like Statoil with healthy natural gas and crude oil production should be fine. Even Chesapeake may come out a winner, as long as management doesn't kill its natural gas operations. The real danger is that small oil-oriented exploration and production companies like Kodiak and Continental may face falling margins, reduced capex budgets, and reduced growth.

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Joshua Bondy has no position in any stocks mentioned. The Motley Fool recommends Statoil (ADR). 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.

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