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Big Oil has had a challenging year so far. Year to date, ExxonMobil (NYSE: XOM  ) has lost around 4.7%, while ConocoPhillips (NYSE: COP  ) has shed 4.6% over the same period. The biggest problem for Big Oil is that production is becoming increasingly expensive. According to Bernstein Research, the marginal cost of production -- the cost of producing an extra unit of production in this case a barrel of oil -- for the world's 50 largest oil companies increased 299% between 2001 and 2010.

To make matters worse, the cost of production is becoming increasingly expensive on the back of reduced production output. ExxonMobil, for instance, saw its upstream output reduced by 1.8% in the fourth quarter of 2013.

Simply stated, oil companies are spending more money and producing less oil. Naturally, investors have priced this predicament into oil stocks, explaining the relative lack of mobility among oil players in the stock market of late.

However, for ExxonMobil and ConocoPhillips, the problem goes beyond just higher costs of production. The two players' relatively high exposure to natural gas amplifies the downside risks. ExxonMobil, for instance, saw natural gas constituting 47% of its entire production profile for Q4 2013.

High natural gas exposure has put a drag on the two oil bigwigs because U.S. natural gas prices, despite showing recent gains over the winter, are still depressingly low when compared with prices in international markets. Lower prices thereby suppress profit margin, not forgetting that production costs are already painfully high.

This low price situation reduces the incentive to produce natural gas. Thereby, considering that natural gas constitutes a reasonable portion of ExxonMobil's and ConocoPhillips' production profiles, some would argue that reduced natural gas production -- induced by low price environment -- is likely to place a drag on overall output in both companies. This couldn't be any further from the truth. For the full year of 2013, ConocoPhillips' natural gas production in North America declined by 16,000 barrels of oil equivalent per day. In stark contrast, production of liquids, which have higher margins when stacked against gas, increased by 21,000 BOE and 49,000 BOE in Canada and the Lower 48 region, respectively.

Natural gas exposure is the real game changer
Over the cruelly harsh winter, there was an unprecedented rise in demand for natural gas, leading to the highest prices in years. At one point, natural gas futures hit $5.58 per million Btu, the highest price since early 2010. As expected, market watchers have followed the price movements keenly, saying that despite higher prices relative to recent years, the recent price movements are largely a function of geographical weather patterns. I can't argue with that. In fact, on the New York Mercantile Exchange, Monday, natural gas futures traded lower relative to recent highs at about $4.7-$4.5, signaling expected lower demand in spring and fall, which typically have warmer temperatures that reduce the need for heating.

Although I agree with the logic behind the movement in natural gas prices -- that it's a function of weather patterns -- I can comfortably say that one key factor has been greatly overlooked or played down, or both. Commentators are reading too much into natural gas price movements and forgetting that unlike before, storage levels are distinctly low. To put this into clearer perspective, total U.S. natural gas storage stood at 1.196 trillion cubic feet as of last week, the lowest for this time of year since 2004.

Lower storage levels present a unique opportunity for producers. This is because it has happened against the backdrop of deliberate slowdowns in capital outlay. As fellow Fool Arjun Sreekumar discussed in a previous article, ExxonMobil said in a presentation that it would reduce exploration and capital spending to about $39.8 billion this year, down from $42.5 billion in 2013. ConocoPhillips in previous statements has also shown an unmistakable incline toward higher margin areas such as liquids going forward.

What does this mean for natural gas prices?

Both ExxonMobil and ConocoPhillips are likely to reduce exposure to natural gas production relative to previous years. Natural gas production is thereby likely to stall for the foreseeable future. This means that the current low storage levels won't be sufficiently replenished. This will contribute to supply constraints and place a sustained upward pressure on natural gas prices. When prices finally reach desirable levels, players such as ConocoPhillips and ExxonMobil will have generated sufficient earnings from the high margin areas that they are currently focusing on, enabling them to aggressively increase capital spending in natural gas production at the said attractive prices.

Foolish bottom line
Natural gas has certainly amplified ExxonMobil's and ConocoPhillips' downside risks relative to other oil majors with less exposure. This thereby means that if prices become attractive, the upside could also be amplified in a similar if not greater -- you have to factor in market excitement -- fashion. Despite dropping around 4% overall this year, ExxonMobil has gained 6.11% since Feb. 10. This is the same period that natural gas prices made notable gains on the huge demand brought about by the harsh winter. Thereby, a sustained higher natural gas price environment prompted by low storage levels and reduced natural gas production (for now) could produce amazing results for ExxonMobil and ConocoPhillips. At current share prices, both are greatly discounted in view of the upside potential. 

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Read/Post Comments (2) | Recommend This Article (5)

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  • Report this Comment On March 14, 2014, at 5:15 AM, Interventizio wrote:

    Excellent article. I'm sure it depicts the rationale behind Buffett's purchase of Exxon. Natural gas is the way to go, and prices are not going to be bottom-low forever.

  • Report this Comment On March 26, 2014, at 1:10 PM, Yieke wrote:

    Thanks Interventizio. In fact, producers may be able to put a price floor with the whole debate on Russia and the rate at which LNG projects are being approved.

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Lennox Yieke

Lennox Yieke is a business writer who has a knack for not only seeing first what others see eventually, but telling the story from an entirely fresh, interesting, informed and ‘Foolish’ perspective. Join him as he covers energy, materials and utility stocks, breaking down mind-boggling numbers and loads of jargon into tidbits of understandable, valuable investing guidance. Always feel free to engage with him and share your latest ideas on Twitter @lyieke

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