Why Natural Gas Producers Have Nothing to Worry About

North American gas prices are low now, but how much longer can that last?

Apr 22, 2014 at 8:18AM

Major dry-gas producers like Chesapeake Energy (NYSE:CHK) took a beating in the late 2000's as North American natural gas prices plummeted. Since then, natural gas prices have rebounded off the $2 per mmBtu lows to around $4.50 per mmBtu.

Even though Chesapeake Energy hastily switched its focus toward liquids-rich shale plays, its production mix is still 70% weighted toward dry natural gas. If Chesapeake Energy and other natural gas producers can begin to fetch higher prices for their dry-gas output, then free cash flow will explode upward as gas assets once deemed unprofitable turn into money-making machines.

By attempting to diversify its hydrocarbon production base, Chesapeake Energy is now investing 80% of its capital expenditures this year toward liquids plays. Back in 2010, roughly 10% of Chesapeake Energy's output was liquids. But due to aggressive asset sales and a complete refocus on liquids-shale output, liquids grew to be 30% of Chesapeake's total production.

Now that Chesapeake Energy can lean on various hydrocarbons to shore up its balance sheet, what can shareholders expect?

American natural gas producers' favorite chart
Back in 2000, coal-powered plants generated 52% of America's electricity, while natural gas trailed far behind with just a 16% market share.

Eia Natural Gas Replacing Coal Chart

Source: Energy Information Administration

Over the next 12 years, a completely different story began unfolding. Due to a combination of cheap domestic dry-gas prices, environmental benefits, the "war on coal," and the inability to export natural gas, natural gas quickly began catching up to coal. In 2012, natural gas powered 30% of America's electricity generation, while coal fell to 37%. 

What makes Chesapeake Energy really grin is that by 2040, natural gas will overtake coal as America's primary source for electricity generation. Keep in mind that as natural gas gains a larger share of the electrical-generation market, that market is also steadily becoming bigger. In 2012, America consumed roughly 4 trillion kilowatt hours; by 2040, the EIA is forecasting that to grow to a bit more than 5 trillion kilowatt hours.

Gaining market share in a growing industry means there are plenty of profits to be had in this sector. Keep in mind that the beginning of liquefied natural gas exports or a major relaxation of coal industry regulations could change these forecasts. 

Chesapeake Energy would be a clear beneficiary of this trend because higher levels of demand and access to foreign markets (via LNG export terminals coming online) will push the average realized price for its natural gas upward. This could turn its natural gas-producing assets (which make up roughly 70% of its output) into cash cows.

Another natural gas producer, one that has stuck its livelihood almost entirely in the Marcellus shale, is also set to reap enormous gains over the long term. Cabot Oil & Gas (NYSE:COG) has operations in two different shale plays, the Marcellus and the Eagle Ford. 

In the Marcellus, Cabot Oil & Gas is running six rigs on its 200,000 net acre position to try to boost output by 25%-45% this year. From 2010 to 2013, Cabot Oil & Gas was able to grow production from 130.6 Bcfe to 413.6 Bcfe; so if the past is any indication, 2014 will be a good year for production growth.

Almost all of Cabot Oil & Gas' output is dry natural gas. But due to the development of its Eagle Ford acreage, things are beginning to change. In 2012 Cabot Oil & Gas operated only one rig on its 62,000 net acres in the Eagle Ford. But due to the massive decline in dry-gas prices, Cabot Oil & Gas decided to accelerate its Eagle Ford development. Now two rigs are operating in the Eagle Ford, with management commenting on potentially adding a third sometime soon.

Foolish conclusion
The natural gas revolution has arrived, and it looks like it's here to stay for a while. Dry-gas producers have gotten hammered over the past few years, but maybe it's time to take a closer look at these two players. Not only do Cabot Oil & Gas and Chesapeake Energy produce enormous amounts of dry natural gas, but they are also diversifying their hydrocarbon-production base by investing in liquids-rich shale plays.

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Callum Turcan may initiate a position in Cabot Oil & Gas within the next 72 hours. The Motley Fool has no position in any of the stocks mentioned. 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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