As recently as its third quarter earnings release, Nucor (NYSE:NUE) was talking up the benefits of a natural gas drilling contract with Canada's Encana (NYSE:ECA). However when it warned that fourth quarter earnings would fall short of Wall Street expectations, it also announced that drilling was coming to a halt. Why?
The steel industry makes use of a number of inputs that are commodities. That exposes participants to often volatile cost swings, including such base necessities as iron ore and coal. For example, ArcelorMittal (NYSE:MT) is a steel company, but it also has material operations in the coal and iron ore spaces.
In fact, the company intends to expand its iron ore production by around 50% by 2015. It believes that iron ore will be a cornerstone for its growth, placing it on an equal footing with its steel operations. The end goal is to take out the middle man so ArcelorMittal can get the best prices possible on the iron ore it uses. And, on the coal side, the company's eight million tonnes of production is about as much metallurgical coal as U.S. based Arch Coal's (NYSE:ACI) output.
ArcelorMittal uses a different steel making technology than Nucor, however. So Nucor has different inputs, one of which is natural gas. Although the price of natural gas is relatively low right now, it has a volatile history filled with extreme price spikes. Nucor partnered up with natural gas expert Encana to protect itself from such cost jolts.
Entering into a partnership was a good move since it kept Nucor from having to learn new skills. The pair's original deal, dating back to the turn of the decade, was hugely successful. According to a company press release, the results of this agreement exceeded expectations by over 60%. No wonder it partnered up with Encana again late in 2012.
For Encana, the Nucor deal is just one of many. It has partnerships with companies as far reaching as PetroChina (NYSE:PTR) and Korea Gas. So this one deal isn't as big a deal for Encana as it is for Nucor. In fact, during the third quarter conference call, Nucor CEO John J. Ferriola went so far as to call it a "game changer."
Halt the drilling!
So why did Nucor and Encana just stop drilling? There's likely several reasons. The first big one is that natural gas prices are low, which means that it's hard to make money drilling. The company won't discuss drilling costs, with Keith B. Grass, an Executive Vice President at Nucor, describing the information as "confidential." But it's safe to assume that it's presently cheaper for Nucor to buy gas than drill for it. So, this is a cost saving move from that perspective.
That's a good thing because the steel industry is still in a funk, suffering from generally weak pricing. The second big reason is, essentially, the same, but from a different angle. Not drilling will shave $400 million of off Nucor's capital spending budget in 2014. That number and time frame, provided by Nucor in the press release, also gives an idea of how long the company plans to keep the drill bit idled.
Is this a problem?
So Nucor and Encana agreeing to halt drilling probably shouldn't be seen as a long-term problem. Low natural gas prices will still be a benefit to Nucor, only it won't be drilling its own gas. For Encana, it's just one of many deals. And the flexibility to start and stop drilling is really a notable plus for both companies. When natural gas prices move higher the duo will be able to restart exploration and Nucor will be able to keep a cap on its natural gas costs. In the meantime, costs remain in check and capital spending is reduced during a difficult period for steel companies.
Reuben Brewer has no position in any stocks mentioned. The Motley Fool recommends Nucor. 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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