Natural gas wholesale prices have fallen almost 7% since the middle of June, and over the past couple of weeks, Ultra Petroleum (NASDAQ:UPL) and Chesapeake Energy (NYSE:CHK) have also dropped. Increased natural gas production is expected to add to the supply, and possibly lead to even lower wholesale gas prices in the short term. While it makes sense that lower gas costs -- which can lead to lower revenue and profit for gas producers -- could lead to a lower stock price, the share price of Westport Innovations (NASDAQ:WPRT) has also fallen almost 8% in July:
The thing is, lower natural gas prices are good for Westport's customers, even though there is no direct affect like with gas producers. Let's take a closer look at what's happening, and what it means for all three of these companies.
Benjamin Graham approach to managing costs
Famed investor -- and mentor to Warren Buffett -- Benjamin Graham looked for predictable earnings, and getting an acceptable level of return. While his approach may have limited some outsized return opportunity, it also significantly reduced the downside risk of losses. Both Chesapeake Energy and Ultra Petroleum use a similar method of selling their oil and gas production: price hedging.
Without getting too deep in the weeds on the various types of hedging instruments -- which are a form of derivative -- the basic premise is that the companies sign agreements that set a price that they will sell their production for. The benefit for both Chesapeake Energy and Ultra Petroleum is a measurable and predictable level of sales and earnings for each hedged unit of gas or oil sold. This means that when gas prices fall -- as has happened recently -- it doesn't affect them as much.
The downside? When prices go up, the hedged production gets sold below market value.
Ultra Petroleum only hedges about half of its production, and would have to ask the board of directors to hedge beyond this amount. In the first quarter, Ultra only hedged 20% of its gas production and 41% of oil, but will hedge a sharply higher percentage of its production over the next two quarters. Its hedging practices are based on natural gas prices historically falling in the summer months when demand tends to be lower, before rising in the winter and fall when it will hedge a smaller percentage of production.
Chesapeake Energy has, in the past, been said to "over-hedge" its production, limiting the upside too greatly in an attempt to limit lost potential in a market decline. According to Chesapeake's annual report, it has 221 mmboe (million barrels of oil-equivalent) of future production hedged, not far below the company's total oil and gas production in 2013 of 244 mmboe. The slide below illustrates just how heavily Chesapeake hedges its production:
Either way, both Ultra Petroleum and Chesapeake Energy's hedging programs allow for downside protection, and predictable earnings.
Westport's movement is speculative, not commodity based
Westport Innovations' stock has been a rollercoaster this year, but it's still well up from a solid earnings announcement in May:
Considering how speculative an investment Westport remains, with adoption of natural gas for heavy trucking just getting under way, it's probably best to not read too much into this price drop. The only recent news about Westport happened a couple of weeks ago, when the company extended the terms of $39 million (Canadian) in debt that was set to expire in September, pushing it out to 2017 while also securing an additional $19 million (Canadian).
While more debt isn't great news, especially at 9% interest while rates are still historically low, this gives Westport both time and flexibility to invest in continuing growth of its business. It's also worth mentioning that this $55 million in debt isn't convertible to shares, and is unsecured, meaning that Westport will have leverage and options when the terms come up in a few more years.
Final thoughts: Keep the long view; don't get caught up in short-term stuff
Sure, the wholesale price of natural gas has come down a bit, but it's still well above the prices that Ultra Petroleum and Chesapeake Energy need it to be at to be quite profitable. Add in their hedging programs, and the downside risk for both is quite low. As to Westport, the wholesale price of natural gas has much less to do with its direct success, and has a relatively smaller effect on the price of natural gas "at the pump" than most people realize.
Don't get me wrong: Natural gas prices do matter, but not the small ups and downs that are largely seasonal. With this in mind, focus on the metrics that matter for the long-term success of these companies. For Westport Innovations, that's strong growth in its operating business units and moving closer to profitability. For Ultra and Chesapeake, it's more about how effectively they manage their investments in new production, and use tools like hedging to limit downside losses if gas prices do decline sharply.