Natural Gas Rig

Source: Flickr user USFWS.

The natural gas industry is a risky one for investors. Companies operating in the space are quite up front about those risks; their annual reports are filled with risk factors that could, and more often than not do, impact future results.

Here are three common types of risk found in the annual reports of Cabot Oil & Gas Corporation (NYSE:COG)Chesapeake Energy Corporation (NYSE:CHK), and Ultra Petroleum Corp (NASDAQ:UPL). By knowing and understanding these risks, investors might want to think twice about allocating too much of their portfolios to natural gas stocks. 

Price volatility risk
More often than not, the first risk listed under the risk factor section of a natural gas stock's annual report will highlight the risk of commodity price volatility. In Cabot Oil & Gas' annual report, for example, it highlights this risk first: "Natural gas and crude oil prices fluctuate widely, and low prices for an extended period would likely have a material adverse impact on our business." The company goes on to point out that it's "impossible to predict with any certainty the future prices of natural gas," which makes it difficult for the company to plan, and could impact its ability to meet future financial obligations.

Both Chesapeake Energy and Ultra Petroleum also highlight this risk in their annual reports using much the same language. They also both note this volatility makes it difficult to budget project returns for drilling new wells, and that it could impact their ability to meet their financial obligations. Suffice it to say, this really is the chief risk facing natural gas stocks.

Reserve risk
Another common risk factor noted by all three companies is the potential for inaccuracies with their reserves. For example, Ultra Petroleum writes in its annual report:

Our reserve estimates may turn out to be incorrect if the assumptions upon which these estimates are based are inaccurate. Any material inaccuracies in these reserve estimates or underlying assumptions will materially affect the quantities and present value of our reserves.

What this suggests is that Ultra Petroleum's proved reserves might not be accurate because they are based on assumptions that could be founded upon faulty data. This is why proved reserves are defined as what a company is reasonably certain can be produced at current market prices and with currently available technology. However, there is still a bit of uncertainty, as these reserves are still the best guess as to the oil and gas in the ground that can be extracted, and even the best guesses can turn out to be inaccurate.

If these reserve estimates are later found to be inaccurate as more wells are drilled and data collected, it could force a company to take a large writedown of the value of their reserves. Chesapeake Energy, for example, had its proved reserves revised down by 78 million barrels of oil equivalent, or boe, last year after the company removed proved reserves in the Marcellus Shale, Eagle Ford Shale, and the Anadarko Basin as additional drilling data indicated there was no longer reasonable certainty these reserves would be produced.

To put that number into perspective, it represented 3% of the company's beginning reserves. While this revision didn't result in a meaningful writedown for the company, the risk remains that a future writedown of reserves due to a revision could be meaningful for Chesapeake, Ultra Petroleum, or Cabot Oil & Gas. 

Regulatory risk
The third common risk facing natural gas stocks is regulatory risk. Ultra Petroleum highlights this in its annual report: "Compliance with environmental and other government regulations could be costly and could negatively impact our production." Ultra Petroleum then goes on to note that these regulations could require that the company get additional permits before drilling, restrict substances that can be used for drilling, and limit or prohibit its ability to drill in certain areas like wetlands. Additional regulations would add to drilling costs, which would further squeeze profitability at a time when profits are already being squeezed by low oil and gas prices.

Chesapeake Energy, for example, is facing a potential emerging regulatory risk facing due to the spike of earthquakes hitting Oklahoma that have been linked to fracking and wastewater injection wells. The state's energy regulator is considering tougher restrictions on drilling activity after calling the spike in quakes a "game-changer." Those new regulations could significantly increase Chesapeake Energy's drilling costs and could potentially prevent it from drilling new wells in the state.

Investor takeaway
Natural gas stocks face myriad risks. However, the three most commonly found risk factors detailed in the annual reports of natural gas producers are price volatility risk, reserve risk, and regulatory risk. All three could have significant long-term impact on producer profitability and shareholder returns.

Matt DiLallo has no position in any stocks mentioned. The Motley Fool recommends Ultra Petroleum. 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.