The best cure for a low commodity price is a low commodity price. At least that's how the old saying goes. Natural gas prices have been sick for a very long time, and many investors are beginning to wonder if there will ever be a cure.
Greenlight Capital's David Einhorn believes there is a cure for natural gas prices, and he's willing to bet Greenlight's money on it. Let's have a look at his reasoning, what he bought, and a natural gas producer that should have a very positive share-price response if he's proved correct.
Why Einhorn has gone long natural gas
In Greenlight Capital's just-released Q1 letter to investors, Einhorn revealed that he's placed a macro bet on seeing natural gas prices increase. That Einhorn was somewhat bullish on natural gas wasn't new information for us. He previously discussed his bullish view on natural gas in connection with his underperforming position in shares of Consol Energy (NYSE:CNX).
But now we've learned that Einhorn has made an investment directly tied to natural gas prices. As you probably know, there's a futures market for oil and gas prices, where you can trade the commodities. Einhorn purchased the 2017 and 2018 natural gas calendar strip prices at average prices of $2.71 and $2.84 per million BTUs, respectively. If natural gas prices are above those levels, Einhorn is going to make money on this trade.
In his investor letter, Einhorn explained why he took this macro position. His belief rests on the following points:
- Natural gas prices aren't high enough to justify drilling, except in the very best locations.
- The industry has responded by dramatically reducing drilling activity.
- As existing wells deplete, supplies should fall.
- The high cost of liquefying and transporting natural gas limits competition to North American sources.
- Excess inventory is only a couple percent in terms of annual production, which has already begun to decline.
Einhorn believes that normal weather combined with the lower production that he expects will lead to a natural gas shortage within a year.
Southwestern Energy -- huge leverage to increasing natural gas prices
After a decade of growth at a breakneck speed Southwestern Energy (NYSE:SWN) won;t grow production in 2016. In fact, production will decline by 25% from the start of the 2016 through the end of the year.
The cure for low natural gas prices is working in a major way on Southwestern Energy. With cash flows crimped by decimated natural gas prices, the company is throttling way back on drilling -- as it should, given that drilling natural gas wells when the commodity price is at $2 is a money-losing proposition.
If Southwestern is suffering, then you can be certain virtually all natural gas producers are as well. That is how the cure to low commodity prices works. As natural gas prices turn back up, the market is again going to start paying attention to the vast high-quality asset base Southwestern has. Production from those assets is split evenly between the Fayetteville shale and Appalachia (Marcellus/Utica).
The following table from Southwestern's corporate presentation helps us understand just how much leverage the company has to higher natural gas prices. With natural gas at $3, Southwestern has 2,600 profitable drilling locations. At $3.50, that number jumps nearly 100% to 5,150. If we get to $4.00 natural gas, the number of drilling locations is an incredible 7,100.
Another way of looking at this is how much recoverable natural gas resource the company has at various natural gas prices. The numbers are huge at all of these natural gas prices, but they get a lot bigger with relatively modest increases in the commodity price.
At $3 natural gas, Southwestern has 25 trillion cubic feet of recoverable natural gas. With just a $1 increase in natural gas prices, that number more than doubles to 55 trillion cubic feet.
Interesting to notice is that Southwestern doesn't even include the current natural gas price of $2 in these slides. That's probably because almost all of these drilling locations are uneconomic at that price. Also worth noting is that while current production for Southwestern is split pretty evenly between the Fayetteville and Appalachia, the vast majority of the company's resource and long-term value is in Appalachia.
Southwestern Energy -- manageable debt
Natural gas prices haven't been great since the start of 2015. With prices now struggling to hold $2, Southwestern is hunkering down and trying to ride out the storm. Capital spending will be less than a fifth of what it was in 2013-2014 and less than a quarter of what was spent last year.
These low natural gas prices have Southwestern working hard to protect its balance sheet -- a balance sheet with over $4 billion in debt that at current natural gas prices is certainly very, very leveraged. Last year's cash flow of $1.5 billion is reasonable relative to $4 billion of debt. Expected 2016 cash flow of $500 million isn't.
Southwestern needs natural gas prices to increase. The good news is that Southwestern has the ability to wait for that to happen.
The company has no significant debt maturities until 2018. That provides two full years for natural gas prices to improve, and you can be sure Southwestern is already working on addressing that maturity.
Additionally, all of Southwestern's debt is unsecured, and the company has only one financial debt covenant -- debt to total book value not exceeding 60%. At the end of 2015, Southwestern had debt to total book of 38% and so was well within the boundaries.
The liquidity situation for Southwestern is also in very good shape. The company has $1.9 billion of undrawn room on a $2 billion revolver.
For the foreseeable future, Southwestern has no debt issues.
A word of caution
If you buy into Einhorn's view on natural gas prices then Southwestern is a really good company to own. There are no problems if natural gas stays down for 2016 and then rebounds in 2017, as Einhorn is betting.
This company has big, big leverage to natural gas prices.
You must also be aware, though, that $4 billion of debt and $500 million of cash flow is not a sustainable situation. That can't go on year after year, and if it does, this company, like so many others, is going to have really big problems.
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