NEW YORK ( TheStreet) -- As natural gas prices hit eight-month lows this week and some market pundits predict sub-$2 prices before 2012 is over, natural gas exploration and production stocks have suffered mightily. Chesapeake Energy (CHK - Get Report), Cabot Oil & Gas (COG - Get Report) and Southwestern Energy (SWN) have been among the losers.
In the first week of 2012, when Chesapeake and
(DVN) announced the completion of joint ventures with foreign players, the stocks were off and running and the deals were one more confirmation that currently out-of-favor natural gas hasn't slowed the
|Natural gas drilling market practices suggest the sector can't break the cycle of too much supply relative to demand crushing prices.|
Yet the fact of the matter is that while a Sinopec from China, Total (Total), BHP Billiton (CHK - Get Report) or ExxonMobil (XOM) can ride out any short-term pain in the natural gas market, the smaller E&Ps tethered to natural gas are exposed acutely to the current pricing doldrums.
Here are key reasons why natural gas exploration and production stocks are currently dying, and why the outlook isn't getting better any time soon.Even as natural gas supply continues to dwarf demand, production won't stop. In fact, production can't stop. There are three factors, let's call them "Catch-22s" in the natural gas market, that even if there are some production slowdowns as a result of the natural gas pricing weakness, won't be enough to bring supply and demand back into balance. First, many of the natural gas exploration and production companies have hedges in place for a majority of their drilling programs and as a result it really makes no difference at what price they are selling the natural gas. These companies often act like trading entities with hedging contracts more important to short-term finances than spot prices. It's with a tongue firmly planted in cheek that energy market experts say the bulge bracket firms' favorite client in recent years hasn't been a hedge fund but Chesapeake Energy. There have been recent quarters, for example, where an improvement in natural gas spot market pricing would have hurt Chesapeake Energy's performance, and there's something counter-intuitive about the financial market's ability to distort physical, on-the-ground reality. Into 2012, there has been a decrease in hedging activity that could limit the impact on gas drilling programs relative to previous years. Second, the leaseholds for much of the acreage held by E&P companies specifies that drilling must be done for the leases to remain under their control. Expect to see more triage done on these leaseholds -- with some companies deciding to give up the rights to the least economic natural gas assets if the worst-case scenario of sub-$3 pricing holds. Overall, though, this dynamic of the nat gas market implies that production will continue, even with natural gas below $3.