Who Emerges Stronger from the Natural-Gas Downturn

Pat Dorsey: Hi, I’m Pat Dorsey, Director of Equity Research at Morningstar. You see a pattern over the past few years here at Morningstar in natural gas prices with the soft natural gas prices in the fall when people aren’t really running out of conditioners a whole lot or heating their homes a whole lot to sometimes be followed by higher gas prices in the winter when the man snaps back considerably. This year with the economic climate and it's worst in several decades, we’re seeing a somewhat different picture and that’s cost us a long with some other factors related to investment then on the pretty heavy side in natural gas capacity over the past few years to reassess some of our thinking in this sector. Lucky to have with me is Social Director for Equity Research, Eric Chenoweth to help us sort through where we’re sitting right now with energy companies in general and natural gas companies in particular. Thanks for joining me here. Eric Chenoweth: Thanks Pat. Part Dorsey: So, a big picture we’ve long talk about kind of soft short term given the economic climate still a positive picture longer term, given the demand pictures but we’ve been changing that a little bit recently? Eric Chenoweth: Well, there’s been an incredible declining industrial demand for gas and that really hit, a lot of it is auto driven but across the board, the chemicals industry is suffering. We’ve seen a lot of bankruptcy announcements from chemicals companies and that’s driving all this unpleasant weakness and industrial demands. Part Dorsey: Well, you’ve been seeing some softer residential demand. I mean typically, that’s very, very stable and aren’t we seeing actually kind of like you know, that number of move people actually turning down the—is that? Eric Chenoweth: There are some reports, yeah. The folks are actually you know a little bit economically sensitive with their home hitting this winter. Part Dorsey: Yeah and that sounds something we would normally see because normally that sort of residential demand for natural gas is very, very stable. Eric Chenoweth: That’s considered pretty a nondiscretionary. Part Dorsey: Typically. Very typically, exactly but so—now you combine this with kind of this—and boom we had over the past few years and drilling activity and that’s what you’re thinking that might make this downturn natural gas crisis last a little bit longer. Eric Chenoweth: Exactly and the challenge is we still have the legacy of this boom and drilling, it is going to be with us for a little bit longer even though if you read much about this you know that we’re dropping rigs every week and there’s less drilling going on. Peep companies are cutting and their spending–you still have the legacy of the 2008 big investment program and that’s going to follow through in terms of higher output in the first quarter and probably in the second quarter so— Part Dorsey: Because companies are cutting back through drilling and expiration but it doesn’t happen overnight. Programs they put in place in the middle of LA are still flowing through and so that’s why we’re seeing production continue to rise despite the soft demand picture. Eric Chenoweth: Exactly and we expect that to start to float through one of the second half this next year but in the mean time we have production still very strong and in demand very weak. Part Dorsey: And so, you know, you might hope for the demand side to moderate to become a little tighter in the back half of this year and then you know whenever the economy resumes growing again. Eric Chenoweth: Sure. Part Dorsey: That would then push prices back up again because we’re still abolishing a long term picture, right? Eric Chenoweth: Yes, and one of the other reasons too, we decided to cut a long term even long term number even though we see a very bullish long term, this is still is that we think that the amount of rigs that came to market, there’s going to be a bit of—I think we’re about 1/3 off our peak ridge running in the US now. And we think we’re going to drop to about half of the peak but that still needs a lot of rigs out there when the producers decide to start investing again to keep cost very low. There’ll be a lot of excess supply, a lot of weak pricing which means a lot of this place will have lower development cost and they would have add in the tight market. Part Dorsey: And so for investors looking to start putting together a shopping list in advance have sort of longer term fundamentals because supply will come down eventually and the economy will grow again eventually. What kinds of companies should they be looking at? Eric Chenoweth: Sure, I think the market’s really segment of the group quite a bit and one of the areas that will be able to take advantage of this type of environment, they’ll have the cash on hand to take advantage of weaker players and assets coming to market at cheap prices would be the companies that either under invested or didn’t do a lot of deals in the last few years. I kept that really low or did a combination to lower that with some hedges. Part Dorsey: And they’ll be looking EOG or ultra for example. Eric Chenoweth: EOG and Ultra that would probably come to mind on the MP side. EOG’s always run a very you know a very conservative financial profile of their company. And they had a very unusual move the summer to hedge that’s which is something they typically haven't done but they got concerned and they look forward so that’s benefiting them on top of that. Part Dorsey: Because they’ve probably lack in some pretty good prices if they hedge that down— Eric Chenoweth: Directing good prices, they have a very low debt levels. And the other thing new about them is their business model focuses more on grabbing up acreage which will be the types of properties that are you know prevalent and cheap. Part Dorsey: Yeah and in the same way, let's say last fall, you had four sellers of financial assets of this. It sounds like, you know, maybe we’ll have forced sellers of energy assets of acreage coming up in the future. Eric Chenoweth: Sure on the flip side, the companies that aren’t like—the companies that did do some deals this summer and I’ going to say they are now going to be faced with the reserved base shrinking possibly, getting written down plus lower prices to value that so the bankers might tighten the screws a bit on them. And if they—back their capacity for those folks to borrow and invest, they might need to come to market with some assets sales sooner than or faster than they would hope. Part Dorsey: Now, Ultra and EOG are more sort of mid, mid cap companies. You know one of the larger cap side, we have the companies that are perhaps not you know specifically exposed in natural gas but which are you know still going to be able to take advantage of an environment and which capital is the scariest resource and get some cheap acreage. You will be looking at all of the majors and in particular anyone with larger cap area? Eric Chenoweth: A lot of them have ramp in price so it's challenging to keep an eye on the EXON and Chevron have been some of our favorites. They’ve run up quite a bit but I think a lot of the European majors now are interesting. VP might even want to keep an eye—a lot of these companies are very interested now and taking advantage of the weakness in North America. They are bit different. They won't be out there scrappy kind of looking for acre. They’re going to want big, big deals they can pull off. I think oil sands in a lot of cases we’ve heard a lot of rumors—in the past month or so. Also, large acre positions in this big shell place. VP has been doing some stuff of just a peak. Stat oil came into the Marcelo’s so I’d say, I’d look for more and more of that and the other thing too with these Europeans—they haven shell in Europe and they haven’t really crack that code yet there or so. Part Dorsey: And so acquiring companies in the US might give them some in house expertise that they could transport back home to use and develop the shell in you— Eric Chenoweth: Sure. Part Dorsey: Thanks— Eric Chenoweth: Thank you. Part Dorsey: I’m Pat Dorsey and thanks for watching.