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Shale Gas: Too Much Of A Good Thing?

Posted: Sep 03, 2008 09:56 AM by Eugene Bukoveczky

Tickers in this Article: GS, AB, DVN, NFX, APC, XTO

Since hitting a high of more than $13 per thousand cubic feet (mcf) in the early part of July, natural gas prices have plunged more than 40% to their current level of about $8/mcf. This naturally prompted a sell-off in the shares of many of large independent natural gas companies, which are currently sporting fairly attractive valuations now that they're trading at levels that are roughly 20% lower than was the case just a month ago. Energy analysts have lately been pointing out that companies like XTO Energy (NYSE:XTO) and Anadarko Petroleum (NYSE:APC) are now trading at only five times their cash flow for 2009, compared to the 5.7 to 7 times range over the past two to three years. The recent announcement by Anadarko that it had authorized the repurchase of $5 billion worth of its shares - about 18% of its outstanding stock - appears to have put some substance behind this view. (Find out what these company programs achieve and what they mean for stockholders in A Breakdown Of Stock Buybacks.)

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Before placing any buy orders on this group, investors need to be aware of the fundamental shift that has taken place in the overall supply equation for natural gas in the North American market; we could soon be facing a once-in-a-generation supply glut, and the reason for it can be summed up in two words: shale gas.

Domestic Gas Production Set to Rise Dramatically
The recent record high prices for gas and the availability of new horizontal drilling technology has prompted a renaissance of natural gas drilling in North America, with a singular focus on unconventional shale gas fields. Over the last few years, we've seen the discovery of a number of fields, such as the Barnett in North Texas, the Haynesville in Louisiana, and the Marcellus in Appalachia. The output from these fields has proved to be so prolific that total domestic gas production in the U.S. was up 8.8% in the first five months of this year compared with the same period a year earlier. This represents a rate of increase that was last seen in 1959, during the great post-World War II drilling boom. It could be just the start of a huge upsurge in domestic production.

In a recent report, a Deutsche Bank analyst forecast that shale gas production would reach 6.6 billion cubic feet a day (Bcf/d) this year, accounting for almost 12% of national production. By 2011, production is expected to more than double to 14.5 Bcf/d. Eventually, sustainable production from just the big seven shale plays could reach 27 billion cubic feet per day; half of current total domestic natural gas production.

Total gas supply estimates have also been revised higher. A recent study funded by the American Clean Skies Foundation suggests that thanks to the success of shale gas exploration efforts, the U.S. now has total recoverable supplies of 2,247 trillion cubic feet, or 118 years worth at current production levels. That's up from earlier estimates of 1,680 trillion cubic feet, or 88 years of supply.

Gas Stocks Still Favored by Analysts
Despite the prospect of excess gas supplies keeping gas prices relatively low for the foreseeable future, gas stocks are still managing to make it onto analysts' buy lists. In a recent note to clients, the research arm of money manager AllianceBernstein Holding LP (NYSE:AB), recommended gas producers Newfield Exploration Co (NYSE:NFX) and XTO Energy. Goldman Sachs (NYSE:GS) recently placed Anadarko, Devon Energy (NYSE:DVN) and EOG Resources (NYSE:EOG) on its buy list. All of these companies are expected to achieve significant production and free cash flow growth in the future, in part due to their exposure to shale gas plays. (For more on analyst expectations, read Analyst Recommendations: Do Sell Ratings Exist?)

The Final Word
The prospect of a future with an abundance of cheap and clean burning natural gas might be placing a cap on the upside for the natural gas stocks at this juncture, but for the overall U.S. economy, this has to be good-news story.

Be sure to read our Oil and Gas Industry Primer to learn more about investing in this hot sector.

By Eugene Bukoveczky

Eugene Bukoveczky is a freelance writer and investment researcher. He holds a CFA designation and has spent several decades working in the investment business in places like Toronto, New York, London and Dubai. He currently resides in Nova Scotia, where, when not writing, he devotes his time to chopping wood, growing his own vegetables, riding his bike to the store, and thinking about other ways to reduce his carbon footprint.

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