How To Play The Oil And Gas Bull Run

Source: Business Insider

Yet, some experts are saying that this rally is far from over. Stan Brownell, an analyst at Argus Media, and Luke Jackson, an analyst at S&P Global Platts, figure that Henry Hub prices would have to jump to $10 or more to provide an incentive to fulfill domestic natural gas demand.

That would mean nearly doubling of natural gas prices from current levels to levels last seen in 2008 when the U.S. produced about 40% less natural gas.

International natural gas demand is booming

An unusually cold winter in Europe as well as a global rebound from Covid-19 have triggered strong demand and depleted natural gas inventories. Meanwhile, Hurricane Ida has knocked out a considerable amount of gas production, with 77% of oil and gas production still offline in the Gulf of Mexico. According to U.S. government statistics, natural gas inventories are currently 17% lower compared to a year ago and 7.4% below the five-year average.

To catch up to the five-year average storage level by early winter, U.S. natural gas producers need to inject roughly 90.4 billion cubic feet each week from now, about 40% higher than the five-year average weekly buildup clip. The latest data by the Energy Information Administration shows that nat. Gas inventories climbed 52 bcf last week, way below what is required to build enough stockpiles for the winter.

Interestingly, the analysts note that U.S. consumption isn't really the driving force behind the strong price action. Indeed, according to data from the U.S. Energy Information Administration, domestic natural-gas consumption through June was in line with 2020 levels. The real culprit here is robust international demand for natural gas as well as a fast-growing U.S. LNG sector.

In the first half of the year, the U.S. exported roughly 10% of its natural gas, or 41% more than a year ago. Normally, excess natural gas produced during the summer would go into underground storage. But that domestic stockpiling has been lower than normal, with producers exporting much of it as LNG.

Asia and Europe still need to stock up more to prepare for the winter, and much of their supplies will have to come from the U.S. because non-U.S. LNG exporters have mostly been down with maintenance-related snags.

For instance, Russia, Europe's most important natural-gas provider, has been slowing its deliveries. Natural gas inventories in Europe are currently a whopping 16% below the five-year average and at a record low for September. Meanwhile, continuous unplanned outages at LNG export facilities in several countries, including Australia, Malaysia, Nigeria, Algeria, Norway, and Trinidad and Tobago, have contributed to increased demand for U.S. LNG.

Europe's natural gas spot prices have historically been lower than prices in Asia; however, this year, Europe's natural gas prices are tracking Asia's spot LNG prices more closely to attract flexible LNG supplies from around the world to refill storage inventories.

A severe winter in the U.S. could lead to domestic markets having to compete with hungry Asian and European buyers, thus driving prices even higher. A severe winter in the U.S. could easily lead to an even crazier surge in natural gas prices.

Commodity price hedging is a popular trading strategy frequently used by oil and gas producers as well as heavy consumers of energy commodities such as airlines to protect themselves against market fluctuations. During times of falling crude prices, oil and gas producers normally use a short hedge to lock in oil prices if they believe prices are likely to go even lower in the future.

According to Tudor Pickering Holt & Co via Barron's, the majority of the energy companies they cover have hedged away significant portions of fourth-quarter cash flow (about 85% hedged on average in the US).

Unfortunately, hedging also means that these companies are unable to enjoy the benefits of rising gas prices and can, in fact, lead to hedging losses. However, some bold producers betting on a commodity rally hedge only minimally or not at all.

Tudor Pickering rates Chesapeake Energy (NYSE:CHK) a Buy, saying the company remains one of the few producers that remain relatively unhedged. This might come off as an odd pick given Chesapeake's history, but it somehow makes sense at this point.

Widely regarded as a fracking pioneer and the king of unconventional drilling, Chesapeake Energy has been in dire straits after taking on too much debt and expanding too aggressively. For years, Chesapeake borrowed heavily to finance an aggressive expansion of its shale projects.

The company only managed to survive through rounds of asset sales (which management is averse to), debt restructuring, and M&A but could not prevent the inevitable—Chesapeake filed forChapter 11 in January 2020, becoming the largest U.S. oil and gas producer to seek bankruptcy protection in recent years.

Thankfully, Chesapeake successfully emerged from bankruptcy this year with the ongoing commodity rally offering the company a major lifeline.

The new Chesapeake Energy has a strong balance sheet with low leverage and a much more disciplined CAPEX strategy. The company is targeting $2 billion of FCF over the next 5 years, enough to improve its financial position significantly.

CHK shares are up 40% since its March comeback.

Meanwhile, Mizuho has picked Cimarex Energy (NYSE:XEC) as another stock to play the natural gas boom.

Mizuho has upgraded XEC to Buy from Neutral with a $95 price target, citing the company's "now-attractive free cash yield" following the recent weakness and payout capacity of its merger with Cabot Oil & Gas (NYSE:COG).

Mizuho says the combined entity trades at an attractive value compared to oil peers and at "just a small premium" vs. gas peers following weakness since the merger announcement.

According to Mizuho's Vincent Lovaglio:

"Balance sheets have improved significantly YTD, positioning the group for attractive cash return not only at $65/bbl but through the cycle, and we remain very constructive for that reason, with average upside 46% in our oil coverage."

Natural gas already makes up the majority of Cimarex's production which should climb even further after its merger with Cabot, another primary natural gas producer.

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