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Chesapeake Energy Corporation (CHK): 3 Lessons From the Natural Gas Revolution

The shale gas revolution in the U.S. has rocked the energy industry like a hurricane, and in its wake there have been a lot of lessons we have learned along the way. With natural gas prices stabilizing and some natural gas producers eking out profits again, it seems as good of a time as ever to reflect on what the boom in natural gas has taught us about the energy space. Let’s look at three lessons that should shape the industry for the next couple years to come.

Earnings Quality Report: Chesapeake Energy Corp. (NYSE: CHK)

1. Take a deep breath and pace yourself. We could also call this lesson “Ode to Chesapeake Energy Corporation (NYSE:CHK)“, because it serves as the quintessential example of what not to do. When horizontal drilling and hydraulic fracturing proved to be a viable way to access scores of shale gas, exploration and production companies bought exploration leases from anyone within earshot of a shale play. In doing so, they put themselves in a bit of trouble because they broke three crucial rules:

Don’t outpurchase your production: When an E&P company leases energy rights, they have a certain time window to start producing and need to continue producing or risk losing the lease. With so much new land and not enough capital to drill, several gas companies, including Chesapeake Energy Corporation (NYSE:CHK) and Enerplus Corp (USA) (NYSE:ERF), have walked away from gas leases, taking a loss on the original purchase.

Don’t outproduce your infrastructure: What makes natural gas more difficult than oil is the ability to transport and store gas. Many companies have resorted to to flaring off gas because they have no means of transporting it. The most glaring example is in the Bakken, where the Energy Information Administration reports that more than one-third of all natural gas produced in the region is flared off.

Don’t flood the market: With so much production and so little takeaway capacity, natural gas prices fell through the floor. Last April, the Henry Hub spot price hit a 10-year low, thanks in large part to copious amounts of natural gas that hit the market. Natural gas companies such as Chesapeake Energy Corporation (NYSE:CHK), Ultra Petroleum Corp. (NYSE:UPL), and EXCO Resources Inc (NYSE:XCO) all saw their share prices tumble with gas prices as well.

CHK Chart

CHK data by YCharts.

What was so devastating was that companies couldn’t slow down production enough to break the cycle, so it took until rock-bottom last April before production slowed enough to stabilize prices. Now, prices are slowly inching back up. Let’s hope companies will learn some patience when expanding into newer speculative plays.

2. Our pricing mechanism gives the U.S. a leg up. The U.S. has some inherent disadvantages against global competitors. We have a mature consumer market with relatively high manufacturing costs. Surprisingly, though, the emergence of cheap natural gas has emerged as a strong competitive advantage for the United States. Many might point directly to production increases, but what is just as important is America’s method for pricing natural gas. The U.S. is one of the very few countries in the world that dictates natural gas prices based on a spot price. Much of Europe and Asia’s natural gas prices are indexed to oil at a BTU equivalency. So while a standard thousand cubic feet of natural gas in the U.S. trades at a ratio of about 33 to one barrel of Brent crude, many European and Asian nations have gas fixed at a six-to-one barrel-of-oil ratio.

For a long time, natural gas has been a relatively regional product, so the two pricing mechanisms could exist. Now, with companies such as Cheniere Energy, Inc. (NYSEMKT:LNG) charging forward with plans to export LNG within the next two years, these two pricing models will clash. If North America’s cheap natural gas starts to hit European and Asian ports, will they break their oil-indexed pricing models? Or will we be able to ride our free-floating prices all the way to the bank?

3. Natural gas users have come out of the woodwork. We could also call this lesson the “Field of Dreams” rule. If you build a cheaper alternative to oil, companies will come. Here are a few examples of industries that are looking to take advantage of natural gas:

Thanks to cheaper feedstocks for chemical building blocks in the U.S., The Dow Chemical Company (NYSE:DOW) and Exxon Mobil Corporation (NYSE:XOM) plan to expand their ethane cracking capacity by 1.5 million tonnes per year. These are only two of the most notable companies in an industry that’s expected to spend about $65 billion between now and 2017 to increase capacity.

The large disparity between the price of a gallon of gas or diesel and a gallon equivalent of compressed natural gas is giving credence to using natural gas as a transportation fuel. Westport Innovations Inc. (USA) (NASDAQ:WPRT) , a pioneer in diesel-to-natural gas engines, has seen revenues grow by more than 400% in the past two years since natural gas has been cheap enough that it’s justifiable to convert from gasoline to natural gas.

Natural gas has also put a lot of pressure on the utility sector to adopt a wider generation portfolio. Exelon Corporation (NYSE:EXC) with its weak natural gas portfolio, just recently cut its dividend in large part because low natural gas prices have cut into earnings. While some utilities may be wary of a big uptick in price, many have planned to balance out their generation capacity with natural gas in the next few years as some coal plants start to retire.

The article 3 Lessons From the Natural Gas Revolution originally appeared on Fool.com and is written by Tyler Crowe.

Fool contributor Tyler Crowe owns shares of Westport Innovations. You can follow him at Fool.com under the handle TMFDirtyBird, on Google +, or on Twitter, @TylerCroweFool.The Motley Fool recommends Exelon, Ultra Petroleum, and Westport Innovations; owns shares of Ultra Petroleum and Westport Innovations; and has options on Chesapeake Energy and Ultra Petroleum.

Copyright © 1995 – 2013 The Motley Fool, LLC. All rights reserved. The Motley Fool has a disclosure policy.

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