Which Stocks Will Lose the Most in the Coming Energy Bloodbath

[20MillionDinar]

Which Stocks Will Lose the Most in the Coming Energy Bloodbath

By Marin Katusa, Chief Energy Investment Strategist, Casey Research

Friday, May 11, 2012

Yesterday, I made a prediction that should scare a lot of investors.

I predicted a massive loss in market valuation for some of North America's largest energy producers. You might own some of these names yourself.

I'll share some specific names with you in a moment… But before we cover them, it's important you know the dynamics that will drive them lower.

I covered the first dynamic yesterday. It's called "reserve write-downs."

As you probably know, the price of natural gas has collapsed more than 60% over the past 12 months. Energy firms that carry billions of dollars of reserves on their books based on the "old" prices (around $4 per MMBtu) will have to "write-down" the value of those reserves to reflect the new prices (below $2 per MMBtu).

Natural gas reserves that were "economically recoverable" – and thus, extremely valuable – when natural gas traded for more than $4 per MMBtu back in 2010 are going to be worth much, much less… now that natural gas is below $2 per MMBtu.

The second dynamic involves "hedging."

Hedging is when one party agrees to sell a commodity to another party at a particular price in the future. This strategy helps commodity producers and consumers know in advance what their price of a given commodity will be. It gives both parties a greater ability to plan for the future.

For example, a farmer might agree to sell his corn for $6 per bushel before he even harvests it. Or an oil producer might agree to sell his production for $100 per barrel. This gives the farmer and the oilman the certainty they need to run their budgets. Even if the prices of their given commodities fall, both the farmer and the oilman are protected from price declines. They've "hedged" their production.

Hedged natural gas contracts have protected many producers from the full wrath of today's rock-bottom prices. They've been able to sell their production at relatively high prices… even while the spot price collapsed.

But… for a lot of producers, these higher-priced hedges are about to expire.

Encana, Canada's largest natural gas company, is a good example. The company had prudently hedged lots of the gas it sold over the last six months. This means it was still realizing $4 or $5 per MMBtu on its sales. Now, those hedges are expiring… and the new hedges are at much lower prices. Encana's cash flow and its economically recoverable reserves are going to plunge.

Encana isn't the only natural gas company in this situation.

In recent months, the second-largest natural gas producer in the U.S., Chesapeake Energy, removed most of its gas hedges for 2012 and 2013 based on the belief that prices are at or near a bottom.

Such a move, known as going "naked to the strip," marks a major turnaround for a company that was one of the best and most active hedgers in the sector. Now, Chesapeake has no protection if gas prices continue to slide. It's a risky scenario seeing as prices are currently below production costs in most U.S. gas basins.

For investors, the fact that many North American gas producers are seeing their high-priced hedges expire makes it more important than ever to understand a company's cash flow picture going forward.

An investor must ask the following questions…

• What percentage of production remains hedged and at what price? • How much will a company have to sell at or near the spot price? • What is the company's average cost of production? • Is the loss of high hedges about to send the company into the red?

These are the questions you need to ask… But be warned: you won't find very many producers with pretty short- and medium-term cash flow pictures. I expect natural gas prices to remain between $1.50 and $2 per MMBtu for the next 12 months.

Those prices will render a lot of production uneconomic. They will force companies to massively write down the value of their reserves. Cash flows will plummet. Shares in gas producers, while down a lot over the past year, will fall more than 25%.

The bloodbath in natural gas stocks is about to get worse.

Regards,

Marin Katusa

How You Can Profit From the Market's Next Big Collapse

By Marin Katusa, Chief Energy Investment Strategist, Casey Research

Thursday, May 10, 2012

If you think the bloodbath is over for natural gas stocks, think again…

Despite falling 50% over the past year, many natural gas stocks are about to enter another major decline.

And if you know what's going on here, you can use this coming decline to make huge capital gains over the next 12 months.

The key idea in this coming trade is something called "reserve write downs." It will cause billions of dollars of market valuation to vanish… overnight. Some very well-known energy firms (that you might own) will suffer huge share price declines.

Here's how it's going to work…

A resource estimate is a geologic "best guess" of how much of a commodity exists within a particular deposit, be it ounces of gold, barrels of oil, or cubic feet of natural gas. A geologist takes information about the deposit's size and grade from drilling results… and then creates a statistical model of the deposit. From that model, he or she can estimate the size of the resource.

However, the amount in the ground is not the amount that can be produced. That's where the reserve estimate comes in. Reserves are a whittled-down subset of total resources. That whittling-down process has two steps.

First, geologic and technologic factors determine a resource's recovery rate, reducing the resource to the parts that are "technically recoverable." For example, recovering oil in conventional fields like those in Saudi Arabia is much easier than recovering oil trapped in tight layers of rock.

Then, economic considerations further reduce the resource to only the bits that are "economically recoverable." In other words, the higher the price of a given commodity, the higher the "economically recoverable" reserves are. If oil is at $120 per barrel, a field has much more "economically recoverable" oil than it does when oil is at $60 per barrel. The higher prices allow firms to spend more money to recover more oil.

With natural gas, the advent of horizontal drilling and multi-stage fracturing altered the first parameter dramatically, ballooning North America's technically recoverable gas resources. And while natural gas prices held steady, reserves ballooned too.

The key bit there was "while gas prices held."

But that honeymoon is over. Natural gas prices in North America have declined roughly 35% this year and are down approximately 60% over the last 12 months. Compared to the unsustainable highs reached in 2008, gas prices have fallen more than 80%.

Natural gas has become a victim of its own success. The incredible technological successes of the last decade enabled producers to book massive volumes of natural gas resources… and increase output significantly.

The result: supply overwhelmed demand, and natural gas prices tanked. This has already crushed natural gas producers… But it's going to get worse.

Companies are valued according to their reserves. And remember, reserves are defined as resources that are economic to extract using existing technology.

Natural gas is now worth less than $2 per MMBtu (the standard pricing unit for natural gas), less than half the $5.82 per MMBtu it has been worth on average over the last decade. A much-reduced price means that less of North America's new natural gas bounty is anywhere close to economic.

And that means reserves – and stock prices – are about to fall dramatically.

Companies haven't downgraded their gas reserves yet because reserve calculations use the 12-month strip price, which is based on gas futures over the coming year. Changes in the strip price lag changes in the spot price.

"AECO" is the price of natural gas in Alberta… and is one of the leading gas benchmarks for North America. Right now, the AECO spot price is C$1.53 per MMBtu… while the year-to-date average AECO 12-month strip – which is the price producers use for reserve estimates – is C$3.21.

But even though it is a bit behind in its decline, the strip price is on the same downward spiral as the spot price… And soon, it will take reserve counts down with it.

When the strip price comes into line with the spot price – and the reserve overvaluation that a higher strip price has been creating disappears – I expect most natural gas companies will be forced to downgrade their reserves by 40%.

When they do, investors will flee, share prices will fall, and the already-pummeled natural gas sector will have to endure another beating. That's why I recommend investors avoid – or consider shorting – companies vulnerable to the coming decline.

In tomorrow's essay, I'll show you a few specific companies… and the other dynamic that will drive them much lower.

Regards,

Marin Katusa

[cris]

Could you give us a quick lesson on Shorting a stock?

[20MillionDinar]

Could you give us a quick lesson on Shorting a stock?

If an individual thinks the price of a stock will go down, he/she essentially thinks that the current price of the stock is a good price at which to sell. That person would ask to borrow a certain number of shares from a bank to sell immediately. Once the stock is sold, the borrower still has the obligation to return the shares to the bank. That means the borrower will have to eventually buy the stock back on the stock market at a later date – also known as “buying to cover” or “covering a short position”. However, in order to make a profit, the borrower wants to buy the stock at a lower price than the price at which they originally sold the stock. The concept of shorting stock remains to buy low and sell high, however, shorting a stock requires you to perform these two steps in reverse order than when making “long” investments.

A sample short transaction would look like the following: An investor would borrow 100 shares of a stock currently trading at $10 per share, and immediately sell those shares for a total of $1000. The proceeds from the sale would be frozen in that investor’s account to cover the total needed to eventually buy the stock back. Several days later, the stock falls to $8 per share, and the investor covers his short position by buying back 100 shares. He buys those shares for $800 and returns them to the lender. The investor earns the difference between the original sale of $1000 and the subsequent cover of $800, for a total profit of $200.

The bank’s incentive to loan someone stock is that they can charge an interest fee on the value of the sale proceeds generated on the stock they lend. Plus, they know that they’ll get the stock back in the future, a fact which limits their own portfolio risk: Banks know that they will be better off lending than not, because regardless of the direction of the stock’s price movement, they will have the same amount of stock, but will also have the added interest income associated with lending the stock.

http://www.marketocr...bHgJmKiMaKiAbDm

This is how you would do it with E*Trade:

Sell-short and buy-to-cover orders

Just as buying a stock allows you to profit when the price rises, selling short makes it possible to profit from a stock price's decline.

The traditional way to make money on a stock is to "buy low and sell high." When you sell short, you hope to do just the opposite. First, you sell shares you don't own (which you borrow from your broker), and then you buy them back later (hopefully at a lower price). There are certain

risks involved in selling short, and it's important to know what they are before placing this kind of trade.

You must have a

margin account in order to place short sales. When you use margin, you are borrowing money from E*TRADE Securities based on the value of the cash and securities you currently have in your account. You are charged interest on the amount you borrow, and the holdings in your account serve as collateral to secure the loan. You can hold the shares short as long as you meet the margin requirements for the position, and as long as E*TRADE Securities is able to continue to borrow the shares.

To open a short position, you enter a sell-short order; to close it, you enter a buy-to-cover (not a regular buy order). The buy-to-cover order effectively returns the borrowed shares to your broker. For step-by-step instructions on how to place a trade, see the Help topic

Place a stock order

.

Before you can sell a stock short, your broker must first have access to the shares you want to borrow.

Edited May 11, 2012 by 20MillionDinar

[WallyWeaver]

I have had my eye on Encana (ECA) for a few months now but have not pulled the trigger yet. The truth is I have been waiting to get my hands on a farmers almanac to see if we are expected to have a cold winter or not.

This past warm winter has also contributed to the low price for natural gas, no question. Ultimately, though, if natural gas remains low and gasoline keeps rising it could be the impetus needed to spur natural gas engine/ vehicle production on a large scale here in the US. Which could become very profitable for natural gas investors. The trick will be getting in at the low or near the low..... but that's always the trick, isn't it?

WW.

[20MillionDinar]

I have had my eye on Encana (ECA) for a few months now but have not pulled the trigger yet. The truth is I have been waiting to get my hands on a farmers almanac to see if we are expected to have a cold winter or not.

This past warm winter has also contributed to the low price for natural gas, no question. Ultimately, though, if natural gas remains low and gasoline keeps rising it could be the impetus needed to spur natural gas engine/ vehicle production on a large scale here in the US. Which could become very profitable for natural gas investors. The trick will be getting in at the low or near the low..... but that's always the trick, isn't it?

WW.

I agree. Natural Gas is definitely the World's next great fuel revolution. However, timing is everything. I'm going to wait this out a little longer. I didn't really understand much about "Reserve Write-Downs" until yesterday and it has given me a new perspective. I definitely have more homework to do!

Also, I didn't really think about Natural Gas for heat in the winters, probably because nobody uses it out here in Hawaii! LOL

Edited May 11, 2012 by 20MillionDinar

[cris]

Thank you very much, I've wondered for a while and

never took the time to wade thru the process of googling

the answer

I really appreciate your insight

[20MillionDinar]

Thank you very much, I've wondered for a while and

never took the time to wade thru the process of googling

the answer

I really appreciate your insight

No problem Cris. Glad I could help.

[WallyWeaver]

I definitely have more homework to do!

Also, I didn't really think about Natural Gas for heat in the winters, probably because nobody uses it out here in Hawaii! LOL

As far as homework goes..... man, I think we all have more homework to do.

The truth is the learning never ends... if you want to be successful.

I was watching Cramer last night and he was talking about the VIX and using several different "lenses" to view it from that seemed to indicate that the S&P will have a 5-6% decline at the end of this month. After listening to his breakdown I was reminded of what you just wrote: I still have much, much more to learn.

As far as your last comment... too funny, life must be good on "the big island."

We have it pretty good here in SoCal, though, too. Hard to complain about an average temp. of around 70 degrees F year 'round.

WW.