The EPA recently decided not to publish a report trying to link ground water contamination to fracking, due to weak findings. With environmental concerns falling away, fracking firms will have free reign to increase production, if they can. Given then high decline in shale production wells, it is time that investors take a less sanguine look at the market.
US Producer Price Index: Natural Gas Liquids and Residue Plant Condensate, Ethane, Mixtures, Other data by YCharts
Free market chaos
In the past decade increased drilling has driven natural gas prices to very low levels. The majority of this increased production is driven by horizontal fracking wells with rapidly declining production profiles. The above chart shows how natural gas production has increased 21.92% in the past five years and 4.15% in the past year, but it has fallen by -0.07% in the past six months.
The increase in natural gas production created a collapse in the natural gas pricing. This caused many drillers to move into natural gas liquids (NGLs) rich plays where they can make money from other substances like butane and condensates. As the industry moved into NGLs the supply boom in NGLs caused prices to fall, and drillers were stuck in the same situation. Now they are looking for crude oil rich plays, like the Bakken formation in North Dakota.
Beware of rosy projections
Regardless, analysts are warning of over stated reserves. While the shale bubble will not burst overnight, eventually companies with high debt loads will have to face the music. The Romans taught us that fortune favors the bold, but it also favors the patient. Shorting the fracking bubble isn’t a six month game. As the years go by production levels will continue to fall, and increasingly more capital will be needed to defeat declining production.
Chesapeake Energy Corporation (NYSE:CHK) is one firm to avoid or consider shorting. This natural gas fracker was driven into the ground by its former CEO, and it still has a total debt to equity ratio of 1.06. The company has already sold off stabilizing midstream pipeline assets and sold a number of other assets into trusts. These asset sales allowed the company to survive, but it has left it a less stable firm.
The company has shifted its focus to oil rich plays, but it still faces a number of challenges. Its Q1 2013, production in the greater Anadarko Basin was just 38% oil. It is expected that its current earnings before interest and taxes (EBIT) margin of -3.8% and profit margin of -3.7% will increase, but investors need to take a hard look at Chesapeake Energy Corporation (NYSE:CHK)’s long term trajectory.
Chevron Corporation (NYSE:CVX) is involved in the U.S. shale market through in the Marcellus Shale play and others. At the same time Chevron Corporation (NYSE:CVX) is better diversified than Chesapeake Energy Corporation (NYSE:CHK). Its diverse international upstream earnings were over four times greater than its U.S. upstream earnings in Q1 2013. It is also involved in the liquefied natural gas (LNG) market. The company continues to work on its Gorgon and Wheatstone LNG projects in Australia.
While the deflating fracking boom will impact Chevron Corporation (NYSE:CVX), it is a large diversified company with a manageable total debt to equity ratio of 0.1. Its international operations will help to maintain its EBIT margin of 19.5% and profit margin 11.4%.
North Dakota Crude Oil Production data by YCharts
A long candidate
Suncor Energy Inc. (USA) (NYSE:SU) makes money in the Canadian oil sands. Canada’s energy producers have been heavily affected by the boom in U.S. energy production. U.S. producers have an advantage as they are closer to refineries in the Gulf Coast and Midwest. The above chart shows how North Dakota’s oil production has increased almost 400% in the past five years, but in the past year it has increased 21.71% and in the last six months it has increased just 1.65%.
As the fracking boom cools down Canadian oil producers will have an easier time buying pipeline space. More pipeline space will help margins by decreasing transportation costs. Right now, refinery restarts are helping Canada’s oil sand producers get better prices for their heavy oil. With a total debt to equity ratio of 0.28 and a market cap around $45 billion, Suncor Energy Inc. (USA) (NYSE:SU) is a stable oil sands player. Its EBIT margin of 13.2% and profit margin of 6.2% are not amazing, but these numbers will improve as U.S. fracking boom calms down.
Conclusion
Production from fracking is starting to taper off. Highly indebted companies like Chesapeake Energy Corporation (NYSE:CHK) are in a dangerous situation. Larger competitors like Chevron Corporation (NYSE:CVX) are more diversified and better suited to deal with the coming challenges. Suncor Energy Inc. (USA) (NYSE:SU) has seen a number of challenges over the past couple years, but its healthy oil sands production will differentiate it from U.S. tight oil producers.
The article The Next Big Energy Short Is Coming originally appeared on Fool.com and is written by Joshua Bondy.
Joshua Bondy has no position in any stocks mentioned. The Motley Fool recommends Chevron. The Motley Fool has the following options: Long Jan 2014 $20 Calls on Chesapeake Energy, Long Jan 2014 $30 Calls on Chesapeake Energy, and Short Jan 2014 $15 Puts on Chesapeake Energy. Joshua is a member of The Motley Fool Blog Network — entries represent the personal opinion of the blogger and are not formally edited.
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