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What Should You Do Before Energy Earnings?

 April 23, 2009 11:59 AM

Energy earnings start each season with the release of Schlumberger Ltd. (....slb) on a Friday.  As every seasoned investors knows, energy stocks are one of the most volatile sectors to play when companies release their quarterly results.  Often times it is a question of tracking how crude oil and natural gas preformed during the quarter in order to determine how the earnings season will treat the energy names, but this time around I believe there will be a lot of money to be made with counter-intuitive thinking.  Before getting into that, it is important to track where we have been during the course of the quarter. 

Believe it or not, crude oil actual rebounded slightly during the first quarter of 2009 rising from $44.60 to $49.66 for a gain of 11.34%.  Oil strength was mostly due to a rebound across all asset classes, especially after oil had dropped more than 70% from its July 2008 highs.  NYMEX Natural gas, however, was a completely different story dropping from $5.41 per Mcfe (thousand cubic feet equivalent) to $3.58 for a loss of 33.83%.  Part of this decline was due to the natural seasonal effects on the natural gas futures curve but a large portion was due to massive overproduction and imports coming into the United States.  Last week Chevron Corp. (CVX) warned that results for the first quarter were going to be uglier than investors had initially expected.  This will probably carry over to some of the other majors such as Exxon Mobil (XOM) and especially BP plc. (BP) with their large United States natural gas exposure.  More than the usual, energy companies have avoided giving guidance for first quarter and fiscal year 2009 to avoid the potentially massive shocks to their stock prices after an earnings miss.  This is a trend we will probably see continue for the next few quarters.  After digesting all of this information, conventional knowledge would tell you to avoid domestic natural gas companies before earnings season, but I think there is a lot of money to be made from the natural gas companies when they report earnings.

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This energy earnings season I am particularly drawn to the natural gas names because the sell off from the top has been so severe.  Because of this, there is undisputed value within these companies in regards to their hedging.  Almost all of the domestic natural gas producers hedge in one form or another, and in most cases these hedges will turn out to be a huge benefit during the quarter.  A great example of this will be Chesapeake Energy (CHK ).  In their April Investors Report, Chesapeake disclosed that they have 42% of their natural gas production hedged in swap contracts that average $7.79 and 40% of their natural gas production hedged in capped collar contracts with a floor-ceiling range of $7.30-$9.00.  As of February 13th, 2009, these contracts were worth an astounding $1.6B in mark to market value.  With natural gas prices dropping rapidly from that date to the end of the quarter, it is very likely that this number has grown much larger.  In almost all cases, when these contracts expire they will be cash gains that, net of tax, should basically jump directly to companies bottom lines.  I believe this is something that the general market has been ignoring when it punishes Chesapeake and other natural gas producing companies stock prices.

Other natural gas names to look at include Southwestern Energy (SWN), EOG Resources (EOG), XTO Energy (XTO ), Petrohawk Energy (HK), as well as any other name with domestic exposure that has hedging derivatives.  Many of these companies will miss earnings on a continuing operations basis but the derivative gains should either somewhat or completely offset these missteps.

- Charles W. Petredis

Disclosure: The fund the author manages is long CHK, SLB, SWN, and XOM.  The author is long CHK.  The author's family is long CHK and XOM.



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