Fund My Mutual Fund: Why are Natural Gas Producers Expanding Production So Aggressively?

While the price of natural gas is in the dumps US producers continue to expand production. Why? Oh I think it's pretty obvious. And it's nothing to do with the magical V shape recovery in the U.S.

As I often say as people mix natural gas and crude together as if its the same thing (hey "it's energy") - unlike crude which can benefit from economic growth in Asia, natural gas is largely a domestic commodity despite efforts to make it more transportable. [Mar 24, 2009: Will Liquified Natural Gas Turn this Commodity Global?] In fact the divergence between the price of oil and natural gas tells you all you need to know about the reflective economies of the globe versus US.

Global economy - huge drop in 2008 and then stabilization as weaker parts of the world offset stronger for the better part of 10 months

US economy - weak, weak, weak, weak, stabilizing the past 4 months at ... weak. No real bounce in the real economy even with constant feeding of money, taking from future generations.

It really is as simple as that when you break it down in the language of commodities.

But as this Bloomberg report says - the natural gas producers continue to churn out product: Gas Glut May Grow as XTO Energy (XTO), Devon Energy (DVN) Wells Prove Prolific

The largest U.S. natural-gas producers may be doing too well at the wellhead for their own good, pumping so much of the heating and power-plant fuel that prices won’t soon recover from last year’s market collapse.
XTO Energy and Devon Energy, two of the five largest producers of U.S. gas, yesterday reported record output and smaller declines in earnings than analysts estimated. Anadarko Petroleum Corp., London-based BP Plc and Chesapeake Energy. previously reported second-quarter output gains that helped them beat estimates.
Even as they lament a gas glut, the companies have been reluctant to let revenue and profits fall further in the short term by being the first to curtail output. Second-quarter production at Fort Worth, Texas-based XTO jumped 32 percent, and Devon of Oklahoma City had a 12 percent gain.

CEO talking to other CEO:

"you go first." "no you!" "no you!!"

"there is no way I'm cutting my production because my bonuses are based on stock prices going higher... my genius is reflected in the stock price. I don't care if the price of the commodity is going through the floor, I need my bonus." "good point! no one cuts!"

Ah the "market" efficiencies that arise when the self interst of those who build generational wealth as long as they hold their jobs for a few years.

“I think they might be cutting off their nose to spite their face here,” said Jim Byrne, an analyst at BMO Capital Markets in Calgary who rates Anadarko, Devon and XTO at market perform. “Everybody’s kind of worrying about themselves, and obviously that’s going to happen, but it doesn’t really bode well in our view, certainly for gas prices.”
“We’re growing production too fast,” said Scott Hanold, an analyst at RBC Capital Markets in Austin, Texas, who has outperform ratings on XTO, Devon, Chesapeake and Anadarko. “We need to slow down..."
The companies are pumping more gas than ever in the face of a demand slump and a supply surfeit that caused prices to plunge 72 percent from their 2008 high. U.S. gas supplies are 19 percent above their five-year average, driven by output from so- called shale plays. The U.S. Energy Department estimates that industrial gas demand will drop 8.2 percent this year.

Clearly our "price mechanisms" are broken in market after market when "the carrot" for those running the companies is based on things that have very little to do with adjusting to the market. Mmmm... love it; really no different from the banks. I wonder if the decisions would be different if CEOs made European style CEO wages and bonuses were based on 5 year targets that had nothing to do with stock price stoking. Nah.

One consequence of overproduction amid a recession-driven slowdown in demand is narrowing profit margins. For instance, Devon’s net income per unit of production tumbled 78 percent from a year earlier.

So how do you get around that problem? Just pump more of an increasingly unprofitable product into a supply glut. I mean if you can't make it up on margin, make it up on volume... anything to get that EPS to the "right spot".

Anadarko, based near Houston, raised its production forecast Aug. 3 and said it’s responding to low prices by cutting costs rather than slowing production.

*Scratching head*
*Pulling out Economics 101 High School Textbook* - ah yes right here: the rational response to lower prices, and gluts of supply are to curtail production of said item

(sic)

(new American edition of said Textbook) the rational response to lower prices and gluts of supply, is to lay off workers and increase production of said item - hence maintaining EPS, retaining bonus, while still flooding the market with more of said product.

**************

It's all connected folks - dysfunction throughout the system based on "free market" (free market as in fellow C-level executives and ex politicians setting your pay) compensation packages for a select few based on completely incorrect short sighted measures.

Oklahoma City-based Chesapeake said all U.S. gas-storage facilities will probably be full by the end of this year, increasing pipeline pressure and forcing production lower.

Then what? haha. Maybe they will sell natural gas to Goldman Sachs (who will not actually take delivery of it but let the producers shoot it off into the atmosphere) in return for future investment banking business. Anything to keep this silly game going. CEOs say "hey we found a buyer" and Goldman just racks up that future backlog of investment banking fees. We are all winners here.

And who better to display the excess CEO compensation than Aubrey C himself [Apr 3, 2009: Chesapeake Energy CEO with New Shady Compensation Deal, Old Deal Suddenly Replaced with New 5 Year Contract - I was Right in my Prediction]

“There was no reason for us to voluntarily curtail gas when pretty soon, everybody is going to start involuntarily curtailing gas, and so we didn’t see any reason to take it on the chin for the team more than we did,” CEO Aubrey McClendon said this week on Chesapeake’s earnings conference call.

That would be funny if not for the fact none of the major parties are curtailing production. But there is hope on the horizon. Foreigners!

International oil majors, not producers like XTO, will drive voluntary output cuts, Chief Financial Officer Louis Baldwin said.

Aha. So someone will blink - it just won't be anyone under US C-level compensation practices. Thank gosh for those international guys - go team Europe! They don't have much to lose compensation wise by adjusting to the market in a rational way. Whew, our saviors.

So the international guys will take one for the "team" and the US guys know where their bread is buttered... mmmm

Investors are rewarding companies for production gains. Devon rose 3.3 percent in New York trading yesterday after reporting higher-than-estimated output and profit. Chesapeake and Anadarko also had gains after their reports. XTO, which rose as much as 1.8 percent after its earnings statement went out, ended the day down 1.5 percent as all but four of the 19 oil companies in the Standard & Poor’s 500 fell.
“There’s a pretty clear correlation between production growth and stock performance,” Hanold said. “These exploration and production companies want to take advantage of that.”

And that folks is the reality of natural gas - at least my version of it. Even when the CEO's do stoopid things to destroy their net wealth, like going on leverage and selling all their shares via margin calls [Oct 11, 2008: Chesapeake Energy CEO Forced to Sell Nearly All Shares to Meet Margin Call]- the company is there to support them. Such as new compensation deals just 1 year into an old 5 year contract ... struck on New Year Eve's when no one is paying attention. Right Aubrey? You know all about taking one for the team? As long as its not you - and it's your company that took it for the team ... the team named Aubrey.

Chesapeake, an oil and gas producer in Oklahoma City, awarded the $75 million to Mr. McClendon as a result of a new, five-year employment agreement struck on New Year’s Eve by directors and the executive. Mr. McClendon’s new agreement replaced a relatively new, five-year contract struck in 2007 that, obviously, had yet to run its course.
... the board also awarded him the $75 million bonus.
“Given that Chesapeake’s earnings dropped by half,” said Marc I. Gross, a senior partner of Pomerantz, Haudek, Block, Grossman & Gross, which represents the Louisiana retirement system, “the $75 million bonus appears not attributable to Mr. McClendon’s exemplary performance but rather to the extraordinary losses he sustained when his Chesapeake shares declined by 60 percent. As such, the bonus appears to be a C.E.O. bailout, while ordinary shareholders got stuck with their losses.”
So who are the Chesapeake directors? In addition to Mr. McClendon, they are Don Nickels, former United States senator from Oklahoma; Richard K. Davidson, former chairman of the Union Pacific Corporation; Breene M. Kerr, an M.I.T. trustee; Charles T. Maxwell, an oil industry analyst; Frank Keating, former governor of Oklahoma; Merrill A. Miller Jr., chief executive of National Oilwell Varco, an oilfield services company; and Frederick B. Whittemore, an advisory director of Morgan Stanley.