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Industry Analysis: Diversified Natural Gas
The Diversified Natural Gas Industry is comprised of companies that produce, market, and transport natural gas. Exploration and production activities are common in this industry. A number of companies also produce crude oil. Barriers to entry in this industry are fairly high for new entrants to overcome. Exploration and production initiatives take time and require substantial capital. Large companies can benefit from economies of scale, and seasoned drillers often have the greatest operating efficiency. An industry participant can benefit from a favorable competitive position for quite a long time. Healthy cash flow is important for success. Significant funds are required for natural gas companies to pursue drilling, maintain and upgrade equipment, and complete acquisitions.
Our presentation of historical figures, estimates and projections for most companies in this industry follows the standard Value Line page format. For those with utility operations, our array includes figures for total capital and net plant, along with long-term debt and common equity ratios.
Generally, the industry attracts aggressive investors, seeking above-average appreciation potential and willing to overlook a good measure of share-price volatility and financial risk. A few companies provide a nice dividend component.
Operating results are closely linked to the performance of natural gas prices. We use the Henry Hub spot price as a benchmark for the industry. Gas prices are affected by a number of factors, including industrial demand and supply. Temperature variations, affecting demand, or supply disruptions can heighten price swings.
Companies with ample and increasing production benefit the most during periods of economic expansion, when natural gas quotations can quickly rise. That said, this group is vulnerable to downturns, which can hurt demand and depress prices, as well as sales/revenue and earnings.
Sales and Earnings
Top-line performance is a very important measure that potential investors should note when considering natural gas companies. Natural gas prices and production levels drive sales. The markets in which a company operates are also worth noting. Sales and net profits can vary widely, depending upon the particular markets a company serves and its competitive position. Trends in profit margins are a good indication of a company's operating health. In addition, the return on equity helps to determine the profitability of a company and the effectiveness of its management.
When considering a particular company, we advise investors to review its revenue, cash flow, and share earnings track record. Our growth projections, which are found in the Annual Rates box on the Value Line page, will also be of interest.
A number of natural gas companies employ active hedging programs, locking in a certain price according to expected production volume. This conservative strategy puts a floor under earnings and ensures a fairly predictable cash flow. Hedging helps management to make more effective capital allocation decisions. However, it also limits upside potential, should natural gas prices increase dramatically.
Spending and Production
Many industry participants must make significant investments in production capacity to remain competitive. An active drilling program often comprises the lion's share of capital expenditures for companies engaged in exploration and production.
A company with holdings of resource-rich properties may have a considerable competitive advantage. Healthy reserve replacement and solid growth in total proved reserves from one year to the next are positive indicators. Investment in pipelines and storage infrastructure may also be important, depending upon the nature of a company's operations.
Assets and Partnerships
It is not unusual for natural gas companies to pursue acquisitions or form strategic partnerships. Such moves allow a company to expand its footprint, diversify the revenue stream, and gain access to a larger asset base. Large acquisition deals, which are primarily funded with debt, tend to be riskier. Small concerns may find themselves to be the target of an acquirer. The level of merger and acquisition activity depends on economic conditions, stockholder influence, and regulatory oversight.
Some natural gas companies looking to expand may opt for a simpler strategy, such as purchasing properties in resource-rich locations, rather than other operators. On the other hand, managements may elect to sell assets that are underperforming or deemed outside of the core business. This allows a participant to strengthen its balance sheet and increase spending (and focus) on essential operations.
Capital expenditures are often funded with debt. It is for this reason that prospective investors must pay close attention to the financial position of industry participants. An ample cash balance and a manageable debt load are obviously preferable, as these qualities afford a company greater flexibility to invest in operations and provide added cushion during periods of economic weakness. Conservative investors would probably prefer to avoid companies with excessive leverage. Thus, we advise investors to analyze the Current Position box on the Value Line page, along with a company's Safety rank and Financial Strength rating.