By Marin Katusa, Chief Energy Investment Strategist

I recently gave an interview on Business News Network (BNN) about natural gas. BNN is Canada’s largest news channel dedicated exclusively to business and financial news, so all kinds of market players rely on BNN to provide them with comprehensive coverage of global market activity from a Canadian perspective. Like similar news channels in the US, BNN intersperses real-time news coverage with economic forecasting and analysis, company profiles, and tips for personal finance.

I have been interviewed on BNN numerous times over the last five years, quizzed on the impacts of fracking, the forecast for uranium following Fukushima, the potential of new frontier oil regions, and the future for coal. This time, the topic was “Five Tips for Natural Gas Investors.” You can watch the interview if you want; I highly recommend it – the education is worth the time.

On-air interviews are usually pretty speedy affairs, so my BNN interview didn’t give me enough time to discuss each point in depth. The Dispatch gives me that opportunity, so here are my five tips for natural gas investors in a bit more detail.

1.  Watch for Looming Reserve Writedowns

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 gleans 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 commodity count.

However, the amount in the ground is not the amount that can be produced. That’s where the reserve estimate comes in. Reserves are an estimate of the amount of a commodity within a deposit that can be extracted economically, which means 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.” Then, economic considerations further reduce the resource to only the bits that are “economically recoverable.”

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 to many times their earlier volume. And while gas prices held, reserves counts ballooned too.

The key bit there was “while gas prices held” – 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 prior to the recession, gas prices have fallen more than 80%.

(Click on image to enlarge)

Natural gas has become a victim of its own success. The incredible technological successes of the last decade enabled producers to delineate massive volumes of natural gas resources and increase output significantly. The result: supply overwhelmed demand, and natural gas prices tanked.

Decade-low prices have already forced producers to cut back on output in an effort to reduce the supply glut. But the second half of the low-gas-prices double whammy is just getting started.

Remember, reserves are defined as resources that are economic to extract using existing technology. Natural gas is now worth less than $2 per MMBtu, less than half the $5.82 per MMBtu it has been worth on average over the last decade. A much-reduced price means that much less of North America’s new natural gas bounty is anywhere close to economic.

And that means reserves are about to fall dramatically.

Companies have not yet downgraded their gas reserves 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 behind changes in the spot price. Right now, for instance, 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 (AECO is the price of natural gas in Alberta and is one of the leading gas benchmarks for North America). But even though it is a bit behind in its decline, the strip price is definitely 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.

2.  Beware the “Barrel of Oil Equivalent”

With their gas reserves worth less every day, some natural gas companies are taking advantage of a misunderstood energy concept to make their assets appear more valuable. The concept is the barrel of oil equivalent or “BOE.”

The BOE is a unit of energy defined as the energy released when one barrel of crude oil is burned. Since different grades of oil burn at different rates, the value is an approximation, set at 5.8 x 106 BTU or 6.12 x 109 joules. The BOE concept then lets us combine different fuels according to energy equivalence. Barrels of oil equivalent are most commonly used to combine oil and natural gas: one can say that one barrel of oil is equivalent to 5,800 cubic feet of natural gas because both produce approximately the same amount of energy on combustion.

The concept was borne of the need to distill a company’s production or reserve information down into a single number that summarizes the situation for investors. While that has some merit, never forget that important details get lost in the distillation process.

The most important of those details is that one barrel of oil may be equivalent in energy to 5,800 cubic feet of natural gas, but we don’t value companies based on the energy contained in their reserves – we value them based on the money they can earn from those reserves. Those earnings depends on the market prices for oil and gas.

A barrel of oil is worth over US$100. Using a somewhat generous natural gas price of US$2.00 per thousand cubic feet (1,000 cubic feet is equivalent to 1 MMBtu, so the units for pricing are interchangeable), we can calculate the value of a BOE of natural gas priced as gas:

A BOE of natural gas is only worth US$11.60! The barrel of oil is worth almost seven times more than the supposedly equivalent “barrel” of natural gas.

For natural gas producers struggling to convince investors that their gas assets are valuable, it is very tempting to take advantage of this wild difference. By using BOEs, a company can immediately multiply the supposed value of their gas reserves sevenfold! Of course, using the BOE lens doesn’t actually add any value to a company’s gas reserves, but it sure makes the “Reasons to Invest” slide of its PowerPoint presentation look a lot better.

As an investor, if you are contemplating a natural gas producer and you see that it values its production or reserves in terms of BOEs, you need to immediately question why. There is a chance that the company produces primarily from a liquids-rich field, meaning each of its gas wells also produces propane, butane, and even oil. If so, there is a legitimate reason to include BOEs in the valuation.

However, if the company primarily produces dry natural gas and yet still lists the value of its production or reserves according to BOEs, you need to tread very carefully. Basing an investment decision on an illegitimate, sevenfold multiplier is a sure way to get creamed.

3.  Investigate Initial Production Rates

In recent months I have noticed a disturbing new tactic being used to dupe investors: companies announcing initial production rates from new natural gas wells based on 24-hour tests. The problem is that the amount of gas a well produces in its first 24 hours is almost meaningless.

Decline rates in unconventional gas fields are drastic. Shale wells regularly decline 80% over their first month of production – a well that spouts 1,500 BOEs per day in its first 24 hours can easily decline to only 200 BOE per day just 30 days later. Those are normal numbers, but it is important to note that for a well to sustainably produce 1,500 BOE per day would place it in the top 10% of natural gas wells in the world!

Using a 24-hour initial production rate fails to take decline rates into consideration, which is why initial production rates are only useful when they are based on a longer time frame. That’s why the rule of thumb for assessing a new well is to always use the 30-day initial production rate. Once a well has been producing for a month, the initial rush of gas that flows through a new opening into an untapped reservoir has subsided and the production rate has settled to a level that will be sustainable over the medium term.

If a company announces initial production rates for its wells that are averaged over less than 30 days, be very cautious. Reputable gas companies only use 30-day IP rates.

In particular, for a company to announce the 24-hour initial production rate from a new well is absolutely ridiculous, because the dramatic decline rates from these unconventional gas fields mean that rate is completely unsustainable and therefore pretty much meaningless.

4.  Know a Company’s Naked Worth

Hedged natural gas contracts have protected many producers from the full wrath of today’s rock-bottom natural gas prices – until now. 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, which meant that 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 is by no means the only natural gas company in this situation. The second-largest natural gas producer in the US, Chesapeake Energy, removed most of its gas hedges for 2012 and 2013 in recent months 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, a risky scenario seeing as prices are currently below production costs in most US 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. 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, because 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, and that’s just the bleak truth.

5.  Don’t Chase High-Yielding Dividends

I wrote about this two weeks ago, in a Dispatch titled Don’t Believe Every Dividend Story You Hear, but it is a warning that bears repeating. When markets turn bearish, investment strategies often turn toward income stocks, and rightly so: if market malaise is expected to keep share prices in check, dividends become a very good place to look for profits. But whenever a particular characteristic – such as a good dividend yield – becomes desirable, it also becomes dangerous.

The sad truth is that scammers and profiteers jump aboard the bandwagon and start making offers that seem too good to refuse. An offer of just that nature reminded me of this danger. At the Cambridge House Resource Conference in Calgary, there was a private natural gas company trying to lure investors with the promise of a 14.7% monthly dividend yield.

If you read that and immediately thought something like, “What?! That’s an amazing yield! But wait – can that really be for real?” then you are exactly on track.

If a dividend sounds too good to be true, it probably is. For a small natural gas startup to be promising an annual dividend of almost 40% is completely ridiculous. The slick guys promoting this stock had almost convinced a very nice older man and his sweet wife to put a fair chunk of cash into the deal by promising that the dividend yield would solve their income issues in their retirement years. Thankfully they asked my opinion on the matter and my response was clear: stay away from this ridiculous scam.

Ridiculous or not, these dividend promises are out there. In fact, promoters trying to cash in on investors’ desires for the relatively security of dividends will promote these “deals” more and more as the market turns negative. When a slowing market generates a shift toward dividend-paying stocks, these profiteers will start promising double-digit dividend yields, representing an appealing combination of yesterday’s bull market, easy-money attitude with today’s “income, please” perspective.

Dividend stocks are a good way to get paid for taking on the risk of investing in a market that has climbed notably of late without a lot of good reason. Just be very careful that you don’t start chasing high yields and that you do get a handle on your greed. We all invest to make money, but the desire to make lots of quick, easy money will lead you into one value trap after another.

Instead, you have to lead with your head. Before buying a stock, make sure you know why you’re buying it and what you plan to do with it. Is it a long-term hold, with a proven management team and a well-planned strategy? Is it a takeover candidate – and if so, who are the contending acquirers and what is the timeline? Or is it a quick flip, based on a rising commodity price or an area play? In any scenario, do you have your exit mapped out? Is there enough liquidity to make a speedy exit?

Some scams and value traps are relatively easy to spot, such as the promise of a 14.7% monthly dividend. Others are much harder to avoid. More generally, investing is complicated and fast-paced, and every decision carries the weight of your hard-earned dollars. It is much easier to bear that weight with help from an expert.

Energy offers the most outstanding opportunities for creating new fortunes since gold took off 10 years ago, but to profit in energy you have to the avoid the kinds of pitfalls I warned about earlier. The Casey energy team is uniquely positioned to help you avoid these traps… and right now you can tap into their expertise and position yourself to profit from the coming energy bull market by taking a risk-free trial of the Casey Energy Report.

Additional Links and Reads

Argentina Oil Takeover Prompts Repsol Legal Threat on Helping YPF Produce Petroleum (Washington Post)

Spanish energy firm Repsol is considering legal action against companies and/or investors that help Argentina exploit the petroleum Repsol planned to tap before its Argentine unit YPF was nationalized. Repsol discovered vast shale oil deposits in Neuquen province that could dramatically increase Argentina’s oil reserves, but in mid-April President Cristina Fernandez announced that Argentina is nationalizing YPF. The move infuriated Spain, as it seems Repsol will have no say in the amount it receives as compensation for handing YPF and its Argentinean discovery book over to the government. Many industry players see the nationalization as yet another sign that Argentina is a dangerous place to invest. For more information on the takeover and reaction to it check out this earlier Bloomberg article.

Gas Spat Sparks Fears for Egypt-Israel Ties (Financial Times)

The termination of a contract that sees Egypt supply Israel with natural gas is highlighting concern that the countries’ partnership is falling victim to the wave of turmoil and change sweeping the Arab world. Egypt is by far the most important Arab country to have diplomatic relations with Israel; the countries’ peace accord has long been a cornerstone of the region’s tenuous peace, and the 20-year gas contract, signed in 2005, was one of the most visible and lucrative signs of Israeli-Egyptian cooperation. But the arrangement has always been enormously unpopular with Egyptians angry over Israel’s treatment of Palestinians. Since last year the pipeline carrying gas through the Sinai has been bombed at least 14 times, and the Islamists set to take control of Egypt’s government once the military hands over power have denounced the deal. (Thankfully for Israel, the country has discovered offshore natural gas deposits in recent years. We delved into Israel’s gas needs and production potential and suggested a way to profit in the latest issue of the Casey Energy Opportunities newsletter.)

India to Auction Coal Licenses This Year (Wall Street Journal)

In an attempt to enhance transparency in the country’s troubled coal sector while also encouraging private investment, India’s government plans to auction coal-mining licenses publicly for the first time. India’s coal needs are climbing rapidly, but domestic production is barely increasing, strangled by excruciatingly slow licensing and regulation. Indian coal producers met only half their annual output target of 73 million tons last year and only 29 of 195 licensed coal blocks have started production. This year coal demand in India is expected to outstrip production by about 100 million tons. While public coal license auctions could help speed up development, India will still face the challenge of easing domestic price controls so that miners can turn a profit.

Fracking Wastewater Tied by Scientists to Earthquakes (Bloomberg)

Scientists think disposal wells for fracking wastewater might be to blame for a sixfold increase in seismic events in the central US. In studying increased seismic activity, the US Geological Survey did not find any evidence that fracking caused any earthquakes, but the team of scientists concluded that fracking wastewater injected deep underground for disposal might have sufficient destabilizing effects to cause the trembles. USGS lead scientist William Ellsworth said none of these manmade earthquakes caused significant damage.

New Keystone Pipeline Nebraska Route Unveiled (CBC)

The company behind the proposed Keystone XL pipeline unveiled a new route for the Nebraska portion of the project. TransCanada says the new route veers east to avoid the sensitive Sandhills region before looping back to the original route. The new pathway adds about 160 km to the original 2,736-km long pipe. With a new route established the proposed project will now head back for a second environmental review.

EU Delays Vote on Oilsands Label (Edmonton Journal)

Politicians in the EU delayed until 2013 a vote on whether to label Canadian oilsands an especially dirty form of crude. The labeling was part of a proposed EU Fuel Quality Directive (FQD) aimed at reducing Europe’s greenhouse gas emissions, but Canada is adamant the FQD singles out oilsands crude as having higher carbon emissions without any sound studies examining the emissions from Europe’s conventional oil imports. While Canada sends virtually none of its bitumen to Europe, the FQD label would set a dangerous precedent and could make trading very difficult for other industries that rely on crude oil products, such as the pharmaceutical sector.