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Mark Deluzio

CXG AT A GLANCE

P/E ► 23.3 AVG EV/EBITDA ► 10.6 AVG ROA ► 9.5% AVG ROE ► 13.2% AVG Debt to Equity ► 0.447 LOW Current Ratio ► 0.770 AVG Interest Coverage Ratio ► 37.5 HIGH

 

 

 

 

 

 

CNX Gas Corporation (NYSE:CXG) is a vertically integrated natural gas producer. Its main revenue stream comes from the sale of self mined natural gas to energy generators and wholesalers such as BP and ConocoPhillips. CXG extracts this natural gas from land that it owns, processes it for sale, and then ships it to customers using its transport network of pipelines. CNX Gas Corp is the 44th largest U.S. natural gas company by production volume.^[1] The stock has nearly doubled since its IPO on January 26, 2006. This is directly attributable to the run up in natural gas prices. The price of this commodity has appreciated even more than crude oil in 2008.

The company was originally a subsidiary of CONSOL Energy (CNX), but was spun off in a public offering in 2005. CNX Gas was founded to extract coalbed methane from CONSOL's longwall coal mines. This relationship is still very strong today as 27% of CXG's production is in connection with CONSOL. ^[2] This is beneficial for CXG because CONSOL has already discovered the proven reserves and CXG saves money on exploration costs. CONSOL still retains an 81.5% stake in the company. Recently, CONSOL made public its intentions to buy back the remaining public shares in a stock-for-stock swap. It is doing so because it believes that the market is not valuing CXG properly.^[3] CXG shareholders have resisted the buyout, and threatened to lawsuits against CONSOL should they continue the buyout. On March 25, CONSOL formally terminated the buyout offer.

Business Financials

CXG Income Statement Analysis

Upon first glance, this income statement may be slightly confusing. This occurs especially when looking at the 2005 numbers. I have highlighted gross profit (sales - cost of goods sold) because it shows a clearer picture of the company's 'core' operations. There is also a corresponding linear increase in the net cash provided by operating activities. Below, I have further examined these 'core' operations:

• Sales from Gas Production - This includes outside sales to wholesalers, related party sales to affiliates and CONSOL, and master limited partnership royalty income. This is the 'core' of CXG's operations, and the healthy growth observed here shows that lower 2007 operating income does not translate into slowing operations. Additionally, the price of natural gas decreased in real terms from 2006 to 2007. This increase in sales shows CXG's growth potential despite a lackluster year for gas prices.

• Extraordinary Income - This is the source of the skewing of CXG's financial results. This grouping includes income from derivative investments, hedging activity, and a variety of insurance measures. Included in these numbers is also purchased gas sales, which is when CXG purchases natural gas from another company and then sells it on the market. When this gas is purchased at a dip and then sold at a higher price, as was the case in 2005, it yields a tremendous windfall.

Natural Gas Sector Trends

After examining these U.S. production numbers, we can see that natural gas has moved back in to a growth stage of production. During this time, CXG's annual production has outpaced both domestic and total production. In 2007, this was not the case. CXG trailed both measures in terms of production growth. With the current pricing environment and growth of production, CXG could be increasing production and the strong balance sheet could easily support it. I will revisit this situation later in the balance sheet analysis section.

Key Trends and Forces

Continued Global Growth

World economic growth is at an all time high. A byproduct of this growth is a large spike in energy demand. As this increase in demand of the past few years has driven Oil Prices to record highs, the spot and futures market prices for natural gas have followed. This is mainly due to the growing demand for electricity. As described below, natural gas is most dependent on this sector to maintain demand. As more developing nations are industrialized and developed at the current breakneck rates, more power plants and factories will consume natural gas. China is now a net importer for coal, and has begun to work on using alternative fuels to power its rapidly developing electricity grid.

Oil Demand/Price Inflation

Although the pricing patterns of oil and gas commodities are similar, they are not as linked as some may think. Because the end use distribution of the two is so different, the prices may deviate a great deal. Nearly 2/3 of the petroleum distillates end up in automobiles.^[10] Thus, the demand environment is much different. Because so much of the demand for oil comes from transportation, natural gas often has a reactive pricing environment. IE- When oil becomes expensive in the summer because of increases in auto travel demand, natural gas looks cheap to the industrial sector. Although traditionally the price relationship is 6:1 in crude oil's favor, it has widened to nearly 10:1. This 6:1 ratio is derived from the heat content of each commodity. One barrel of crude oil generates approximately 6 times as many BTU of heat as a Million cubic feet of natural gas.^[11] But as described above, the demand for each goes beyond just heat generation and their prices can deviate a great deal. Although we are at a wide point in the relationship, natural gas prices equaled crude oil's 13 times this decade.^[12]

Demand for Power from Utilities Directly Benefits CXG

Electrical generation is the number one usage of natural gas. The chart below shows that natural gas consumption is at the same level now as it was in 2007.

Despite this flat consumption growth, the end usage shares have changed drastically. Usage for electrical generation has grown and every other form of consumption has fallen. This new makeup of end usage shows the importance of the utility market in the natural gas industry. Forces that greatly affect utility power consumption, such as weather, are the most important to a natural gas company investor. When winters drag on and and cold weather persists into spring, home heating usage increases and so does the demand for natural gas. When a summer is milder than average and air conditioning usage falls, so does the demand for natural gas.

Price efficiency also comes into play. Coal still has significant pricing power over natural gas when it comes to electricity generation. However, increased CO2 fines and environmental regulation will bring the cost of coal up artificially. Carbon Trading markets are also adding to the inherent cost of generating electricity from coal. Additionally, natural gas plants are much easier to fund. JP Morgan, Citigroup, and Morgan Stanley have now enacted a set of "Carbon Principles." What this means is that they give investment priority to clean energy groups (ie- natural gas, solar, wind, etc) and force coal-fired plants to prove that they are decreasing their CO2 emissions.^[14] This means that it is easier for a natural gas fired electric plant to receive funding than a coal plant. The more natural gas utilities constructed, the more demand for natural gas, the more sales and profits for CXG and its peers.

Domestic Industrial Production Growth

Of the 23.1 TrillionCF of natural gas delivered to U.S. consumers in 2007, 28.8% was used in an industrial capacity. Considering that a slightly smaller 24% of oil consumed and a minuscule 7% of coal are used in industrial production, natural gas is more heavily dependent on the United States' manufacturing output.^[15] Two major U.S. economic indicators that investors in natural gas companies should keep an eye on are the Index of Industrial Production^[16] and the manufacturing portion of the Employment Report^[17]. Since both of these have slid considerably over the last 12 months and projections call for further falls, there should be downward pressure on natural gas prices from the industrial sector in the short term. This is one of the major reasons that natural gas has trailed oil and coal's price increases.

Liquefied Natural Gas Imports

Historical and Projected Natural Gas Imports, courtesy of the EIA

Effect on U.S. Suppliers like CXG

Just a few short years ago liquid natural gas (LNG) importation was an almost non-existent market. From 2002-2007, LNG imports rose a staggering 237% to 771 BillionCF. Pipeline imports from Canada only increased 11% to 3380 BillionCF in the same period. ^[18] This represents an increase of LNG from 1.1% to 3.8% of total U.S. marketed supply.^[19] Great strides in LNG technology and economies of scale have made the LNG industry much more accessible to both sides of the market. As the chart to the right illustrates, the U.S. Energy Information Administration expects LNG imports to surpass Canada pipeline imports by 2015.^[20] As Canada's natural gas reserves continue to be depleted, this market will become an even larger player in the U.S. natural gas industry. The ease and efficiency at which these LNG imports can enter the U.S. market will prevent significant realized price appreciation by U.S. based suppliers.

Global Trade and Current Market Conditions

There are two significant pressures that are keeping the price of natural gas at its slow upward march. The significant increase in U.S. natural gas exploration and production is keeping the price from moving up toward global averages which are 20-30% the U.S. spot price. The massive migration of LNG imports towards more demand driven markets in the Eastern Hemisphere is keeping the price from moving down to much lower historical averages dictated by domestic supply level growth. Despite the fact that current LNG prices and economies of scale are making importation much more feasible for buyers and suppliers, increased demand from nations such as Japan and India is causing the level of U.S. LNG imports to fall year over year. At current rates, the U.S. will import 3.4% less LNG than it did in 2007.^[21] This decrease in imports comes somewhat counterintuitively with a 6.6% increase in U.S. based production.^[22] This illustrates that despite the fact that prices and demand are increasing in the U.S. market, LNG imports are moving instead to foreign markets with higher local prices.

Informative article on the inefficiencies of the global LNG trade in the Wall Street Journal^[23]

Competition

Balance Sheet/Assets

CNX Gas's balance sheet has very little net debt (interest bearing debt applied against cash on hand) relative to its peers. Its $35.7 million of net debt represents only 7% of its equity. Considering the oil & gas sector's average is 73%, CXG has positioned itself well for growth without taking on significant debt. Although corporate valuation theory would suggest that they are incredibly under-leveraged, this is not necessarily a bad problem to have in the face or a recession and falling energy demand.

Reserves

The cause behind the lack of leverage on CXG's equity may lie in the substantial reserves that CXG already has in its possession. Since CXG already has massive reserves at its disposal, it does need to take on debt to purchase more land or resources. It can determine its own growth rate through increasing production/extraction.

However, it is clear when we look at some secondary calculations in regard to CXG's production numbers that they could benefit from growth in operations. Their developed/estimated reserves ratio is the lowest in this peer group. This suggests that they could take on more debt to bring more of their assets into the operational phase. CXG's production as a share of estimated reserves is also the lowest. This suggests that despite their large potential, CXG may not be leveraging their operations enough. With natural gas prices at their highest in years, and futures activity suggesting that they will increase by 15% in the next twelve months,^[24] CXG should be ramping up operations and growth to take advantage of the pricing environment. CXG, unlike their competitors, has such a strong balance sheet that they can take on major debt at current low market interest rates.

Notes

1. ↑ U.S. Energy Information Administration Annual Report, page 10
2. ↑ 2007 CNX Gas Corp Annual Report, page 31
3. ↑ http://phx.corporate-ir.net/phoenix.zhtml?c=66439&p=irol-newsArticle&ID=1101131&highlight=
4. ↑ CXG 10-K, page 34
5. ↑ CXG 10-K, page 34
6. ↑ U.S. Energy Information Administration, Annual Marketed Production, Bcf
7. ↑ Domestic + All Imported Natural Gas
8. ↑ U.S. Energy Information Administration
9. ↑ CXG 2005 & 2007 10-K
10. ↑ U.S. EIA, Energy Breakdown for 2006
11. ↑ http://www.freerepublic.com/focus/f-news/2005893/posts
12. ↑ http://www.freerepublic.com/focus/f-news/2005893/posts
13. ↑ Price data from www.bloomberg.com and http://www.eia.doe.gov/cneaf/coal/page/coalnews/coalmar.html
14. ↑ JP Morgan Press Release
15. ↑ U.S. Energy Information Administration, 2007 Annual Coal Report
16. ↑ www.investopedia.com
17. ↑ www.bls.gov
18. ↑ U.S. Energy Information Administration
19. ↑ U.S. Energy Information Administration
20. ↑ U.S. Energy Information Administration, Natural Gas Outlook
21. ↑ U.S. Energy Information Administration
22. ↑ U.S. Energy Information Administration
23. ↑ Wall Street Journal Online
24. ↑ NYMEX Futures Interests

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