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Avoid Natural Gas Stocks in 2020

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Fossil fuels have weakened in recent days as the optimism sparked by OPEC and Russia agreeing to shave a further 500,000 barrels daily off their collective production fades.

Natural gas has suffered the greatest decline, losing 25% since the start of 2019, and appears poised to fall further in 2020 despite some pundits claiming that greater consumption will lead to higher prices.

Gas appears caught in a long-term slump that won’t ease anytime soon. Even the advent of winter, which typically leads to higher consumption for heating, has failed to lift the fossil fuel.

Growing consumption

Gas is known as the clean fossil fuel, becoming the transitional fuel of choice for cleaner electricity generation as the world moves from coal-fired electricity to renewable sources of energy in the battle against climate change.

Gas produces half of the carbon dioxide emissions of coal, accounting for roughly a quarter of global electricity production.

Countries such as China are pushing to replace coal as a source of energy with gas to reduce pollution, which is expected to drive a notable increase in demand for the fuel.

The U.S. Energy Information Administration (EIA) expects natural gas-fired plants to be responsible for 37% of U.S. electricity production by the end of 2019.

Greater supply

Increased consumption will do little to drive the price of gas higher, as supply is expanding at an even greater clip, which is being primarily driven by the world’s two largest producers, the U.S. and Russia.

U.S. gas production is forecast to expand by 15% over the next decade, primarily because of the shale oil boom, which saw the U.S. become the largest producer globally in 2011.

Russian production will also grow at a steady clip with its gas output forecast by the U.S. EIA to expand by 18%.

Such significant supply growth will weigh on prices for the foreseeable future, making it unlikely that the fossil fuel will rally despite rising consumption.

This along with the Canadian AECO natural gas benchmark trading at around an 18% discount to the North American Henry Hub price, is bad news for Canadian natural gas drillers.

Significant impact on drillers

Painted Pony Energy (TSX:PONY) and Peyto Exploration & Development (TSX:PEY) have struggled to deliver value over the last year, having lost 46% and 50%, respectively. For the aforementioned reasons, they may fail to unlock value for investors in 2020.

For the third quarter 2019, Painted Pony reported a net loss of $37 million compared to $14 million for the equivalent period in 2018, while Peyto announced a net profit of $6 million, almost a fifth of the $29 million reported a year earlier.

That can be attributed to a combination of weaker gas prices and declining production as both companies reduce capital expenditures to preserve cash flow and their balance sheets.

Painted Pony’s average third quarter daily production fell by 19% year over year to 47,495 barrels of oil equivalent, while Peyto’s dropped by 10% to 76,707 barrels.

Softer earnings and declining cash flow have weakened their balance sheets. Painted Pony’s net debt by the end of the third quarter increased by 6% compared to the end of 2018 to almost $370 million, primarily because of a marked increase in its working capital deficit.

Peyto’s net debt fell by 8% to $1.1 billion due to a reduction in the amount drawn on its bank facility and lower current liabilities.

Nonetheless, both drillers balance sheets are progressively weakening because of the poor outlook for gas, causing their profitability to decline. That becomes clear when considering their third quarter netbacks,  an important measure of operational profitability.

Painted Pony reported that its third-quarter netback had fallen by 38% year over year to a paltry $1.07 per million cubic feet equivalent (Mcfe), while Peyto’s plunged 30% to $1.61 per Mcfe. For the aforementioned reasons, there will likely be no improvement in either driller’s financial position.

Foolish takeaway

Despite growing consumption, gas appears caught in a multi-year slump with no end in sight. Supply growth is significantly eclipsing demand, creating a glut in many energy markets and weighing on prices.

For these reasons, most gas producers will struggle to unlock value, making them highly unattractive investments.

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Fool contributor Matt Smith has no position in any of the stocks mentioned.

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