Guest contributor Thomas Choi has been advising energy companies on market issues and economics for more than 20 years. He is currently the director of the natural gas practice at management consulting firm Altos Management Partners.
The natural gas markets over the past year went from a raging bull to a severe bear market. This time last year, knowledgeable (and not-so-knowledgeable) people were forecasting that U.S. natural gas prices would remain above $10/MMBtu, an extremely high level by historical standards. Many of the same people were forecasting that oil prices would reach $200/barrel.
Resource doomsayers were touting peak gas and peak oil theories, saying that production levels for these commodities had already reached their peaks and were in a steady decline towards an ultimate depletion of these vital resources. As it turned out, production levels had not peaked but rather grew, once again pointing out that production rates reflect economic decisions rather than simple depletion curves.
Now we are in the midst of a worldwide economic recession, and natural gas prices have crashed to less than half of their peak levels. Reflecting the collapse in commodity prices, share prices of gas companies have suffered a similar decline. A near-term recovery seems highly unlikely, but do the low share prices signal a buying opportunity, or warn of continued market weakness?
With prices of most energy stocks trading well off their 52-week highs, should investors feel emboldened to bargain-hunt -- especially now that the market seems to have maintained a steady climb from its lows, and fears of a global financial meltdown have subsided?
Before answering these questions, we must first remember that production and infrastructure decisions require long lead times. Major projects take a minimum of three to five years to come to fruition. Current low oil and gas prices reflect a temporal over-supply resulting from investment decisions made under prevailing high prices. Furthermore, there has been significant erosion of natural gas demand because of the worldwide recession. Hence, current prices do not necessarily reflect long-term marginal costs of supplies toward which prices will eventually gravitate.
Will the U.S. natural gas industry revive and flourish? And if so, which sectors will likely perform the best?
The answer to the first question is unequivocally yes. Driven by environmental concerns, legislation is sure to come to either tax or limit carbon emissions. For example, the Waxman-Markey bill establishes emission caps on greenhouse gases, including carbon. While the efficiency and efficacy of such a bill is debatable, its impact on the natural gas industry is undeniable. The bill would shift the balance toward natural gas and away from higher-emitting coal for electricity generation. That is its goal, rather than just being a tax. Even if all other sectors remain steady, the growth in fuel burn for electricity generation is enough to drive robust growth in natural gas demand.
Stiffer environmental regulations are good news for all sectors in the natural gas industry, especially exploration and production (E&P) companies such as BP (NYSE: BP), Chesapeake Energy (NYSE: CHK), and Anadarko Petroleum (NYSE: APC); drilling and service companies such as Precision Drilling (NYSE: PDS) and Schlumberger (NYSE: SLB); and LNG (liquefied natural gas) importers, such as Cheniere (AMEX: LNG).
A rising tide lifts all boats …
Of course, some boats rise more than others -- and some leak and eventually sink. However, sage investors have observed that it is more important to select the right business than the right company within a business.
When natural gas supplies were tight and prices sky-high, production was primarily a volume game. The market would buy anything that produced and paid enough to make it profitable. That has drastically changed in the past year. Now it is a cost game. With ample supply available in the market, high-cost sources are forced out, and marginal sources barely turn a profit. Now it matters less how much you can produce than how cheaply you can produce it.
Hence, a smart investor will avoid producers of marginal supplies, as those companies will, at best, just eke out a profit, and instead seek out low-cost providers. Much has been made in recent years about shales, such as the Barnett and Marcellus shales. No doubt these regions hold vast volumes, sufficient to supply the entire U.S. demand for decades. However, these supplies exist in difficult geological formations, making their extraction costly. We should not be too swayed by volume assertions but rather focus on the all-in cost of production.
Cost is the key
LNG is another major supply aimed at the U.S. market. In recent years, several new regas terminals have been built (or are under construction) in the United States. Because of recent increase in shale production coupled with a decline in natural gas demand, most of these terminals currently suffer from chronic low utilization. The stage is now set for fierce competition between shale production and LNG imports. Again, the key is cost. Certainly, shales have a locational advantage, since they are already in the United States and many areas are within proximity of existing natural gas infrastructure. Technological improvements have brought their production costs down, but the inherent difficulties of extracting these supplies limit how cheaply they can be produced.
Furthermore, many of these exporting countries have minuscule domestic markets relative to their resource holdings and must therefore export to monetize their assets. In anticipation of growing demand, LNG projects coming online this year (and those already in the pipeline) will more than double world LNG supplies within a decade. As new LNG supplies become available, the U.S. is positioned to become the single largest consumer of LNG. If LNG developers such as Cheniere can weather the current bleak conditions, they can be sure that brighter days are ahead.
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