The Natural Gas Game Has Changed

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"It has to go up."

If you are an investor in the natural gas space, you have probably said these words to yourself more than once, thinking about the price of natural gas. There are several logical arguments that would justify such a statement. Unfortunately, it looks like some of those arguments are being thrown out the window. 

Natural gas is in unprecedented territory, and here's why.

Apparently, not all BTUs are created equal
Generally speaking, the value of both oil and gas are based on their energy potential. When we burn these type of fuels, they emit a certain amount of energy, which is measured in British Thermal Units, or BTUs. In a similar way to how the amount of alcohol in a can of beer is different then if that can was full of whiskey, the amount of energy in the standard measure of oil is greater than the standard measure of natural gas. The standard ratio is that one barrel of oil is equal to about 6,000 cubic feet of natural gas. This is known as the BOE equivalent rate.

If the energy density of oil is about six times greater, then the BOE equivalent rate should be about 6:1, right? For years, this trend had generally held true:

Henry Hub Natural Gas Spot Price Chart

Henry Hub Natural Gas Spot Price data by YCharts

Thanks to new drilling technology, though, U.S. gas production took off. All of a sudden, the country was producing gas at such a rapid pace, the market could not keep up with the supply. This has sent gas prices tumbling all the way to decade lows, and the BOE equivalent rate went way out of sync. With prices low and natural gas E&P companies struggling, some value investors saw this as an opportunity to gobble up some deeply discounted companies under the premise that natural gas prices would return to the BOE equivalent rate. Heck, even I made a case for it.

Those who have held onto the BOE equivalent rate are in for a bit of bad news. During Devon Energy's (NYSE: DVN  ) recent conference call, Devon CEO John Richels said that he believes that you can no longer use that rate as a fair assessment for natural gas prices:

Given the sustained divergence in the value of oil and natural gas, it's become pretty obvious to just about everyone that the energy equivalent BOE conversion rate of 6:1 has been rendered meaningless from an economic perspective. Based on the current price realizations of our oil and gas mix, a value or price equivalent is a much more meaningful way to evaluate growth in the value of a hydrocarbon stream.

So much for BOE parity. In retrospect, this should be a little less of a surprise. Several big natural gas players such as Chesapeake Energy (NYSE: CHK  ) and Linn Energy (NASDAQOTH: LINEQ  ) have spent much of the past few quarters reducing their exposure to natural gas, and more to oil. Chesapeake has done a rather commendable job of increasing liquids production by 41,000 barrels per day, and Linn has done what it does best ... buy things. It just recently announced the acquisition of Berry Petroleum, which has a 75% oil portfolio. 

Don't hate the game, pick new players
If we have to throw out the BOE parity price, than what should we use instead. According to Mr. Richels, Devon expects to use an oil to natural gas price ratio of 20:1 for its guidance. Even based on current price parity, that would involve either a significant dip in oil prices, or a surge in natural gas prices to the $5.00 range. This may still be hopeful thinking, considering that, during Ultra Petroleum's (NASDAQOTH: UPLMQ  ) conference call, CEO Michael Watford stated that the ramping down of U.S. natural gas production may take all of 2013 before any real impact on price would take place.

If this is what we can expect from the natural gas space, then the best candidates to perform well in these conditions is natural gas users. Sustained low gas prices will help to push the door open even further for companies like Westport Innovations (NASDAQ: WPRT  ) and Clean Energy Fuels (NASDAQ: CLNE  ) , which look to turn natural gas into a viable transportation fuel. With major U.S. Trucking firms taking a hard look at converting truck fleets, Westport will be the go-to company for engines, and Clean Energy Fuels will have one of the most complete natural gas fueling station networks in the country. 

What a Fool Believes
Great investors have two great traits: 1) they maintain poise when others panic, and 2) they are willing to reconsider an investment when the market dynamics change. When a major company like Devon starts to think of natural gas in a different way, then investors should do the same, as well.

Westport has taken on a great challenge: make natural gas a viable transportation fuel in the face of gasoline. This David and Golaith story has caught the attention of investors, and the expectations for this company have steadily risen. To help you determine whether Westport Innovations can meet these lofty expectations, The Motley Fool has just released a brand-new premium report breaking down the company's opportunities, competitive advantages, and risks. To get started, simply click here now for instant access.

Read/Post Comments (5) | Recommend This Article (11)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On February 23, 2013, at 7:25 AM, bankstrader wrote:

    I have been on the trail of these ideas and am a firm believer that CHK ,WRPT and CLNE will take of in the next 2 to 5 years with a great return. Get on board now and enjoy the ride!!

  • Report this Comment On February 23, 2013, at 10:37 AM, smuggest wrote:

    This is an illogical argument. BOE is a relative measure of the energy potential in a substance. Nothing has changed re that 6 to 1 gas to oil BOE ratio except that pricing is no longer hinged to it. Obviously this is because supply has increased faster than demand.

    We all know the fracking story on the supply side. The only questions of relevance then are on the demand side: Why hasn't demand kept up? Is that a permanent or a temporary condition?

    The answer here is that demand is slow to respond because there are switching costs involved. Any conversion from oil to gas will require new investment in equipment and infrastructure.... And industries/companies are not going to make that investment until 1. they are convinced the gas supply story (and advantageous pricing) is sustainable and 2. They have the access to capital to make the investment.

    What's interesting is that we can already see that just about every energy intensive industry investing in greenfield projects is going with NG for those new projects (because there are no switching costs on greenfield investments). It is going much slower though with conversions. My read is that this is more about the access to capital hurdle than the sustainability one.

    Bottom line here is that the 6-1 pricing model is TEMPORARILY out of whack. Over the long term it will revert back (as the demand side responds by switching from oil to NG). The question is how long that will take... Not whether it will happen. My guess is that it will be a long, slow reversion taking upwards of 10 yrs. if you have that kind of patience, there should be commensurate rewards.

  • Report this Comment On February 23, 2013, at 2:41 PM, PurringCat wrote:

    One should not assume temporary trends and current status to be an all defining criteria. As things stand right now, gas is at a big disadvantage to oil. But it will likely not remain that way.

    The biggest disadvantage that gas has compared to oil is that oil is a liquid which can be transported easily through pipeline and containers such as trucking, rail, and shipping. Gas can be transported easily enough through pipelines, but is difficult to transport through containers because of its gaseous nature. To transport via containers, gas must be cooled low enough to change it to a liquid. The facilities to allow shipping of gas as a liquid are currently very limited and still in the process of being designed and built. That of course will change over the next few years. When more facilities are available to cool gas and ship it via container, gas will become more like oil, a global commodity which is priced according to global demand. That will do much to neutralize the price advantage that oil has over gas.

    I can foresee a time when the current price advantage of oil over gas is reversed. This is because gas has a strong environmental advantage over oil which will cause it to be more valuable than oil in the future. The derived products of oil, such as gasoline and heating oil, do not burn as cleanly as natural gas. In a world that is very concerned about global warming and polluting substances, such an advantage should not be dismissed. The clean burning nature of natural gas may yet significantly change the price ratio of oil to gas in a way that gas will actually be valued compared to oil at a price higher than the 1:6 energy ratio.

  • Report this Comment On February 24, 2013, at 10:07 PM, smuggest wrote:

    PurringCat, you make a good point. The advantages that liquids have over gas re transport are real and salient. I'd take it a step further by noting that on a volume basis liquids will always enjoy a BOE advantage - that's probably the one challenge that is going to always weigh against The Westport, CLNE vision... In a NG vehicle you are either going to have to live with more refueling stops or a larger fuel tank.

  • Report this Comment On February 27, 2013, at 12:08 AM, Mayvau wrote:

    Perhaps the largest LNG market in the future, and one that also never seems to be discussed in forums such as this is for ocean shipping fleets. River barge , ferry and tug markets should also not be forgotten.

    The current world wide use of bunker fuel is perhaps one of the most intensive producers of pollutant emissions there is. The top 13 container ships produce as much harmful pollutants as 650 MILLION cars.

    The problems of the "tank in the trunk" are not that much of a problem on a large container or bulk carrier ship.

    Also as most LNG storage infrastructure seems to already be based upon water access, the conversion for many projects to fueling stations would seem to be minimal. The massive effects of changing bunker to LNG for environmental reasons would go a long way towards convincing many environmentalists of the advantages of allowing pipelines from the interior to the sea.

    Finally the conversion of literally thousands of ships would keep many shipyards perhaps idled by defense cuts busy for years to come.

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