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3 Lessons From the Natural Gas Revolution

The shale gas revolution in the U.S. has rocked the energy industry like a hurricane, and in its wake there have been a lot of lessons we have learned along the way. With natural gas prices stabilizing and some natural gas producers eking out profits again, it seems as good of a time as ever to reflect on what the boom in natural gas has taught us about the energy space. Let's look at three lessons that should shape the industry for the next couple years to come.

1. Take a deep breath and pace yourself. We could also call this lesson "Ode to Chesapeake Energy (NYSE: CHK  ) ", because it serves as the quintessential example of what not to do. When horizontal drilling and hydraulic fracturing proved to be a viable way to access scores of shale gas, exploration and production companies bought exploration leases from anyone within earshot of a shale play. In doing so, they put themselves in a bit of trouble because they broke three crucial rules:

  • Don't outpurchase your production: When an E&P company leases energy rights, they have a certain time window to start producing and need to continue producing or risk losing the lease. With so much new land and not enough capital to drill, several gas companies, including Cheaspeake and Enerplus (NYSE: ERF  ) , have walked away from gas leases, taking a loss on the original purchase.
  • Don't outproduce your infrastructure: What makes natural gas more difficult than oil is the ability to transport and store gas. Many companies have resorted to to flaring off gas because they have no means of transporting it. The most glaring example is in the Bakken, where the Energy Information Administration reports that more than one-third of all natural gas produced in the region is flared off.
  • Don't flood the market: With so much production and so little takeaway capacity, natural gas prices fell through the floor. Last April, the Henry Hub spot price hit a 10-year low, thanks in large part to copious amounts of natural gas that hit the market. Natural gas companies such as Chesapeake, Ultra Petroleum, and EXCO Resources all saw their share prices tumble with gas prices as well.

CHK Chart

CHK data by YCharts.

What was so devastating was that companies couldn't slow down production enough to break the cycle, so it took until rock-bottom last April before production slowed enough to stabilize prices. Now, prices are slowly inching back up. Let's hope companies will learn some patience when expanding into newer speculative plays.

2. Our pricing mechanism gives the U.S. a leg up. The U.S. has some inherent disadvantages against global competitors. We have a mature consumer market with relatively high manufacturing costs. Surprisingly, though, the emergence of cheap natural gas has emerged as a strong competitive advantage for the United States. Many might point directly to production increases, but what is just as important is America's method for pricing natural gas. The U.S. is one of the very few countries in the world that dictates natural gas prices based on a spot price. Much of Europe and Asia's natural gas prices are indexed to oil at a BTU equivalency. So while a standard thousand cubic feet of natural gas in the U.S. trades at a ratio of about 33 to one barrel of Brent crude, many European and Asian nations have gas fixed at a six-to-one barrel-of-oil ratio.

For a long time, natural gas has been a relatively regional product, so the two pricing mechanisms could exist. Now, with companies such as Cheniere Energy (NYSEMKT: LNG  ) charging forward with plans to export LNG within the next two years, these two pricing models will clash. If North America's cheap natural gas starts to hit European and Asian ports, will they break their oil-indexed pricing models? Or will we be able to ride our free-floating prices all the way to the bank?

3. Natural gas users have come out of the woodwork. We could also call this lesson the "Field of Dreams" rule. If you build a cheaper alternative to oil, companies will come. Here are a few examples of industries that are looking to take advantage of natural gas:

  • Thanks to cheaper feedstocks for chemical building blocks in the U.S., Dow Chemical  (NYSE: DOW  ) and ExxonMobil  (NYSE: XOM  ) plan to expand their ethane cracking capacity by 1.5 million tonnes per year. These are only two of the most notable companies in an industry that's expected to spend about $65 billion between now and 2017 to increase capacity.
  • The large disparity between the price of a gallon of gas or diesel and a gallon equivalent of compressed natural gas is giving credence to using natural gas as a transportation fuel. Westport Innovations (NASDAQ: WPRT  ) , a pioneer in diesel-to-natural gas engines, has seen revenues grow by more than 400% in the past two years since natural gas has been cheap enough that it's justifiable to convert from gasoline to natural gas.
  • Natural gas has also put a lot of pressure on the utility sector to adopt a wider generation portfolio. Exelon (NYSE: EXC  )  with its weak natural gas portfolio, just recently cut its dividend in large part because low natural gas prices have cut into earnings. While some utilities may be wary of a big uptick in price, many have planned to balance out their generation capacity with natural gas in the next few years as some coal plants start to retire.

What a Fool believes
We're still in the early stages of the natural gas boom, so don't be surprised if we learn a lot more lessons along the way. Some sectors in this space still have a lot of room to run, so investors would be wise to keep a pulse on the energy sector. With Chesapeake Energy trading at incredibly low valuations and in the middle of a bog management shakeup, there's a great opportunity for investors to get in. To learn more about Chesapeake and its enormous potential, you're invited to check out The Motley Fool's brand-new premium report on the company. Simply click here now to access your copy.

Read/Post Comments (14) | Recommend This Article (62)

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 March 22, 2013, at 9:47 PM, verdure wrote:

    Oh I see, you're one of them there professionals are you Kahuna? So why have you been looking over the MF's shoulders since 1995?

  • Report this Comment On March 22, 2013, at 10:26 PM, LAVol wrote:

    There are better risk/reward investments in the sector than Chesapeake (EOG, CLR, even MHR). I haven't been able to pull the trigger on Cheniere. As a veteran natural gas marketing guy, I fear the low gas prices will moderate and competition will squeeze margins on LNG exports. If I were to have to either short or long Cheniere, I would definitely be long. I'm just not comfortable with the risk at this point in time. I've seen 3 boom/bust cycles in natural gas, and I think we will see a bottom in the next 18 months. If it rebounds hard, LNG might not be a good bet. If the trough is long in duration, LNG will be a great bet. What will happen is buyers of LNG will hedge their purchases. If the market turns up, they'll likely liquidate the hedges and take the paper profits vs. taking physical delivery. JMO.

  • Report this Comment On March 22, 2013, at 11:27 PM, effinayright wrote:

    When our predictions go South, we explain.

    When our predictions go North, we brag.

    ---Motley Fools

  • Report this Comment On March 23, 2013, at 12:33 AM, TMFrunAMuck wrote:

    @verdure - thanks for recognizing that as well.

    @effinayright - examples to justify?

  • Report this Comment On March 23, 2013, at 2:44 AM, sevenheart wrote:

    LaVol- Nailed it. Ridden through those boom and bust cycles myself, we haven't seen the bottom on this one yet.

    As for flaring gas in the Bakken- it's a safety deal, when you are drilling and encounter associated gas you have to do something with it or you risk explosions and uncontrolled fires so it is flared off through a system called a gas buster that removes the gas from drilling fluids. Take away capacity is critical for marketing production gas, production of oil requires the burning of some gas to keep the oil flowing, especially in the near arctic conditions of winter time North Dakota.

  • Report this Comment On March 23, 2013, at 9:05 AM, tonyh103 wrote:

    my old gas company, Enserch/Lone Star Gas, went south in the late 1990's, and is now a part of Atmos Energy. One of the reasons, in my opinion (i had 30 years experience by the time i took early retirement),

    was that they tried to expand to far, too fast - including investments overseas that went bust. I would certainly take that into consideration when i was doing my research.


  • Report this Comment On March 23, 2013, at 2:52 PM, robertmello wrote:

    I'd stay away from WPRT. I've lost over 40% on it. I'm stupid enough to hold on to it also hoping it will come back. At least do your own homework before buying if you don't want to take MY word for it.

  • Report this Comment On March 24, 2013, at 6:42 PM, dsciola wrote:

    Interestng piece on NG. Ive heard that the best plays, at least for the producers, are the ones that manage to be the 'lowest cost producers', UPL supposedly being one of them.

    Any light you can shed here on this? What costs go into producing NG and what strategies go into being the 'lowest cost producer?'

    Thanks for the insight.


  • Report this Comment On March 24, 2013, at 7:50 PM, ershler wrote:


    Flaring continues long after drilling is done. One can easily see more than 2 dozen flares from existing wells standing on a rig floor around the New Town area. I've asked many people about this and they have all said it wasn't economical to produce it but maybe they were all uninformed. A DD from Louisiana absolutely couldn't believe they were flaring it and not using it to run the rigs.

    The last two winters definitely haven't been near arctic but I am curious how flaring helps oil flow since the flares are at least 50 feet away from wellhead and don't seem to be warming anything but the space around the flares.

  • Report this Comment On March 24, 2013, at 11:34 PM, TerryHogan wrote:

    I just want to point out that way before shale gas rocked the energy industry like a hurricane, Scorpions rocked you like a hurricane.

    However, if you are watching the Natgas industry, you should be listening to the Wind of Change.

    Don't think that you are Warren Buffett and There's No One Like You in the investing world.

  • Report this Comment On March 29, 2013, at 10:43 AM, Busterbou wrote:

    First. NG comes up the hole with the crude usually. So unless u have an economical and safe method to collect it, store it , remove liquids from it, transport, etc then your best option is just to burn it in a flare. Your primary goal is to get the crude up and transport it to market.

    Second, most equipment on drilling rigs, etc runs on diesel and gasoline just like 99% of equipment engines in the world. So the use of natural gas on rigs is pretty small at best.

    Third, the flaring has absolutely no impact on warming crude to flow out of the ground. The crude is underground and thus is usually plenty warm enough when it flows up to the surface.

    Fourth, NG volume that rises to the surface that exceeds the collection, separation, transportation, etc that u have available, will just be flared. Most wells must flow at least a little each day, otherwise they may stop flowing completely and possibly costing the rig operator a lot of money to restore full flow later.

  • Report this Comment On March 29, 2013, at 11:05 AM, ershler wrote:


    There has been a lot of articles written about oil field equipment being retro-fitted to run on natural gas and new equipment incorporating that feature. It must be common in other parts of the country if the DD I knew was surprised they weren't doing it in North Dakota. I think he worked in Mid-Con before.

  • Report this Comment On March 29, 2013, at 11:05 AM, johnnySpadre wrote:

    right on mr Busterbou! You sound like you are in the business. Are you an engineer? I am, petroleum. I noticed allot of comments, as did you, that there are allot of misinformed people about oil and gas production and how it works.

    good luck in the market and let me know if you're ever interested in sharing info.


  • Report this Comment On March 29, 2013, at 1:30 PM, ziq wrote:

    The practice of hydraulic fracturing has come under increasing criticism by environmental groups. Whether their objections are well-founded or not, it would be small "f" foolish to ignore it.

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