Ironic Twist: Natural Gas Will Play Central Role in Big Oil's Next Bull Run

How natural gas will center in Big Oil's next iconic bull run.

Mar 29, 2014 at 11:08AM

In many ways, natural gas has become a thorn in Big Oil's side. Continually low natural gas prices are making production uneconomical. ExxonMobil (NYSE:XOM), which had natural gas as 47.3% of overall production output in 2013, is feeling the pinch. Royal Dutch Shell (NYSE:RDS-A) is suffering the same fate. According to its most recent earnings report, natural gas represented 49.4% of Shell's overall production output in 2013.

Oil majors have presented their dissatisfaction with the low natural gas price environment. In their annual reports, ExxonMobil, Royal Dutch Shell, and Chevron (NYSE:CVX) all see reductions in natural gas profits going forward.

From this view, the statement "Natural gas will play a central role in Big Oil's next bull run" is a bit ironic. How can a low-margin product drive the next huge rally for Big Oil?

Natural gas exports are opening up
The prospect of exporting natural gas is brightening. The Federal Energy Regulatory Commission has issued a presidential permit to a project run by Energy Transfer Partners (NYSE:ETP). The permit allows the company to build a 37-kilometer pipeline linking Hidalgo County in Texas and the city of Reynosa in Tamaulipas state, Mexico. Estimates indicate that Mexico's natural gas demand alone could see close to 10% of U.S. current natural gas output going south. The green light from FERC comes as the Obama administration approved yet another liquefied natural gas terminal in Oregon, bringing the total number of export terminals approved so far to seven.

In addition to the fact that more natural gas export terminals are gaining approval, the standoff between the U.S. and Russia over the latter's annexation of Crimea is putting a lot of pressure on the U.S. to export natural gas. Former Soviet satellites, which include Slovakia, Poland, Hungary, and the Czech Republic, have been heavily lobbying Washington to eliminate bureaucratic bottlenecks and export U.S. natural gas to Europe in order to neutralize the strength of natural gas as a key weapon in Russia's political arsenal. The same sentiment is shared by European nations, which share the U.S.' view on Russia's annexation of Crimea.

As things stand, the U.S. has imposed a slew of sanctions on key Russian businessmen in a bid to arm twist Russian President Vladimir Putin to rethink his stance on Crimea. Russia has even been suspended, though not expelled, from the G8. As the adversarial groundswell against Russia continues to gain steam and alliances shift in the global political space, using U.S. natural gas exports as a counter to Russia's influence in the European natural gas market is increasingly gaining appeal as a viable option.

Imagine allowing exports against the backdrop of reduced production
Big Oil can afford slower profit growth or even a decline in margins, but it can never risk slipping into the red. Profits are crucial because oil majors typically pay perennial dividends, with some having increased their payouts continually for decades at a go. A scenario where an oil company has to finance both dividends and operations externally through debt is alarming and highly undesirable. Thereby, profits must suffice at all costs, even if it means reducing exposure to a low-profit product such as natural gas.

Oil majors are currently reducing their exposure in low-margin natural gas. Chevron, for instance, will allocate only 2% of capital designated for upstream activities to natural gas between 2014 and 2016. Its stance reflects a wider play in the overall upstream industry. Other producers, too, are on a go-slow on all matters natural gas.

For the next two years, oil producers will likely produce less and less natural gas. Now, let's introduce another factor. Natural gas storage levels are low. Earlier in March, U.S. total natural gas storage stood at 1.196 trillion cubic feet, the lowest for that time of year since 2004 and a reflection of low overall storage levels.

If you try to imagine a case where demand from Mexico and Europe increases amid reduced domestic production, the only plausible outcome is a higher natural gas price regime. And if you further factor in the fact that natural gas storage levels (supply) are at decade lows, the argument for sustained higher prices significantly strengthens.

Foolish bottom line
As the possibility for exports comes to greater focus, the potential for an iconic bull run for Big Oil similarly increases. Should export demand increase, which is highly possible, oil producers will enjoy the privilege of setting a comfortable floor under natural gas prices. This is because demand will increase against the backdrop of slow natural gas production and low storage levels. I can bet that this said price floor will not only bring in great margins but offset the suffering that Big Oil has gone through in the current low natural gas price environment.

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Lennox Yieke has no position in any stocks mentioned. The Motley Fool recommends Chevron. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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