Europe’s Predicament Is Big Oil’s Triumph

Europe's impending energy shortage is a big opening for U.S. natural gas producers

May 25, 2014 at 10:03AM

U.S. consumers and industries are enjoying lower natural gas prices driven by massive shale finds across North America. This was evident during the winter when more families turned to natural gas and abandoned propane due to the huge price differential. Moreover, 6,861 megawatts, which is just over 50% of overall U.S. power plant capacity additions in 2013, came from natural gas in 2013, according to the EIA, signaling the attractiveness of the cheaper energy source to industries.

While industries and consumers enjoy cheaper natural gas prices in the U.S., producers have been thrust into a strikingly dissimilar position. The low prices are squeezing margins and pushing most producers away from natural gas to crude oil, which presents a relatively higher profit margin on each unit cost incurred. ExxonMobil (NYSE:XOM), for instance, the largest domestic natural gas producer, saw natural gas production fall by 1,197 mcfd (million cubic feet per day) from 2013 levels, to 12,016 mcfd during the first quarter of 2014, a 9.9% yearly decline, reinforcing earlier statements that it would reduce exposure to natural gas.

Although the momentary upward swing in natural gas prices over the winter provided a one-off profit bump for natural gas producers in the first quarter, the long-term price outlook remains low considering that surplus natural gas output still outstrips domestic demand. In consideration of this, most big producers have since announced capital spending cuts, particularly in natural gas projects. Chevron (NYSE:CVX), for instance, will allocate only 2% of capital earmarked for upstream activities between 2014 and 2016 to natural gas.

Natural gas prices will, however, rise in the future because of the impending energy resource shortage in Europe. And not only that, but how Europe intends to plug its energy deficit could permanently realign the global market structure in favor of U.S. producers.

Europe's role in higher prices
Some European countries, particularly in Western Europe, now have less than a year's worth of energy resources on hand and are growing more reliant on imports from the Middle East, Norway, and Russia, according to an academic report from the Global Sustainability Institute (GSI) at Britain's Anglia Ruskin University.

This means that Europe will need to import more energy, including natural gas, which it is heavily reliant on. This need is further compounded by the fact that continued industrial expansion in recovering European economies will increase demand for natural gas.

Importing natural gas from Russia, which is one the major European suppliers, is however becoming increasingly unpredictable because of the political situation in Ukraine that has since pitted Russia against Western Europe and the U.S., including inviting the imposition of sanctions by the U.S. and the European Union against Russia.

The Western powers' vision of how Ukraine should develop is fundamentally different from Russia's. This ideological rift means that continued developments in Ukraine could prompt an escalation of sanctions toward Russia. Furthermore, Russia could retaliate, including cutting natural gas supplies to Europe. Dmitry Medvedev, the Russian Prime Minister, in an interview with Bloomberg said that Russia had prepared a slew of retaliatory steps to counter potentially wider sanctions from the U.S. and the European Union.

The political entanglement between Western powers and Russia has prompted the latter to diversify its gas supply destinations in order to reduce dependency on European demand. Russian President Vladimir Putin will be in Shanghai, China, on May 20 and 21 to sign a long-term deal to sell gas to China. Under the deal, Russia's government-controlled Gazprom will provide 38 billion cubic meters of gas each year over 30 years to China National Petroleum Corporation starting 2018.

The opportunity for Big Oil
Russia's shift to the East will inadvertently reduce its natural gas supplies to Europe. For a Europe that needs natural gas to power industrial expansion and drive economic recovery, but suffers from depleting energy reserves, this is a deadening blow. Europe will need a reliable natural gas supplier to swiftly step into the place of Russia.

This is a golden opportunity for Big Oil as it further strengthens the case to expedite the approval of U.S. exports of natural gas. In fact, there have been repeated calls from Europe to speed up the process. And as if in response, liquefied natural gas export terminals have gained faster approval from the Obama Administration in recent months. The U.S. is very unlikely to leave Europe, its unwavering ally, at such a time. Not only will such a misinformed move compromise their shared geopolitical interests, but it would also hamstring Europe's economic recovery, ultimately hurting the U.S. too.

If the current situation between Russia and the Western powers prevails, U.S. natural gas exports to Europe will almost certainly begin.

The costs associated with exporting natural gas, as well as the exposure of U.S. natural gas to the global market, which has marginally higher price levels, will lead to an inadvertent upward revision in the price of U.S. natural gas. Similarly, because of the longer time horizons that international supply contracts have, exportation of U.S. natural gas to Europe will put a relatively permanent floor under U.S. natural gas prices, securing continued high profit margins for natural gas producers.

Foolish takeaway
Most major producers such as ExxonMobil and Chevron have reduced their exposure to natural gas in recent years owing to low domestic prices. This will however change in the coming years because increased European demand induced by Russia's shift to China could prompt U.S. natural gas exports, leading to markedly higher price levels for U.S. natural gas. When this happens, Big Oil will relocate capital to natural gas projects in order to cash in on price increments. As a result, profit margins will rise significantly, along with dividend payouts and share prices, presenting rewards for both growth and income investors. Buying now when all this has not yet been priced into major natural gas producers' shares is a great way of getting in early on the next Big Oil rally.

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Lennox Yieke has no position in any stocks mentioned. The Motley Fool recommends CVX. 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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