President Obama is expected to announce proposed rules to limit carbon emissions from existing power plants on Monday. Though the details of his proposal won't be known until tomorrow, it's widely expected to trigger a shift away from coal-fired power generation and toward natural gas and renewables.
Here's why the new rules are likely to be bullish for natural gas and what that means for major natural gas producers like Chesapeake Energy (NYSE:CHK), Cabot Oil & Gas (NYSE:COG), and Range Resources (NYSE:RRC).
Good news for natural gas
Under almost every scenario envisioned, the new rules are expected to drastically reduce coal-fired power generation, which releases about twice the amount of carbon dioxide per MWh as combined-cycle gas-fired power generation. According to a recent study by the U.S. Chamber of Commerce, the new rules could force the closure of more than a third of the nation's coal-fired power capacity by 2030.
This reduction in coal-fired capacity would increase utilities' demand for natural gas -- a substitute for coal in power generation -- by 3 billion to 10 billion cubic feet per day, or bcf/d, up from 22 bcf/d currently, according to preliminary estimates from America's Natural Gas Alliance, or ANGA. The advocacy group's estimates are based on an assumption that existing gas combined-cycle power plants would run at 75%-80% of capacity under the new rules, up from 40%-45% of capacity currently.
A forecast of a 3 bcf/d increase in gas demand assumes "mild standards, mild enforcement," while 6 bcf/d is based on "aggressive standards but flexible compliance" and 10 bcf/d assumes even more aggressive standards and implementation, according to ANGA chief economist Erica Bowman. Other experts forecast similar scenarios.
Kevin Book, who heads the research team at ClearView Energy Partners, an energy policy research and consulting firm, estimates gas demand from the power sector will rise by 5.6-6.5 Bcf/d. His calculation assumes the Obama administration will announce a target goal of 1,500 lbs of CO2 per MWh by 2020, which would represent a nearly 15% reduction in carbon emissions from last year's level of around 1,750 lbs of CO2 per MWh.
Potential winners from new rules
While the impact on natural gas demand will obviously depend on how aggressive the new rules are and on how much coal-fired capacity is replaced by gas turbines, one thing seems pretty clear: The new rules will be bullish for natural gas demand and bearish for coal demand.
However, greater power sector demand for gas doesn't necessarily mean the cleaner-burning fuel's price will rise appreciably, given the sheer size of U.S. reserves and the incentive for companies to drill at current prices. The nation is estimated to contain as much as 4 quadrillion cubic feet (that's a 4 followed by 15 zeros) of recoverable gas reserves, with less than 1% of that quantity being depleted each year (nearly 26 trillion cubic feet were produced in 2013).
The U.S. has so much gas that energy producers can easily ramp up drilling activity to meet any expected shortfall in demand without causing a major spike in price, according to experts. At the current Henry Hub spot gas price of around $4.50 per Mcf, many gas producers are earning high margins on their production. And some can even turn a profit at much lower prices.
For instance, Cabot Oil & Gas, a gas producer with primary operations in Pennsylvania's Marcellus shale, generates pre-tax returns in excess of 100% at a wellhead gas price of just $3.00 per Mcf. Similarly, at a wellhead gas price of $4.00 per Mcf, Range Resources, another Marcellus-focused producer, earns an internal rate of return of roughly 105%, while Chesapeake Energy generates a 117% rate of return from its operations in the northern Marcellus.
One stock to consider
Since all three companies are earning strong returns at the current gas price of around $4.50 per Mcf and have at least several years of remaining drilling inventory in the Marcellus, they can easily ramp up production in response to higher demand. While all three are well positioned to benefit from the Obama administration's new carbon rules, I think Cabot may have the most upside potential.
In addition to having what is arguably the lowest cost-structure in the industry, Cabot also has some of the strongest production growth prospects -- with 30%-40% growth expected this year and 20%-30% in 2015 -- and a remaining drilling inventory that should last it at least a decade, if not much longer. It should also benefit strongly from new Marcellus infrastructure expected to go into service over the next couple of years that should help boost the average price it receives for its natural gas output.
Yet despite the recent surge in gas prices, the company's shares are down 5% year to date, even as its gas-focused peers have outperformed the broad market. In my view, Cabot's exclusion from the rally is unwarranted and may present a good buying opportunity. While the company does appear pricey by traditional metrics like price-to-earnings -- shares currently trade at around 22 times forward earnings -- I think further multiple expansion is quite possible given Cabot's exceptional growth prospects and the likelihood of improving Marcellus price differentials.
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Arjun Sreekumar owns shares of Chesapeake Energy. The Motley Fool recommends Range Resources. Try any of our Foolish newsletter services free for 30 days. We Fools don't 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.