Worst may be over for natural gas investors
A quick survey of the investment spectrum shows that few sectors have exhibited as much bloodshed as natural gas in recent times.
Investors with natural gas exposure have certainly had an interesting ride over the past few years. After a virtual supply drought pushed prices above $11 per mcf (thousand cubic feet) as recently as 2008, a surge in production in the United States has the market awash in the fuel. In turn, despite a recent rebound, natural gas prices remain well below their 52-week highs (see Chart 1).
Large independent producers like Encana Corp. and Chesapeake Energy Inc. have not been immune either, with their respective equity values falling over 30 per cent in the past 12 months.
So, from a contrarian’s standpoint, have we seen the bottom in the sector? Here, we outline a number of fundamental indicators that investors should be aware of before adding exposure to natural gas.
The most significant factor driving natural gas prices down has been an overwhelming surge in production. In this regard, exploration and production companies (E&Ps) have been victims of their own success, as the emergence of new drilling technologies in shale gas formations has brought about a glut in supply.
In the United States, for instance, marketed production grew eight per cent in 2011 – the largest year-over-year increase on record. And while the gas rig count south of the border has declined recently, activity levels remain well above the 2009 trough and the productivity of the average rig has more than offset the impact otherwise expected from a smaller fleet.
Consequently, storage levels within the United States have risen rapidly and currently sit around 3.1 trillion cubic feet, which is about 20 per cent above 2011 levels and far exceeds the five year seasonal average (see Chart 2).
Nevertheless, recent reports have suggested a more positive trend on the storage front, with 13 of the past 14 weeks showing injections below both 2011 levels and five year averages.
The market continues to keep an eye out for signs of drilling cutbacks.
First, many analysts believe that prices for natural gas will have to rise as they are currently below the marginal cost of production for many drillers. Should low prices persist, one would expect economic forces to drive more E&Ps to signal cuts in production.
In recent months, industry-leading producers have announced initial rounds of production curtailments, including the likes of Chesapeake and ConocoPhillips.
As we’ve seen, producers appear increasingly motivated to reallocate capital to liquids-rich plays that are expected to generate greater netbacks at current gas price levels. In response, aggregate supply growth of natural gas has faded (see Chart 3).
While the recent trend has been positive, analysts and traders will be looking for continued evidence of production rationalization before bidding higher prices.
In North America, the single largest factor affecting demand for natural gas is temperature. The demand and price of natural gas is highly elastic in both the summer (air conditioning) and winter (heating) seasons. When temperatures stray significantly from normal seasonal levels, as we saw this past winter, gas demand tends to adjust swiftly. One analysis equates an average temperature one degree (Fahrenheit) above normal to a decline in heating demand of about one bcf per day.
Cold winters typically help keep inventories in check, but in 2011/12 abnormally warm temperatures left inventories at record highs as a result.
One factor helping to pare down this overhang has been the increase in gas-for-coal substitution by power producers in recent years. A recent analysis by Bernstein estimates that U.S. utilities could increase gas-fired power generation by 450 million megawatt-hours by the end of 2012. This equates to an approximate 13 per cent swing in consumption for natural gas or 3.3 tcf annually – a level more than sufficient to alter the commodity’s supply/demand balance.
Of course, this relationship is dynamic and, as gas prices recover, the potential for substitution recedes. As some market observers note, ‘the best cure for low gas prices is low gas prices’.
Looking longer term, further relief to the supply/demand equation should stem from the diversification of exports away from the United States towards liquefied natural gas (LNG) exports to key Asian markets with shortages. Thee economics of exporting gas from North America to Asia are highly attractive, given that the current pricing differential between these two markets is upwards of $10 per mcf or more. Clearly, a sustained differential of this magnitude presents an enormous opportunity for North American producers and should help alleviate the glut.
A logical consequence of a sustained low price environment will be capitulation, as more leveraged and smaller producers begin to feel the squeeze.
Given that medium-term fundamentals for the fuel appear positive, consolidation in the sector would be welcomed from an investor standpoint. It would create something of a “floor” on valuations while also signaling improved prospects for the sector to the market. Likely suitors for natural gas companies in western Canada would include Asian companies seeking to build resource positions with long-term LNG exports in mind. PETRONAS’ recent $5.5 billion acquisition of Progress Energy provides some hint of this potential trend.
The large unknown is the weather patterns next winter and how fast the supply response will be through the summer and fall of 2012. As market indicators reflect a more stable supply/demand balance, natural gas weighted equities should provide attractive returns, as they will be key in ensuring your investments are able to weather the current storm.
Tyler Simms, CFA, is a Associate Portfolio Manager with Calgary-basedMcLean & Partners Wealth Management Ltd.