The Value Opportunity in Natural Gas


Oil and gas stocks have been decimated in the past year as people fled the carnage. We saw a bottom in the market during the early winter and have had a rebound in recent months. While much of the focus is on oil, I believe the much bigger long-term opportunity is in natural gas.

A few weeks ago David Einhorn put together a presentation that largely coincides with my view of the oil and gas stocks. His short view is that many of the oil frackers are overvalued, but that the companies geared towards natural gas are competitive on a global scale. 

While I would love to buy some of the companies focused on oil at deep discounts to their intrinsic value, I don’t see those values yet. I do believe it is possible that we see those values in the next year or so as it becomes accepted that Saudi Arabia will not cede any market share. As I covered before, here and here, I believe the geopolitical aspects of oil are so strong that short of agreement with Russia over eastern Europe and Iran over nuclear weapons, or war, we will see oil under $80 for at another year. Here’s an excellent article from Newsweek regarding how Iran is dealing with lower oil and the geopolitical issues.

That’s not to say there can’t be a spike in oil prices if there is war. If we see conflict, then oil would rise sharply. For that contingency I do not want to own oil companies. As Einhorn pointed out, better to own oil. I am exploring opportunities to do just that. However, that for is another column.

Natural Gas Trends

 The opportunity in natural gas derives from several factors. 

The first is that natural gas has become relatively cheap, like oil, due to the increase in American production. Because the United States is the global swing supplier of both oil and natural gas right now, as well as, a huge consumer, the U.S. has a major influence on pricing. As demand rises or falls for natural gas or oil by America, prices move accordingly. Unlike oil where, we are seeing flat demand, the demand for natural gas is increasing in several ways.

The most important increase in demand for natural gas is the shuttering of coal fired power plants. Natural gas is taking the place of coal in power generation. So far this year, according to the EIA, gas deliveries to electric power plances increased 13% year over year to 26.5 Bcf (billion cubic feet). This trend is not going to end anytime soon. Current law requires utilities to cut emissions 30% by 2030.

In the next few years, the EIA expects electricity from natural gas to exceed that from coal as more coal powered electric stations cease operations, roughly scheduled to be about 20% of national capacity. Over the past ten years already, coal power generation dropped from 2,012,873 Megawatt hours in 2005 to 1,585,697 in 2014, while natural gas increased from 760,960 to 1,121928.

In addition to the United States increasing demand for natural gas, China and other nations are increasing their demand as well. And to put to rest any notion that environmental extremists are at fault for the U.S. switch from coal to natural gas, that is exactly what is happening in China as well. A few weeks ago, China closed four coal fired power plants in Shanghai and is closing more nationally in order to cut emissions. I would suggest that with the vast super majority of climate scientists of the belief that coal is the worst polluter on a planet where we likely impact global warming significantly are not extremists, but that it is those who fall in the super minority on this issue who are the actual extremists. Regardless, most nations are adjusting their policies and that is leading to more demand for natural gas (and nuclear and solar). 

In addition to increasing utility generation, U.S. industry, in particular the chemical industry, is slowly increasing their demand for natural gas. The primary reason is that natural gas, which is used as a feed stock, as well as, for energy, is that is often half price here in America versus other nations. In addition, as wages increase globally, the need to offshore production has decreased for many American companies. If I am right, and globalization is due for a snap back of protectionism, then many U.S. companies will also seek the relative safety of domestic production. Keep an eye on General Electric in this regard as they seem to be pivoting back to “made in the U.S.A.”

Natural gas is also seeing an increase in demand as a fuel for transportation. While we have taken it on the chin with our Westport Innovations investment so far, the reality is that demand for natural gas engines is increasing briskly. So, while Westport might be struggling in the current environment and with transitioning from a flawed prior business model, there is no doubt that natural gas engines for trains, trucks and buses is becoming more common place as diesel vehicles need to be replaced (versus converting existing vehicles which proved uneconomic).

Beginning in the fourth quarter, the United States will begin exporting liquefied natural gas for the first time from Cheniere Energy’s Sabine Pass LNG facility. This is a monumental change in U.S. energy policy.

Sabine Pass will have capacity approved by FERC of up to 2.76 Bcf/d that will be nearly fully used by the end of 2016. This is a significant amount as the U.S. total production of natural gas is 92 Bcf/d, while demand is about 100 Bcf/d. You read that right. We are going to export natural gas despite still being a slight net importer of natural gas – mainly from Canada with some from Mexico and others. I expect natural gas pricing to rebound to about $4/mmbtu by summer of 2016, a roughly 60% increase over current prices.

FCG Natural Gas ETFNatural gas futures are currently in contango and show a significant price jump over the winter already. Even delivery of the June contract is about 10% higher than today’s spot. Clearly futures traders are already anticipating a significant rise in natural gas prices.

For a retail investor hoping to make money on an expected rise in natural gas prices, the temptation is to buy UNG, the natural gas ETN, however, the problem is that the contango largely defeats the anticipated price appreciation. Once again, I warn against using futures based ETFs. Unless they are in backwardation or have explosive upside they are nearly impossible to make money on for anybody but day traders.

With the combined increase in demand for natural gas from utilities, industry, transportation and the international market leading to an expected increase in natural gas prices the best approach to winning on natural gas is to buy stocks in companies heavily levered to natural gas. These companies, many of which have scaled back production in the short-term due to low oil prices, are poised for a significant rebound in the coming two to four years. Many, like I believe Chesapeake Energy will, could double or triple in share price. 

The chart to the left shows the most liquid natural gas stock ETF. It is comprised of a group of large natural gas producers. The past year has not been kind to it. Companies throughout its holdings have seen cratering share prices. The algorithm shows that we are near the bottom of the risk range, due to value buyers stepping in, and indeed have already started to see a turn in price back up for a longer term time frame. On short-term pullbacks, FCG is an accumulate and in fact I am nibbling in new client account or selling cash secured puts regularly.

FCG should beat the S&P 500 handily in coming years. Not until it is nearly overbought again would I consider taking profits except for accounts that do swing trading.