Fabrice Taylor, CFA, publishes the President’s Club investment letter. His letter and The Globe and Mail have a distribution agreement. You can get a free copy here.
“Well, they might not be going quite to zero but …,” says a portfolio manager. The subject at hand is natural gas prices and the manager sees nothing but bad news ahead.
To an investor, this is a tipoff to start getting bullish. Natural gas and the stocks of those who produce it are in the doghouse. Market sentiment is near all-time lows, which conveniently matches natural gas prices.
When professional managers get as bearish as they are now, investors should perk up. We are most likely near the bottom for natural gas prices. We may not be exactly there – the summer might bring fresh lows – but we’re close. Investors should be prepared because even modest price improvements and a change in sentiment could propel some stocks upward.
Gas is an unusual commodity. You can buy it for a couple of bucks in Alberta or New York but you have to shell out eight times more in Japan, even though it’s the same stuff. That’s because natural gas is expensive and/or difficult to transport, so it’s a regional commodity. Since there’s no easy or immediate way to get it from Texas, where it’s abundant, to Tokyo, where it’s scarce, prices can and do vary widely.
And they are pathetically low in North America where technology has unlocked trillions of cubic feet of North American gas supplies over the past few years.
At around $2.40 (U.S.) for a thousand cubic feet (mcf), prices are so low that they’re starting to kill the industry. What’s going to turn this around? Three things.
The first is economics. The price of gas is below the marginal cost of supply. When that happens producers cut back. In the United States, we’ve recently seen output declines in shale plays – the first in quite some time. These aren’t big declines, to be sure, especially considering the glut of gas in storage. But, the bullish argument goes, it’s a start, and it has the feel of a trend.
Cutting production is not a decision a shale producer takes easily because the production from a shale well declines at an alarming rate. Whereas the output of a more conventional gas well drops off by about 20 per cent a year on average, shale wells fall off at 30 per cent annually. So cutting back on drilling can lead to a relatively fast drop in supply. But cut back producers must, given current pricing.
U.S. dry natural gas production runs about 65 billion cubic feet per day, an increase from around 50 bcf/day a few years ago. That production growth came largely from shale plays. Think about that: the big increase in supply declines at 30 per cent a year.
To keep production flat the industry needs to replace close to 20 bcf/day of production. But analysts point out that the industry doesn’t produce enough cash to fund this replacement at current prices, and it doesn’t look like investors are terribly interested in financing gas with fresh money. So output has to be curtailed until prices recover. That’s the most immediate catalyst for a rise in gas prices.
A medium term source of relief is increasing demand. Power producers have been switching from coal to gas as the price has plummeted. That doesn’t mean they won’t switch back if gas rises too much but gas is more economical up into the $3 to $4 mcf range. And of course it’s much cleaner.
Besides that there are incremental sources of higher demand, as you’d expect when energy is plentiful and cheap. Truck fleets are slowly being transformed to use gas, as are drilling rigs themselves, which can burn thousands of litres of diesel per day. The current cost of diesel is similar to paying $20/mcf of gas. Eventually, reason dictates, gas has to displace some diesel demand. It’s a no-brainer.
Longer term of course there is new infrastructure, which is going to be vital to the gas industry on this continent. New pipelines and liquefied natural gas terminals such as the one proposed at Kitimat, B.C., are crucial to reaching new markets. Given the huge difference in prices between North America and the rest of the world, it’s quite likely that new infrastructure will be built, although it will take many years.
The case for natural gas isn’t based on soaring prices. Instead it’s based on a modest and gradual rise in prices to a sustainable level and incremental demand growth. That will swing solid producers and market sentiment into positive territory.
Low-cost operators with the ability to increase reserves and production and raise money should do well in this scenario. Their investors will too.