Natural Gas - Investment Opportunity or Value Trap?

Natural Gas - Investment Opportunity or Value Trap?

Supply and demand forces in the North American natural gas market have undergone significant changes in the past couple of years. The introduction of technological innovations, like horizontal drilling and multistage hydraulic fracturing, has made previously uneconomic natural gas reservoirs more accessible and highly productive.

These new developments have increased supply, which has been positive for consumers because of the decline in natural gas prices, but extremely challenging for natural gas producers.

Over the past three years, North American natural gas production has increased by 19 per cent, while consumption has risen by only seven per cent. Furthermore, in 2011-2012, the U.S. experienced its fourth-warmest winter since record-keeping began more than a century ago. Although parts of Western Canada seemed to endure harsher than usual temperatures, our friends to the south enjoyed a very mild winter. The result? A 67-per-cent collapse in natural gas prices, down to levels not seen since 1999.

To earn a positive return on invested capital, natural gas producers on aver-age need a price above $4.50 per thou-sand cubic feet (mcf). With natural gas prices at $2.50 per mcf, producers are a long way from earning an economic return.

As a result, they're taking drastic steps to improve margins. They are shifting capital from lower-return natural gas drilling to higher-return oil projects. This has resulted in a 40-per-cent decline in the natural gas drilling rig count since October 2011.

In addition to reducing natural gas drilling, producers are temporarily lowering higher-cost production (known as "shutting in"). In the first quarter of 2012, natural gas companies such as EnCana, ConocoPhillips, Chesapeake and Progress Energy announced total production shut-ins amounting to more than one billion cubic feet a day (bcf/d), or approximately one per cent of daily production. These efforts are starting to affect production.

While producers do their best to navigate the low natural gas price environment, the demand side of the equation is starting to improve for them. Consumers are increasing their demand for natural gas in the following ways:

Power utilities are increasingly using natural gas as a substitute for coal.

Natural gas consumption in power generation was up 41 per cent year-over-year in March and up nearly 32 per cent year-over-year in the first quarter of 2012.

Industrial and petrochemical companies are making significant investments in new projects because of lower input costs (natural gas) in North America compared to Asia and Europe.

Dow Chemical, Sasol, Lyondell-Basell, Shell and Methanex have announced multibillion-dollar projects in Louisiana and Texas.

Natural gas exports via liquefied natural gas (LNG) are on the horizon. Cheniere Energy, Shell and EnCana have announced large-scale LNG projects. Cheniere's facility will be located in the Gulf of Mexico, while EnCana and Shell are looking to build plants in Kitimat. The earliest we expect to see natural gas exports is 2015.

So what does all this change mean? Although current conditions appear gloomy for natural gas producers, valuations for natural gas assets have fallen to a point where they are starting to attract shrewd long-term investors. Private equity firms, such as Black-stone, Apollo Group and KKR, have made large investments in natural gas assets over the past six months.

Furthermore, owners of natural gas power plants around the globe are making significant investments in natural gas assets. For example, Toyota Tsusho and NW Natural have partnered with and purchased assets from EnCana to gain access to natural gas production in order to offset the cost of purchasing gas in the open market.

Finally, we continue to see long-term commitments to natural gas via mergers and acquisitions as Petronas, the Malaysian national oil company, recently made an all-cash bid for Canadian natural gas company Progress Energy, held in Leith Wheeler clients' portfolios. The bid was at a 75-per-cent premium to where the market was valuing Progress Energy.

Leith Wheeler is positive on the long-term prospects for natural gas and has added recently to its natural gas investments (EnCana, Progress Energy, Tourmaline and NuVista Energy). We believe natural gas prices of $2.50/mcf are not sustainable. Our research tells us that the economics of acquiring, exploring, producing and developing natural gas assets are not profitable at these prices. We believe the marginal cost to produce natural gas is closer to $4.50/mcf and that the long-term price of the commodity will revert to that level.

We are also confident that the companies we own are among the lowest-cost producers of natural gas in North America and, as such, will profit richly when natural gas prices revert to the marginal cost of production. Furthermore, as more LNG facilities are added to export North American natural gas, the price will move in the direction of LNG pricing, seen today at $15/mcf.

Investors with a long-term view will be able to withstand and, more importantly, benefit from large and prolonged fluctuations in prices. We believe natural gas companies can endure low prices and benefit from a rising price environment.

It is important for investors to remain patient with their natural gas holdings, as we expect them to outperform as natural gas prices return to more sustainable levels over the long run.

This article is not intended to provide advice, recommendations or offers to buy or sell any product or service. The information provided is compiled from our own research that we believe to be reasonable and accurate at the time of writing, but is subject to change without notice