Why It Might Finally Be Time For Natural Gas To Make A Comeback
Alex Redleaf, Whitebox Advisors
Photo: Forbes.com
Currently one of my strongest investment convictions is to be long cheap options on natural gas, mostly by owning E&P (exploration and production) firms that have become attractively cheap with the collapse of gas prices. Natural gas prices seem to me to be at inflection, or Stein’s Law, points. You remember Stein’s Law: “If something cannot go on forever, it will stop.”
One of the signs that an asset class is at an inflection point is that people stop talking about the intrinsic value of the asset and instead talk about supply and demand. Take the mortgage bubble. As single family home prices started to look bubbly, one heard a lot about the higher intrinsic value of recent construction. Americans made enormous amounts of money in the 1980s and 1990s and were buying bigger and better homes. In this context, the bubble could be seen as an economically rational shift toward bigger and better real assets rather than mere inflation.
Toward the end, however, the intrinsic value argument could no longer justify the rapid appreciation in the prices of homes built only a few years earlier. So the conversation turned to supply and demand, first focusing on the excess demand for certain locations. When that was debunked, the focus switched from the houses to the mortgages and how the foreign demand for dollar-denominated AAA securities would keep housing prices aloft.
By then it was all over. People can’t really believe in supply and demand arguments for very long when both supply and demand are obviously elastic. People can’t believe in other words, that either suppliers or demanders will remain permanently indifferent to intrinsic value.
To listen to current market chatter on natural gas prices, one might think that the current supply and demand imbalance, which has held prices down to $2-$3 per MMB (and sometimes lower) for months, represents an eternal stasis. The market is enormously impressed by the news that the U.S., using current technology, is apparently the Saudi Arabia of natural gas. So impressive is all this sudden abundance that a recent Barclays report considered the possibility of negative natural gas prices, if all available storage is filled, and energy companies pay to have it taken away.
Economically it’s hard to think of better news than the cost of energy heading toward zero. Eternal two-dollar natural gas is the equivalent of dollar-a-gallon gasoline at the pump, a huge secular boost to the economy. In a dollar-a-gallon world the rest of our investments would do so well we really wouldn’t mind if our natural gas play went to zero.
It won’t because buyers and sellers will adjust both their near and long-term behavior. The ink was hardly dry on the Barclays report when the market actually noticed that gas producers have already had gotten the message and begun slashing capital spending, implying reduced near-term production levels. Through mid-May prices are already up 30% from their April lows. Barclays further points out that the E&P companies are effectively locked in to reducing new drilling for the next year or so, having promised investors they would cut back on dry gas drilling and pursue liquids (oil and “wet gasses” such as propane).
Near-term demand is also somewhat elastic. Though the switch from coal to gas for electricity production is a long-term proposition, there is also a short-term dynamic. Even at double today’s prices, natural gas is cheaper than coal for electricity generation. At the margin some electricity producers can idle coal plants or ramp up gas facilities over short time horizons depending on how extreme prices get.
The short-term supply and demand dynamics of the gas market are sufficient to make us like natural gas even within calendar 2012. Ultimately, however, our gas play is about long-term closure of the roughly 5x spread between U.S. gas and oil or natural gas from Europe or Asia. That spread is sustained largely by issues that are being vigorously addressed: transportation bottlenecks and the time and cost of converting from coal and petroleum to natural gas. Some $100 billion has already been invested in creating port facilities to export Liquefied Natural Gas or LNG. Once these facilities come on line in three or four years they will put immediate pressure on the spread between U.S. and foreign prices.
On the automotive front, truckers are very interested and have started building NG powered fleets. Almost a fifth of all transit buses in the U.S. use natural gas, and perhaps a quarter of new bus purchases annually are for NG vehicles. Clean Energy Fuels Corp, the T. Boone Pickens project, has installed almost 300 filling stations and is building a network of 150 truck stop fueling stations on major highways. Revenue for 2012 is anticipated to be triple that of 2008, and projected to rise more than 40% next year.
We can’t know exactly when the natural gas/oil spread will close. We do know that whenever suppliers and demanders can adjust their behavior they will drive divergent prices of equivalent goods toward intrinsic value.
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