Opportunity in Natural Gas: How to Capitalize

August 27, 2003
Opportunity in Natural Gas:
How to Capitalize
Throughout the multi-year downturn in global stock markets, the Perspectives model
portfolio has consistently made money. One central reason is that we’ve often resorted to
specialty holdings, such as gold, emerging markets and energy. The gains from these
holdings were considerable and kept us firmly in the black, even during the darkest days of
the bear market.
One such specialty pocket is that of stocks that are sensitive to natural gas prices. Our core
holdings in Devon Energy and EOG Resources have already posted handsome gains, but
the best for the sector is yet to come. Let me explain why and give you my
recommendations of how best to position yourself.
Sporadic Shortages
Here’s the problem: US natural gas demand is steadily outstripping available supplies, all
while demand itself is rising. By 2010 or so, when significant new sources may finally come
along, the country’s demand for natural gas will have risen a whopping 33%. So acute was
the shortage of natural gas last winter that the price for the commodity more than doubled.
That, in turn, curtailed activity in several key sectors of industry. Analysts expect similar
price spikes in the future, whenever inclement weather takes hold or industrial activity
strengthens. Federal Reserve Chairman Alan Greenspan seems to agree. So concerned is
the central bank chief that he went to Congress twice in the past six months to warn of the
economic consequences of not addressing the natural gas shortage!
Why does the shortage exist to begin with? There are two major reasons. The first is that
various “oil shocks” made it relatively easy for government to urge consumers and industry
to look for alternatives. Natural gas caught on faster and to a greater extent than was
anticipated by almost everyone.
The second reason for the shortage is that the US has not had the political will
to either spur domestic natural gas production, or to make a serious effort to
create facilities to transport natural gas in its liquefied form (LNG) to US
shores. Unlike Europe, where dozens of LNG terminals can accommodate
inbound tankers, the US has only three such facilities. Construction of at least
12 additional terminals will be required to mitigate the situation, a process
which will take years, enormous capital expenditures and which will be
vigorously opposed by many who live near contemplated sites. Natural gas
tankers will pose an easy target for terrorists and, for this and other reasons,
are seen as a potential environmental hazard. Also on the radar screen of
environmentalists are pipelines. As the grid of available pipeline capacity is
expanded, protests mount. Part of the problem is that operators can often only
bring natural gas to the contiguous United States by running part of their lines
under the ocean, which heightens environmental risks. Two years ago, the
Bush government introduced a plan to move on several fronts at once. By
bringing massive reserves of natural gas into production and making a $20
billion investment in new pipeline capacity, the administration would have liked
to solve the natural gas impasse once and for all. But both sides of Congress
have signaled that the plan is doomed.
Natural Gas Statistics
World’s largest reserves
(trillion cubic meters)
Russia
Iran
Qatar
Saudi Arabia
United Arab Emirates
United States
Algeria
Venezuela
Iraq
1,680
812
509
224
212
183
160
148
110
World’s largest producers
(billion cubic meters)
Russia
United States
Canada
555
548
183
World’s largest consumers
(billion cubic meters)
United States
Russia
United Kingdom
Germany
Canada
Japan
667
388
94
83
81
77
All statistics: BP Statistical Review of Energy
Why? The key problem is that the Bush administration wanted to tap the huge
natural gas beds in Alaska, including inside the Arctic National Wildlife
Refuge. Opponents of the plan have ridiculed the energy proposal as
extremely shortsighted and, from an environmental perspective, they’re
probably right. What is rarely said, however, is that the massive reserves of
US natural gas (the world’s largest outside of the Middle East and Russia!) are
almost exclusively situated in areas which are as environmentally sensitive as
the Arctic Wildlife Refuge.
In short, the message the US government created--namely to use clean-burning natural gas over oil--has been wildly
successful, but efforts to increase supplies have stalled on every front. In a way, then, the natural gas imbalance is a
microcosm of the US energy situation as a whole. When all forms of energy are considered, the United States lacks a
coherent vision. On the one hand, Americans from coast to coast completely lack the will to cut back on even the most
wasteful usages of energy; on the other, they oppose creating incentives for added production.
Natural Gas the Preferred Energy Source
Natural Gas Statistics
The US Supply Deficit
(billion cubic meters)
2002 shortfall
119
Pipeline imports from Canada
LNG imports from Trinidad
LNG imports from others
109
5
5
Total imports
119
The trouble with natural gas, in particular, is that reducing demand voluntarily is
not easily done. Just as individual consumers using natural gas are unlikely to
replace their heating systems in order to switch back to oil, industry is equally
inflexible. More and more of America’s utilities use natural gas-fired
generators to create electrical power. Whole sectors of industry, also, are
woefully dependent on natural gas: the chemical industry, in particular, uses
natural gas in the production of fertilizers, plastics and synthetics. Pulp and
paper mills, as well as the steel, glass, automobile and food processing industry
use natural gas as their primary energy source. Moreover, as new regulations
curtail environmentally unfriendly energy (coal) or energy that’s considered
unsafe (nuclear), natural gas usage is boosted even further.
The bottom line: a sizeable supply deficit for natural gas will remain for years, which will lead to sporadic price spikes.
Timing these spikes will prove difficult, as fluctuations in weather patterns and industrial activity are notoriously difficult to
predict. For you as an investor, that means that the best time to position yourself in this volatile arena is at times of weakness
in natural gas prices. The certainty that a balancing of demand and supply will take years to accomplish will most likely lead
to a protracted uptrend at least in the near and intermediate terms.
The reason I’m writing to you
today is because natural gas
prices have retreated
sufficiently since last winter to
make investment compelling.
From a seasonal viewpoint, as
well, the timing appears
favorable. Winter is not far
away and the odds are good
that the US will once again
enter the cold season with
insufficient natural gas
inventories. And finally there is
the economic cycle. The US,
Canada and Japan, three key
natural gas users, are all in the
recovery phase.
What to do now
One way to play natural gas is to buy commodity futures or options on futures. Both belong to the realm of seasoned
traders, which is not the constituency of Perspectives. The preferred vehicle for investors is that of energy stocks with a
strong natural gas exposure. We already hold core positions in two such companies: Devon Energy and EOG Resources.
Today, I’d like to add two other firms with good leverage to natural gas: Encana Corporation and Burlington Resources. At
the same time, I’d like to significantly boost our exposure to the natural gas sector. But more about that later; let me first tell
you why I believe in this quartet of natural gas sensitive stocks.
Devon Energy (NYSE:DVN). Devon represents the largest energy holding in my model portfolio. I view it as the premier
investment for those seeking a company with extraordinary growth and strong leverage
to natural gas price movements. An independent energy company engaged primarily in
oil and gas exploration, development and production, Devon holds a strong portfolio of
producing properties in the United States, Canada and abroad. Management has done
a superb job in growing through a string of well-timed and superbly executed
acquisitions (in the past three years Mitchell Energy, Anderson Exploration and Ocean
Energy) and it has also been very successful in growing reserves and converting them
into producing assets. Devon is vulnerable to a decline in natural gas prices, but will handsomely benefit in an environment of
price strength.
Current Share Price:
2004 Cash flow per share:
US$50.90
US$12.47
Yield: 0.4%
Price/2004 Cash Flow: 4.1X
EOG Resources (NYSE:EOG). EOG explores, develops, produces and markets natural gas and crude oil. The company
operates mainly in the United States (67% of production), Canada (16%) and Trinidad
& Tobago (17%). EOG’s growth profile is compelling, and the company’s most recent
acquisition of Canadian assets from Marathon may boost it further. What attracts me to
the stock: EOG trades at a reasonable valuation, has a very strong balance sheet, and a
whopping 87% of operations is weighted towards natural gas!
Current Share Price:
2004 Cash flow per share:
US$40.90
US$8.25
Yield: 0.5%
Price/2004 Cash Flow: 5.0X
EnCana Corporation (NYSE: ECA, TSX: ECA). EnCana was formed through the merger of Alberta Energy and
PanCanadian Energy Corporation. It is an independent natural gas producer and gas
storage operator. Approximately 90 of the Company's assets are in four key North
American growth platforms: Western Canada, offshore Canada's East Coast, the
United States Rocky Mountains and the Gulf of Mexico. EnCana also operates in
Ecuador and the North Sea. I like the company because it has extraordinary exposure
to natural gas.
Current Share Price:
2004 Cash flow per share:
US$36.80
US$7.80
Yield: 0.8%
Price/2004 Cash Flow: 4.6X
Burlington Resources (NYSE:BR). Through its principal subsidiaries, Burlington Resources Oil & Gas, Louisiana Land
and Exploration, Burlington Resources Canada and Canadian Hunter Exploration Ltd.,
BR is engaged in the oil and natural gas exploration, development, production and
marketing. The Company conducts business in North America, Canada and elsewhere.
Burlington Resources is not capable of the type of growth I foresee for the other three
companies, but it has superb leverage to natural gas. Each 10-cent shift in the
commodity price translates into a gain of roughly 4% in next year’s cash flow!
Current Share Price:
2004 Cash flow per share:
US$47.75
US$8.85
Yield: 1.2%
Price/2004 Cash Flow: 5.4X
How much to buy?
Our model portfolio currently holds a healthy exposure to natural resources stocks, which keeps appreciating. At market
prices, natural resources now make up 21.5% of total equities. Natural gas oriented stocks make up only a modest part of
that: about 1.75% has been held in Devon Energy and 1.75% in EOG Resources. I’m now positioning the portfolio to take
advantage of what I believe will be a protracted uptrend in natural gas prices. At this time, I’ll double the exposure we hold
in Devon and EOG, while adding 2% positions in each of Burlington Resources and EnCana Corporation. I may
recommend further additions as the story develops. £
Publisher: Cavelti & Associates Ltd., Toronto, Canada.
All rights reserved.