Don't Jump The Gun On Natural Gas

Includes: BOIL, GAZ, UNG
by: Hamlet Capital

The rise of natural gas prices over the past month has prompted some to suggest that a reversal of its negative five-year trend is in the offing. Popular natural gas funds performed handsomely. Those included United States Natural Gas ETF (NYSEARCA:UNG), iPath Natural Gas ETN (NYSEARCA:GAZ), and ProShares Natural Gas ETF (NYSEARCA:BOIL). However, this recent performance is really nothing to get excited about.

There is no doubt that on account of its abundance and ease of extraction, the use of natural gas will increase in the long term, particularly its share in the power generation and heavy transportation markets. Export terminals could likely be constructed in the future, but all these market changers are at least five to ten years away in terms of having a significant and permanent impact on natural gas prices.

Regarding power generation, some speak of converting coal-fired plants into natural gas burners as though it is as easy as flicking a switch. The reality is that the cost of conversion would rival that of building a new plant from scratch. Most plants are designed to burn only one type of fuel. The few dual-fuel power plants in operation are already utilizing natural gas over coal. Indeed, much of the future power capacity will be in the form of natural gas plants, but an investment now in anticipation of this would leave the equity holder with a flat investment until the end of this decade or more.

Much has been written on how heavy-goods vehicles, train locomotives and even ships will gradually adopt natural gas as fuel. Natural gas engines are not a new technology, but there have been no dramatic breakthroughs in their efficiency to warrant replacing diesel fleets. Transportation companies will convert only if all discounted costs such as initial expense and maintenance were less than those of diesel. The cost per BTU is only one factor involved in a decision to convert. By itself, natural gas prices cannot dictate fleet composition. A well developed and predictable infrastructure already exists for diesel transport fuel. The same cannot be said for natural gas. Distribution, compression, refrigeration and storage would account for huge startup costs were a mass conversion to natural gas occur. Unforeseen safety issues might also hinder its adoption.

Given that substantial demand from new power plants and heavy vehicles is years off, there is only slight probability of substantial near-term demand growth. The huge potential supply of natural gas, most of which is still in the ground in wet and dry formations, is more efficiently extracted due to improved techniques. Shale formations are much more common than was thought a decade ago. Additionally, shale extraction technologies are not exclusive to the United States, possibly limiting potential future export projects.

The volume of natural gas coming on line cannot be easily reduced due to the cost and effort required to shut in existing production. Also, byproduct production of natural gas from liquid drilling and refining operations is unlikely to abate. Some point to decreased rig counts as an indicator for increased prices. But with the advent of new fracking technology, a single rig can produce more gas than multiple rigs 20 years ago. There is little to limit the large volumes of natural gas being brought to market.

The main markets for natural gas in the United States are heating, power generation, and industrial, namely plastics and fertilizer manufacture. While industrial consumption is largely dependent on economic conditions, the single largest variable of natural gas consumption is the weather. Cold temperatures drive consumption for heating, while hot temperatures do the same for power generation use. November's price increase was largely on account of unusually cold temperatures in some regions of the United States. Continued weather abnormalities this winter could indeed offer more price upside to natural gas, but making an investment based on weather predictions is pure speculation.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.