By Sumit Roy
For the financial markets, the ramifications of the Tōhoku earthquake and its aftermath are many. We already saw significant moves across asset classes, from stocks to commodities to currencies, but these short-term effects will likely soon be forgotten. Looking a bit further out, Japan will need to undertake a massive reconstruction effort, which will not only give a much-needed boost to the country's devastated economy, but also lead to a demand increase for raw materials like copper and iron ore.
But perhaps the most notable consequence of the Japanese tragedy will be its impact on the nuclear power industry. Indeed, momentum toward nuclear power that took years of record energy prices and concerns about climate change to develop was shattered in a single week as the events in Japan unfolded.
Backing Off Nuclear Power
This week, German Chancellor Angela Merkel called for a "measured exit" from nuclear power, as the country temporarily shut down half of its nuclear reactors for safety probes. Meanwhile, China — which has led the world's nuclear charge — has halted approvals for new nuclear projects, and ordered safety checks on existing plants and those under construction.
In the U.S., the Obama administration voiced its continued support of nuclear power, insisting that it remains a key component of the country's clean energy future. But the fact remains that the U.S. has built no new nuclear plants in over 36 years. Moreover, given recent events, the public's already-shaky perception of nuclear power has likely deteriorated further, making the construction of new plants even less likely.
But if nuclear power becomes less of an option, obviously something else must replace it. Exactly what that substitution is becomes all the more important as electric vehicles gain traction and electric power becomes an increasingly crucial element in the energy mix.
Without question, the main beneficiary will be natural gas.
Look no further than Japan itself; the country — which is already the world's largest LNG importer — has further boosted imports of liquefied natural gas to offset its lost nuclear output. Benchmark U.K. National Balancing Point prices have risen 10 percent since the Tōhoku earthquake, trading last at 63 p/th, or close to $10/mmbtu. That rise still leaves prices close to 50 percent cheaper than crude oil on an energy-equivalency basis.
Although benchmark U.S. Henry Hub natural gas has also risen in recent sessions, it remains largely disconnected from global dynamics, given our abundance of supply and lack of export capabilities. At around $4/mmbtu, U.S. gas prices remain extremely cheap relative to competing fuels, which makes the commodity especially compelling for utility operators.
John Rowe, CEO of Exelon (EXC), the largest nuclear plant operator in the U.S., recently said that, given current electricity prices, new nuclear plants were not economically feasible: "Nuclear plants are out of the money by at least 30 or 40 percent right now and probably by a factor of two." He added that a steady supply of the fuel means that "gas is queen for at least a decade and perhaps two."
All this bodes well for U.S. natural gas demand, which surged 5.7 percent in 2010 to hit record highs, boosted mainly by a 7.4 percent increase in electric power demand. Indeed, natural gas has seen its electric power market share increase each year over the past decade. Recent catalysts should only accelerate that trend; the confluence of low prices and popular resistance to coal and nuclear will serve to increase gas' share of the pie even further. If current growth rates are maintained, natural gas could surpass coal as the No. 1 fuel in the electric power sector by early next decade (incidentally, gas surpassed nuclear as the No. 2 fuel in 2006):
Source: Department of Energy
Getting Exposure To Natural Gas
Given natural gas' bullish fundamentals, investors should consider exposure to the sector. The purest way to bet on the global LNG market is through ICE futures NBP. Though they've rallied recently, prices for the benchmark remain below their 2008 highs, sitting near 80 p/th. Thus, to mitigate the steep forward curve, investors may want to avoid the front end and concentrate instead on the out-years.
While natural gas prices outside of the U.S. are much higher, more investment opportunities exist here at home. But don't stick just to UNG; in this case, it's best to avoid futures (or futures-based ETFs) because so many better opportunities exist elsewhere.
Low-cost producers with positions in gas-rich, unconventional plays offer some of the space's most attractive long-term investments. Even if natural gas prices remain depressed for some time, these companies will still be able to increase output and cash flow rapidly, and can capture any upside in prices. Such firms include Range Resources (RRC), Southwestern Energy (SWN) and Ultra Petroleum (UPL).
The First Trust ISE-Revere Natural Gas Index Fund (FCG) offers a solid pure-play pick for ETF investors, but for those looking for diversified oil & gas exposure, I find the best ETF in the space is the iShares Dow Jones US Oil & Gas Exploration Index (IEO). Other ETFs often weight too heavily toward the integrated oil companies and even the refiners, while others, like the TR/J CRB Wildcatters Exploration & Production Equity ETF (WCAT), offer worse performance for a higher price. But even IEO isn't a perfect play, as it contains firms whose output contains a large percentage of crude oil. Then again, in the current high oil price environment, that's been an added bonus to returns.