Smells Good: The Case for Natural Gas

by: Michael Fitzsimmons

So much attention is being paid to the high cost of crude oil these days, is natural gas being overlooked from an investment perspective? As we all know, natural gas is the dominant heating fuel in a majority of US homes. Natural gas is a fuel for electrical power generation and an important feedstock for the fertilizer industry. Increasingly it is being used as a transportation fuel.

The following natural gas data was obtained from the EIA website:

                                        2002              2006

Marketed Production   19,884,780   19,381,895 [MCF]

Producing Wells           387,772        448,641

Residential Prices        $7.89            $13.75 (thousand cubic feet)

Certainly hurricanes Katrina and Rita impacted natural gas production, distribution, and prices for the periods shown. That said, the trend is clear: US nat. gas prices are rising and roughly 60,000 more wells were needed in 2006 to produce a slightly lower amount of nat gas as in 2002.     

As I write this article, oil is trading at $128/barrel and natural gas is trading at $11.79 per thousand cubic feet, for a price ratio of 10.9 oil/gas. On an energy basis, according to the EIA website:
     1 barrel of crude oil (42 gallons) = 5,800,000 BTU
     1 cubic foot natural gas = 1,025 BTU
So, comparing apples to apples on a BTU energy basis, the energy ratio would be 5,800,000/1,024,000 = 5.6 oil/gas [BTU]. The conclusion here is that, based purely on energy equivalency, natural gas is a bargain at today's prices. One could therefore make a decent bullish argument that natural gas prices need to rise to keep up with oil on a purely energy equivalent basis.

However, it is important to understand that natural gas has limited worldwide transportation. While the market for liquid natural gas [LNG] is growing, it is not close to being transported worldwide on an equal basis with crude oil. That is, natural gas pipelines are predominantly "local". (The US is lagging on LNG terminal licensing and construction, but once enough people get cold in winter or pay too much, the US will be dragged into the 21st century.) Gasoline is refined from crude oil, not natural gas. These two factors are largely responsible for the "energy discount" natural gas trades at versus crude oil.

Will this energy discount continue in the future? Although worldwide pricing for natural gas will surely continue to show considerable variation among localities, worldwide nat gas price differentials should narrow as LNG terminals and transportation vessels increase in number and volume. Transportion and processing costs will be tacked on, but in general expect prices around the globe to consolidate more closely.

Readers of my previous articles know that I am a firm believer in the peak oil theory, strongly suggest the US develop a comprehensive energy policy to confront peak oil, and have published a suggested energy policy
Part of this proposed energy policy proposes that natural gas increasingly be used in place of crude oil based gasoline for transportation solutions. I have identified the nat gas powered Honda Civic GX as an alternative, and people like T. Boone Pickens are working to develop wind energy in the great plains in order to offload the natural gas being used for electrical generation so that it can be used for transportation. Picken's company, Clean Energy Fuels (NASDAQ:CLNE), is currently focusing on natural gas powered fleets. However, there is nothing to say natural gas cannot be used in mass transit or individual automobiles like the Honda GX. There is certainly a need for some infrastructure, however as the price of oil continues to rise, these obstacles to natural gas will slowly but surely be negated.

Long term, there will be a large and growing global market demand for natural gas to replace refined crude oil as the price of crude oil continues its dramatic climb due to worldwide supply/demand fundamentals. Oil is increasingly hard to find and more costly to produce than in years past. In many cases, natural gas is a much cleaner burning fuel as well. Also, expect the US dollar to continue to weaken due to two primary causes:
1) huge fiscal deficits due to the irresponsible tax and spend policies of the last 8 years.
2) as Ross Perot would say, the large sucking sound of $700 billion a year (at current oil prices, and they are rising...) leaving the US to find a home in the Middle East and Russia to pay for oil due to the lack of an US energy policy.
I bring this up because natural gas, as a worldwide commodity, will in the years ahead provide protection against a devalued US currency.

So, how do we play this from an investment perspective? Well, the largest producer of natural gas in the US is ConocoPhillips (NYSE:COP). In hindsight, COP's takeover of Burlington Resources was CEO Mulva's masterpiece. Natural gas pricing and volumes should power ConocoPhilips for years to come. COP is cheap with a PE=11 and a dividend yield of over 2%.

However, many times the smaller players show the greatest increase in production volumes, earnings, and stock price appreciation. My biggest regret is not acting on Continental Resources (NYSE:CLR) earlier! Just as I was looking at the stock at $30 it went to $40. Just as I convinced myself to get in at $40, it went to $50 and then $60. A double while I pondered over the financials! Oh well, my point is, there are others, just do some homework.

Meanwhile, check out these natural gas investment ideas to see if they have a place in your portfolio:
Natural Gas Specific:

  • UNG (Natural Gas Fund ETF)
  • Apache Corporation (NYSE:APA)
  • Chesapeake Energy (NYSE:CHK)
  • Devon Energy (NYSE:DVN)
  • Fidelity Select Natural Gas [FSNGX]

Energy Services:

  • IEZ (iShares Dow Jones US Oil Equipment Index ETF)
  • Schlumberger(NYSE:SLB)
  • Nabors Industries (NYSE:NBR)
  • Fidelity Select Energy Services [FSESX]

A small cap kicker in the nat. gas arena might be Capstone Turbine (NASDAQ:CPST).
Disclosures: The author owns SLB, NBR, FSNGX, and FSESX.