Natural Gas: A Relatively Safe, Long-Term Investment With Significant Upside

by: Alex Forger

Natural gas (NG) presents an excellent, and relatively safe, opportunity for investors with a long term investment strategy. NG is a great investment opportunity for several reasons: 1) supply and demand favors an increase in the NG price; 2) there is a strong export market for NG; 3) NG benefits from current trends; and 4) NG is resistant to the risks posed by our current recession. This article will first articulate why the NG price has dropped near historic lows, and then expand on these four bullish considerations.

This article analyzes NG generally. It does not discuss specific investment vehicles that will capitalize on an increase in the NG price - this will be included in a follow up article.

Why are Natural Gas prices where they are today?

To develop an informed opinion on the future price of NG, it is critical to understand why it has recently fallen to historic lows. Simply, this depressed price was caused by a large increase in NG supply, and a lack of demand.

NG flooded the market when fracking and horizontal drilling technology enabled Oil and Gas companies to tap into reserves that were previously out of reach NG. The result was that NG supply flooded the market, with stockpiles and production reaching all-time highs. With much more NG than we could use or sell, its price decreased substantially.

The flood of supply was not accompanied by a relative increase in effective demand, which drove the price of NG down. I refer to effective demand, because in my view, US consumers and businesses are largely prevented from using NG because the current infrastructure does not support it. Right now we rely primarily on oil and coal for energy, and building a NG infrastructure takes time.

But this scenario is a blessing in disguise for the savvy, long term investor. Supply is decreasing, the building of NG infrastructure is underway, and demand will increase due to future trends and a strong export market, among other things.

The supply and demand landscape for natural gas

Any analysis of a commodity's price must begin with supply and demand, and both favor an increase in the NG price over the long term. There are two main reasons supply and demand favor an increase in the price of NG.

First, NG production and storage surpluses are decreasing. The amount of NG drilling rigs continues to decline, with the active rig count almost cut in half year over year - from 896 to 495. This rig count is near its 12-year low. In addition, injections into NG storage have been consistently declining. Overall NG storage is still too high, but businesses are adjusting by reducing production.

Second, there is a huge price discrepancy between the price of NG and oil. Recently, oil has fluctuated between 85-93 $/bbl, and NG between 2.7-3 $/MMBtu. Based on powering capacity, the ratio between oil and NG should be 6:1, but it currently exceeds 30:1. It was at 50:1 last April. So at current prices, it is many times more expensive to produce X power output with oil than to produce X power output with NG. This ratio will continue to decline as consumers and businesses turn to the cheaper alternative for power.

NG and oil are not perfect equivalents, but their differences do not warrant this large of a discrepancy. Some costs specific to NG include that it must be processed to extract methane, it must be frozen before it can be transported, and more expensive gas tanks are needed to support it is a vehicle fuel. But these costs will be reduced as the trend towards NG infrastructure continues, and regardless, the costs as they stand do not warrant a 30:1 discrepancy.

There is a Strong Export Market for US NG

Foreign NG prices are significantly higher than US NG prices. In July, European and Japanese NG prices were 3.77 and 4.91 times higher respectively than US NG prices. This export market is being pursued, with US NG producers now applying for export licenses, with some agreements already reached between US companies and Japan.

Whether to export NG is a source of debate, but there is good reason to believe NG exports should, and ultimately will, occur. There is increasing political pressure to reduce our trade deficit, and NG exports would aid that significantly. NG exports would stimulate the economy as NG companies profit and expand. It would create demand for NG, which would reduce the surplus of NG supply and incentivize businesses to resume drilling. Right now, NG is currently sitting unused in stockpiles because prices have dropped so far. This doesn't help anyone, and exporting would remove this stagnation.

Critics argue that exporting would raise domestic NG prices, placing yet another burden on consumers struggling through a recession. The effect of exports on domestic NG prices is unclear, but a moderate increase in NG prices could actually be beneficial. It would provide a reliable source of NG demand, and help stabilize its price. Stable NG prices would eliminate risk because businesses could better project the costs of switching from oil to gas.

NG Benefits from Current Trends

It addition to the bullish indicators currently in the market, NG is well positioned to capitalize on future trends. Because NG gas is "cleaner" than oil and coal, it benefits from the green movement, which is gaining momentum. NG is a cleaner alternative that does not have the prohibitive expense associated with other alternative energy sources.

One green trend that is particularly bullish for NG is potential of the Natural Gas Vehicle (NGV) market. Electric vehicles (EVs) have gotten the majority of attention thus far, but NG even benefits from electric vehicles production because it is a cleaner way to produce electricity.

More importantly, the alternative energy vehicle market is poised to switch to NGVs. Honda was the first big auto company to release a NGV, and it is outselling electric competitors. In addition, both the private and public sector are starting to invest in NGVs. For example, General Electric (NYSE:GE) is partnering with Chart Industries and the University of Missouri to develop an inexpensive home fueling system for natural gas vehicles with a $2.3 million grant from the Energy Department. In addition, the government plans to invest over $13 million dollars in the Methane Opportunities for Vehicular Energy (NASDAQ:MOVE) project, which is devoted to developing NGV and NG fueling systems. Finally, Clean Energy (NASDAQ:CLNE) is a company focused on developing an infrastructure for NGV fueling stations. In a project called 'America's Natural Gas Highway,' CLNE plans to implement 150 NG fueling stations, with over 70 anticipated in 33 states in 2013.

NG is Recession Resistant

NG investments are relatively safe in today's economic climate because NG is non-cyclical, meaning it is not highly correlated with economic fluctuations. Because NG provides a necessary service - power generation - it will stay in demand regardless of the state of the economy. The recession arguably helps the prospects for NG because it is currently so cheap. The recession is a catalyst for change, and businesses and the government will scramble to capitalize on this very plentiful resource.

Conclusion

Because of all these factors combined, the price of NG is well positioned to rise over the long term. This article argues a bullish perspective on the commodity, but it leaves open the question on how to best capitalize on a NG price increase. I plan to follow up with an article that evaluates concrete NG investment options by analyzing how pure of a play they are on NG, and dividing them into categories based on risk tolerance levels.

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. I have no business relationship with any company whose stock is mentioned in this article.