Natural Gas Prices Tick Up On Hot Weather, But Investors Shouldn't Expect Much More Upside

Includes: EGN, SCG, SO
by: Roger S. Conrad

Four months ago, natural gas bottomed out at a 10-year low of less than $2 per million British thermal units. Since then, the price has rocketed around, actually bursting over $3 in early July before backing off later in the month.

According to the US Dept of Energy (DoE), America's inventories of natural gas are still running 20 percent above their five-year average. That's despite the fourth-hottest summer on record, which drove demand for gas to generate electricity up 21 percent over 2011 levels. Gas' stockpile surplus is well down from its high of 61 percent above the five-year average, which was reached at the end of March 2012.

But the conditions that have relentlessly pushed down prices the past five-plus years--mainly abundant supplies of low-cost shale gas and no way to export it from North America--are still very much with us. Prices are likely to plunge once again during the next stretch of mild weather. Overlooked is the fact that conditions for accelerating natural gas usage have never been more robust. The key is the continued dash to gas by electric utilities and other power producers, spurred by the fuel's low price, wide availability and, to a lesser extent, its environmental advantages.

At $10 gas, almost any producer is a winner. The numbers fall sharply at $4 to $5 and are a very short list under $2. Cheap gas, however, is a major boon for companies geared up to take advantage of rising gas usage in power generation. Check out the graph "Electrics Move to Gas," which tracks the percentage of US electricity generated by coal, natural gas, nuclear and renewable energy, which is mainly hydro, wind and solar.

Since 2004, the percentage of nuclear has risen slightly, as operators have increased efficiency of existing plants. Fueled by government mandates and subsidies, wind and solar have also enjoyed a powerful surge, offsetting a slight decline in hydro output.

The most powerful trend, however, has been relentless switching from coal to natural gas. In fact, the pace this year has likely been underestimated by the DoE's Energy Information Administration, as coal and gas generated equal amounts of power in April for the first time ever.

Contrary to popular belief, the Environmental Protection Agency [EPA] under the Obama administration, has played only a bit part in the big switch. Tighter enforcement of laws already on the books for mercury and acid rain gasses has induced some older plant closings. But the EPA pointedly exempted operating coal plants from new rules on carbon dioxide.

Rather, this switch is being fueled primarily by price. Gas is too cheap for coal to compete with. And short of a new set of government subsidies, that's not likely to change any time soon.

The table "What's to Come" highlights planned additions to the US power supply and their source.

Except for subsidized renewables, natural gas plants are virtually the only generation facilities under development. Nuclear reactors now under construction at SCANA Corp (NYSE:SCG) and Southern Company (NYSE:SO) in the Southeast US may alter the equation late in the decade. Southern, however, is one of the biggest coal-to-gas switchers, with 47 percent of electricity now coming from gas, up from 16 percent five years ago.

Meanwhile, coal is down to 35 percent of output from 70 percent. And gas use may get another lift if Congress doesn't extend the wind power tax credit past scheduled expiration on Dec. 31, 2012. Even with scorching temperatures this summer, natural gas prices only managed to briefly crack $3 per million British thermal units. That makes it highly unlikely we'll see a return to even last summer's price range of $4 to $5.

Producers have been able to make up the difference in recent years by shifting focus to oil and natural gas liquids [NGL]. This ability, however, has been thrown into doubt by the plunge in oil prices from nearly $110 a barrel earlier this year to less than $80 for a time in late June.

One low-risk energy play in the current pricing environment is Energen Corp (NYSE:EGN). Its Alabama gas distribution utility represents only a small portion of overall earnings and aggressive price hedging and reliance on proven reserves have kept profits very steady.

Disclosure: I am long SO, EGN.