Natural Gas: Driving Your Competition Out Of Business

The abundance of natural gas can be attributed to some technological advances in drilling methods. Horizontal drilling and hydraulic fracturing has enabled the extraction of vast volumes of shale natural gas that otherwise would be uneconomical. A decade ago this was unheard of.

The supply spike has had a dramatic impact on prices as demand has not increased to keep pace with the increase in supply/reserves. Exploration and production exploded and naturally prices have cratered to now being under $2/MMBTU. The industry has been through similar rough patches in the past. As is often the case the marginal producers cannot drill profitably at low prices and eventually disappear either through bankruptcy or asset purchases by stronger remaining competitors.

Rig counts have recently been on the decline and at current low nat gas prices will likely continue to decline either through strategic decision making or bankruptcy. Up until recently the major integrated oil energy companies were ramping up production of natural gas in spite of low prices. Their ability to do this was thanks to the bread and butter oil revenue that could subsidize less profitable operations. The main motivation to keep on drilling even at these low prices can only be summed up as - drive out your weak competition.

The majors can withstand the pain of low nat gas prices. Take Exxon through its XTO acquisition for example. They bet heavily on natural gas but their investment horizon is long-term and can subsidize any operating losses (if so) through their other diversified operations. In the near term many marginal nat gas producers will likely go out of business and the normal cyclicality of the industry will help consolidate the industry and restore some normalcy to production and eventually nat gas prices. Given the Henry Hub futures curve, prices are expected to climb over the next several years. Hence, those companies that have the staying power may benefit tremendously by the upward sloping futures curve and market share gains.

The transition away from dirtier carbon fuels such as coal to natural gas burning turbines in electricity generation will set a trend for natural gas demand over the long term. A whole new infrastructure will be required to be able to accommodate this important shift. Notably coal shipments will likely continue to decline affecting coal mining companies as well as rail companies that help move the commodity. Pipelines will have to be built which will require steel among other materials. So the loss of one industry will be the gain of another. The transformation of an economy has its pros and cons. Surely the environmental gain is not insignificant as fewer rail miles are traveled transporting coal and fewer coal burned to boil water and spin steam turbines.

Investors need to pay close attention to company balance sheets in the natural gas industry and determine who the likely survivors will be. Betting with the 800-pound gorilla is always easier and given the dynamics at play and likely outcomes, probably not a bad idea for now.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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