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What about Natural Gas?

All eyes are on oil, but the natural-gas industry faces interesting times.

Paul Justice, 11/03/2008

With commodity price volatility picking up, Morningstar's oil and natural-gas analysts have taken a long, hard look at the companies that they cover. I sat down with Eric Chenoweth, the associate director of Morningstar's energy team, to get his take on the state of the North American natural-gas space.

Paul Justice: As recent as June, worries had persisted that the world is running out of hydrocarbons. Then in July and August, several ex-energy sectors rallied while claiming that the great "commodities bubble" had popped. Clearly, there is little stability in the market consensus regarding the true state of the energy markets. Specifically regarding North American natural gas, several new productive basins have raised concerns that we may have a 1980s-style supply overhang in the near future. What's your assessment of the state of natural-gas supplies today?

Eric Chenoweth: We expect that natural-gas production will expand in the U.S. in the coming years. Technological advancements (horizontal drilling, fracturing, and completion) have helped the industry gain confidence in unlocking gas from tight shale targets. In particular, success in the Barnett shale (under Fort Worth, Texas, and surrounding counties) has helped embolden many producers to explore the broader shale-gas potential in North America. Fears of an oversupply situation have emerged this year thanks to some very impressive wells drilled in the Haynesville Shale (northern Louisiana and eastern Texas) and some extrapolation of those limited well results. Also, it looks like domestic gas production will expand 5%-10% this year, which is a pretty big gain. One of the big limitations to seeing all of this potential realized in short order (and another investing opportunity) is the new midstream infrastructure (pipelines, gathering systems, and processing plants) that will be required to bring gas from these new producing regions to market.

We're watching the activity in the Haynesville and other shale plays closely. It's worth noting that foreign sources of gas supply have been weak (especially liquefied natural gas) this year, as natural-gas prices in Asia and Europe have been nearly double what we've experienced in the U.S. This global pricing dynamic-if it persists--should limit the flow of LNG to the U.S. The good news in all of this is that the base decline rate for natural-gas is still high in the U.S., which means that the producers need to drill to maintain and grow production.

PJ: What about the demand side?

EC: Demand for natural gas has evolved considerably over the past decade and a half. The largest single source of natural-gas demand is now power generation (it took the lead from industrial demand definitively in 2007). This trend is continuing to expand, as more new gas-fired power plants get built in the U.S. relative to coal plants. So the outlook for natural-gas demand is good. It's worth noting that gas demand is very weather-sensitive in any given year, so a cold or warm winter can really influence the price of gas, and it typically leads to a lot of the volatility we see in the stocks of the gas producers. The good news is that demand for gas is less economically sensitive today than it was a decade ago.

PJ: How have natural-gas stocks held up regarding these concerns?

EC: We had a fairly cold winter last year, so the gas stocks started out the year with a bang. However, as the supply grew and the estimations of the productive potential of the Haynesville grew, the stocks really took a dive late in the summer.

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