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Natural Gas Reaches Capitulation

Supply glut, warm weather, and rock-bottom prices challenge producers.

Philip Guziec, 06/15/2012

With the cost of gasoline spiking over $4 per gallon and natural-gas prices falling to 10-year lows, energy concerns have been in the news a lot this year. On April 11, I sat down with two Morningstar equity analysts—Mark Hanson and Avi Feinberg—to dig deeper into what’s going on in the oil and gas sector and what it means to investors.

Philip Guziec: Update us on the situation with natural gas. It’s a very different story today than it was just a decade ago.

Avi Feinberg: Today, natural gas is about $2 per 1,000 cubic feet, which is the lowest price in a decade. What’s going on? Well, there’s a confluence of factors here. There is certainly growing production, with shale plays and other unconventional production. Year to date, production is up about 5% in the United States. At the same time, we had a historically warm winter, so demand is off by about 5% so far this year. Combine those factors, and you have record-low natural-gas prices. The question is, How long will this go on? That’s a tough question to answer.

Guziec: We’ve seen headlines about the United States having a 100-year supply of natural gas. Is that really the case?

Mark Hanson: Some people say there’s 100 years of supply. But it’s hard to really know exactly how much. Certainly, there is a wealth of supply, and it’s a blessing and a curse.

On the one hand, firms have found ways to unlock the source rock. Traditionally, they went after pockets of gas; now, they’re actually going after the source—the rock where the gas migrated from.

The flip side is that the United States has no real ability to export excess supply. We can only store between 60 and 90 days’ worth. We can’t store the stuff in tankers offshore. It’s very difficult to compress and move it to global markets. The facilities involved in that process cost several billion dollars and take several years to construct, so it’s a threeto four-year story before large-scale exporting becomes a reality. In the short term, as Avi said, weather factors and excess supply are going to put pressure on natural-gas prices throughout the summer. Now, that can get worked off in a matter of a few quarters, but those producers that rely almost exclusively on natural gas for their revenue are really going to be challenged.

On the demand side of things, coal-to-gas switching typically takes place below $3.50 per 1,000 cubic feet. So you’ve seen a pretty big uptick in consumption of natural gas from power producers. Ultimately, the savior of the natural-gas market in the short term could be power generation, where enough people have incentive, given low prices, to work off that excess supply.

Feinberg: I agree with Mark. Long term, you’ll see more coal-to-gas switching, for sure. We think that that’ll help stabilize the supply-demand balance. But that’s not to say it couldn’t get even uglier in the shorter term. Storage is about 60% above the five-year average for this time of year, closing in on 1 trillion cubic feet above the average. So that’s a lot of gas to work off, and we’re only partway through the injection season.

Guziec: The injection season?

Feinberg: When they start injecting gas back into storage, which typically occurs during the warmer months, from April through October. It started early this year because of the warm weather.

Physical storage capacity tops out at about 4.1 trillion cubic feet, and there’s a possibility we could test that limit if we don’t have a hot summer, which could further depress natural-gas prices in the short term.

Guziec: Do we have long-term price assumption for natural gas?

Feinberg: Yes, $6.50 is our long-term view on natural gas, starting in 2014 and forward. We assume that there is a demand response on the coal-to-gas switching side. We also assume that producers are going to be rational. We’ve already seen a lot of rigs switching over from dry-gas plays to rich-gas plays, which are areas where the gas has more liquids embedded in the gas stream. Rich-gas plays are a lot more economic at today’s prices. The prices of natural-gas liquids tend to track the prices of crude oil, so there are much stronger returns in drilling rich-gas areas than dry-gas areas right now.

Guziec: OK. Let’s turn to oil. What’s driving the current price?

Hanson: Demand has picked up fairly significantly from the depths of late 2008 and early 2009 and is recovering into a morenormal rate. Emerging markets, in particular China, are still a big driver of oil consumption.

On the supply side, with the Iranian sanctions that are being put in place by Europe and the United States, the question has become one of swing capacity: Who has the ability to ramp up supply to meet incremental demand? That ability is limited and has been the big driver of current pricing. West Texas Intermediate (WTI) in the United States has been above $100 per barrel for most of 2012, and its counterpart in Europe has been close to $120 per barrel.

Guziec: Do we see a steady long-run supply curve, or do we see more volume coming online?

Hanson: The incremental barrel is increasingly difficult to find. You’re going into deeper and deeper waters to try to locate that barrel. Saudi Arabia can pump out only so much, and with limited capacity, it’s going to be a tight situation, depending on what happens in China and whether they have a hard or soft landing. If they curtail demand significantly, you could see prices come down. But over the next handful of years, current conditions probably will continue.

Guziec: What about things like oil sands, tar sands, gas to liquids? Will they have a material effect on making the supply curve more shallow?

Hanson: It could, but you have to remember, too, that Saudi production is fairly cheap. Oil sands are relatively expensive. So anytime you have oil above $100 a barrel, the producers are going to have incentive to bring on that supply. If you see any softening in demand at that point, then the incremental barrel probably doesn’t come from oil sands. Guziec: OK, but do we see prices going to $300 per barrel based on increasing demand, or as prices rise, do we see more supply coming online from these alternative, higher-cost sources?

Hanson: I just don’t see there’s anywhere you can really step on the gas and have that much of an impact.

Guziec: No pun intended?

Hanson: No pun intended. As hard as the United States is pushing right now, a state like North Dakota or Texas might be able to add a half million barrels, maybe 1 million, per day. Global demand is more than 80 million barrels per day. There are not too many places that haven’t been explored or developed where you can say, “Yes, if demand goes up 10 million barrels per day, we can meet that demand without having to go offshore or develop the $150 barrel.”

Feinberg: Just to add to that, our long-term price outlook for WTI is $95 per barrel, starting in 2014, which then grows with inflation.

U.S. oil demand is 19 million barrels per day—by far the largest demand worldwide. And as we saw in 2008 when prices spiked, there’s a demand response when gas prices start creeping above $4 per gallon. We’re approaching similar rates now. I think that keeps oil range-bound. That’s not to say that we won’t see price spikes up above $100 for a sustained period of time. There’s definitely the geopolitical element there. But there’s a fundamental upside ceiling, as well.

Guziec: Is the geopolitical risk more of a trading risk as opposed to a long-term supply risk?

Hanson: Well, Saudi Arabia is producing 10 million barrels per day, and they say they can go up to 12 million. If there were a disruption in Saudi Arabia, it would be a real wild card. Iran is producing 2 million barrels per day. It’s hard to say that a society like Iran could survive very long if they weren’t able to sell oil. It’s one of their primary exports and primary sources of capital. If that dries up, it’s likely Iran would respond to sanctions to bring supply back online.

I think it’s obvious that there’s a range of reasonableness. At $150 per barrel, demand is destroyed; at $50 per barrel, no one invests. So prices oscillate between those two extremes. You can certainly see spikes for short periods of time, but it’s difficult to envision those extremes sustained for two or more years.

Guziec: So, we’ve got cheap natural gas. It’s going to triple over the next few years. We’ve got expensive oil. It’s going to stay about where it’s at in the long run. Where do you see the opportunities for investors?

Hanson: On the upstream side—the guys that actually produce gas and oil—the oil companies are expensive at this point. We think the real opportunity right now resides in the gas producers.

Ultra Petroleum UPL is almost all dry gas. We think that the fair value estimate for that stock is around $50 per share. It’s currently trading at about $19 per share, so there is pretty significant upside. But the company will have to navigate some turbulent waters over the next few quarters. It could be facing some covenant issues and some balance-sheet tightness, but if it can get through some of those issues and gas prices recover, Ultra stands to benefit as one of the low-cost producers in the industry, with 10-plus years of drilling inventory in two of the better fields in the United States.

Feinberg: A name we like in the midstream space is TC Pipelines TCP. Our fair value estimate for it is also $50, and it’s trading at about $43. It’s about 12% under value, but this is a low-uncertainty name because of its very high-quality assets. TC Pipelines owns interests in or outright owns six natural-gas pipelines, primarily in the Western United States. These pipelines produce 100% fee-based cash flows, so they’re not exposed to the actual underlying commodity price. Management is very conservative and runs the business for the long term. TCP currently yields about 7%. We think that they can grow that distribution about 4% to 5% per year.

Guziec: TCP is a master limited partnership, correct?

Feinberg: Yes. It’s a limited partnership that is publicly traded. So you get the liquidity of a typical C corporation on a stock exchange, but with a limited partnership structure. The advantage of a MLP is that you don’t pay federal income taxes at the partnership level, so you’re not double-taxed as you would be under a traditional C-corporation structure. That being said, MLPs can create complex tax issues, so consult a tax professional. Guziec: Certainly. Are there any other opportunities out there? Is anything materially overvalued right now?

Hanson: I would say companies are more fairly valued than overpriced. Most of the oil companies I cover are 3 and 4 stars, meaning they’re fairly to slightly undervalued.

Feinberg: Midstream energy is on the whole around 94% of fair value, so slightly undervalued. There is a fair number of 4-star names, but nothing in the 5-star category right now. I also have a few companies that are a little bit overvalued, 2-star names. Those tend to be in the crude-oil-focused space because they’ve had some really strong quarterly results. Given some of the logistical constraints with the shale development of crude oil, they’ve been able to collect a lot of rents. With pipeline capacity being very tight between certain markets and trucking fleets being tapped out to the max, they’re able to charge attractive fees for business that aren’t always there.

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