A Look Inside the Natural-Gas Industry

Nearly all of the energy companies we cover at Morningstar have an interest in natural gas. Like oil, natural-gas prices tend to be highly volatile, inducing cyclicality in the earnings of natural-gas producers. However, the natural-gas industry has its own unique economic characteristics that, while related to oil, make it quite different than oil. Natural gas prices have recently risen well above their average historical levels in the United States. Higher prices have translated into greater earnings for producers and grabbed the attention of investors. Here are our takes on the natural-gas industry's long-term fundamentals and current outlook.

Fundamentals:
Unlike oil, there is no global price for natural gas, because it is still a geographically stranded resource in most of the world. While gas can be transported over long distances through pipelines, it is not readily shipped between continents like oil. Local prices differ depending on access to supplies, and price differences can be quite large. In North America, natural-gas prices have recently been above $5 per thousand cubic feet (mcf), while natural gas sells for less than $1 per mcf in parts of Russia and the Middle East.

Like oil, natural-gas reserves are scattered unevenly among countries, with most of the world's proven gas reserves in Russia and various Middle Eastern countries. Because the transportation of natural gas is so difficult, countries with abundant natural-gas supplies, like Russia, Qatar, and Saudi Arabia, can't export gas easily or cheaply to areas with high demand, such as the United States. This means that current U.S. consumption is almost entirely supplied by North American producers. Local competition is fierce, however, and there are many firms in North America competing to produce natural gas.

It's possible that the duration of domestic producers' advantage over foreign producers is limited. Some of the world's major energy firms are investing in liquefied natural gas (LNG) facilities and ships. Over the next decade, these firms believe that they can reduce transportation costs enough to compete with domestic producers.

Over the past decade, demand for natural gas has boomed in the United States. After it was deregulated in the early 1990s, natural gas began to gain market share from other energy sources. Consumers were attracted to natural gas' low price, abundance, and clean-burning properties, and investment in natural-gas-fired power plants drove much of the new demand. North America's natural-gas supply hasn't kept up with demand, however, and prices, while volatile, have generally risen. Today, gas prices are nearly twice their historical 10-year average.

In our opinion, powerful economic forces work to drive natural-gas prices toward a long-run level that is just above producers' marginal costs. When prices rise above that particular level, both suppliers and consumers of natural gas are pressured to change their behavior. In the short run, consumers might simply seek substitutes for natural gas, such as heating oil, propane, or coal. If high prices persist, consumers might invest in projects that boost energy efficiency, which could cut their demand for natural gas for an extended period of time.

On the supply side, producers are likely to increase their investment in natural-gas drilling projects that quickly boost production. If high prices persist, some producers might develop properties that were once considered economically unfeasible, which may explain the recent boom in unconventional natural-gas development. If producers boost natural-gas output and customers reduce consumption, gas prices could fall hard and fast. Of course, the reverse should happen when prices are particularly low.

Outlook:
Over the long term, we assume a benchmark midcycle natural-gas price of $4 per mcf with 6% inflation.

Rather than attempt to predict every peak and valley of the natural-gas pricing cycle, we use a methodology that incorporates our thoughts on long-term price trends and also factors in the current stage of the cycle. We start with our best estimate for the current quarter's NYMEX natural-gas futures price and assume that price gradually returns to our inflation-adjusted midcycle price over seven quarters.

How does this translate into numbers? We currently assume an average price of $5.85 per mcf in 2005. In 2006, when our seven-quarter price fade ends, we assume a price of $5.02 per mcf. After that, our long-term inflation assumptions take over, generating an estimate of $4.60 per mcf in 2007 and $4.87 per mcf in 2008.

It's worth reiterating that over the long term we are trying to model average, midcycle prices. That said, we see nothing that would change natural-gas prices' cyclical, volatile behavior. We fully expect that some years (like 2004) will be far above our midcycle price, while others will be below.

We adjust our benchmark natural-gas pricing assumptions on a company-by-company basis to account for the quality and location of the firm's reserves, hedging program, and any political or regulatory factors.