Contributing editor Tom Slee is back with us this week and he has been taking a long, hard look at natural gas prices and why they are so low. Some of his conclusions may surprise you. Tom managed millions of dollars in pension money during his career and is also an expert in taxation. Here is his report.
Tom Slee writes:
It's official: we have just lived through one of the warmest winters on record. Temperatures were a staggering 21% above normal, the highest since 1895. For many Canadians it was a welcome relief from clearing driveways and digging out cars. But it was bad news for the energy sector. A lot of companies, such as utilities and coal producers, depend on a long cold spell.
As a result, their 2012 earnings are going to suffer. Railways relying on coal shipments are feeling the pinch and midstream energy companies such as Keyera are now left with excess gas storage and servicing facilities. Even energy retailers have been meeting consumer resistance as home heating bills shrink.
To make matters worse, even before the current warm spell corporate profits were being squeezed by a glut of North American natural gas. It's currently trading at about $2 (all prices in U.S. figures) per thousand cubic feet (mcf), the lowest price for 10 years. In fact, gas inventories are bursting at the seams. It's an odd situation because energy prices normally move in unison. Traditionally there has been a fairly constant relationship between coal, oil, and natural gas prices. However, in this cycle oil has boomed and traded above $100 a barrel from February until last week while gas and coal have slumped. The last time natural gas prices were this low was in 2002 when oil traded at $20 a barrel.
Is it a permanent change? Some analysts and industry experts think so. They are convinced that the emergence of shale gas production is a game changer. According to their estimates this supposedly new, almost unlimited supply is going to solve America's energy dependence problems and keep gas prices at their present levels indefinitely. If so, conventional Canadian gas producers such as Encana and Peyto have serious problems.
Obviously, shale gas is an increasing factor in the market. It accounts for approximately 27% of American production already. President Obama has hailed it as whole new energy source capable of making the United States self sufficient. But is it really? For a start, there is far less economically recoverable supply than claimed. According to some producers we have 85 years of shale gas reserves at the present consumption rate. In fact, there are 11 years of proven deposits. Beyond that it's a lot of wet finger guessing. Surveys show perhaps another 20 years of "probable" supply in the present fields, maybe a further 22 years "possible" in potential fields, and an estimated 30 years or so in undiscovered fields.
More important, this is relatively expensive energy. Shale gas has been extracted since 1825 but it only became viable in the 1970s when the U.S. government poured money into its development. The process is expensive and complicated. If it were not, the private sector would have made it into a major industry years ago. It could become a whole lot more expensive if environmentalists are able to limit the destructive chemicals being used.
However, politicians and developers have successfully promoted shale gas as cheap and plentiful because it suits their purposes. They point to the fact that when natural gas demand collapsed in 2008, along with everything else, U.S. shale operators continued to drill as if price was unimportant. The truth is that much of that activity was required to meet lease and new pipeline contracts.
Since January, with gas at $2 per mcf, shale operators have been closing down their operations along with everybody else. It's now apparent that they need about $6 per mcf to break even, perhaps $7.50 as deposits decline. Arguably, shale gas will push energy prices higher, not depress them as demand picks up.
I think that the natural gas glut results primarily from the warm weather, a weak economy, over supply due to excessive and unwanted shale production, and the fact that oil companies are working full blast and producing gas as a by-product. A perfect storm!
One thing is certain. All this has combined to cast a pall over Canadian oil and gas stocks. Enerplus is down 45% from its 52 week high. Pengrowth is off 37% and Arc Resources recently plummeted almost 24% in less than four weeks. Keyera, hurt by tumbling propane prices, has slipped badly.
There are two immediate fears. If gas prices remain low then some companies may cut their dividends: NAL Energy has already reduced its annualized payout to $0.60 a share from $0.72 last year. Also, a lot of producers secure their lines of credit with gas reserves and these are shrinking in value. So, along with reduced income, companies are feeling a second cash pinch as banks reduce their loans.
The entire situation spells opportunity. I see the gas industry headwinds as temporal rather than structural. The weather will become more seasonable and investors are going to put shale production into perspective. It's an important development but not a sea change. The present North American gas prices are an aberration as last week's rally suggests. In Europe, natural gas trades at $7 per mcf while in Asia the price is closer to $10. As a result, American producers are moving rapidly to increase their exports.
At the same time you can already see supply tapering off. Companies are slashing their output. Currently there are only 624 rigs operational, the lowest number in 10 years. When inventories are exhausted and demand picks up, producers will be scrambling. The most pessimistic forecasters are looking for $3.75 per mcf next year. Stock market prices are likely to reflect the improvement long before then.
This is the time to gradually accumulate senior gas producer stocks while they are at bargain prices. This strategy allows you to participate in the eventual recovery. Choose companies with a proven track record and well hedged production that will protect them during the balance of 2012. Look for producers with substantial untapped credit facilities so that they can retain sufficient cash flow.
Encana (ECA) fits the bill with 56% of its production hedged, substantial unused credit, and a strong balance sheet. The shares are trading at well below their C$22 book value and at C$21.24, US$21.20 yield 3.8%. These are suitable for long-term investors seeking income and prepared to wait for capital growth. ARC Resources (TSX: ARX) at C$19.85 also offers excellent value with 65% of its gas output hedged and more than 50% of its credit untapped.
My own pick remains Talisman Energy (TLM, Financial) mainly because of the company's 50% oil and 50% gas production. We should see earnings growth this year as oil continues to trade around $100 a barrel and a surge in 2013 when gas recovers. This is one of my "Four best stocks for 2012" and my update follows.
Coal stocks are also cheap. A combination of the unusually warm weather, low-priced gas being used to generate electricity, and the closing of old coal-fired utilities has driven domestic coal prices lower. U.S. metallurgical output, priced at $380 a metric ton a year ago, is now at $200. Appalachian thermal coal is at $55 a ton, the lowest level in two years. Actual production is down 15% from 2011 levels. We are, however, seeing some signs of recovery thanks to an improving U.S. economy and the weather reverting to a more normal pattern. Moreover, the major international producers have been protected by foreign demand. China's steel production rebounded in March and Peabody Energy (NYSE: BTU), which is on our Recommended List, turned in a better than expected first quarter.
Even the railways have felt the impact of a warm winter because their business and coal production go hand in glove. CSX and Norfolk Southern get almost one-third of their revenues from coal, Union Pacific approximately one-fourth. In March, Burlington Northern had 130 train sets of coal cars in storage, a line of idle units almost 150 miles long. The rails are hurting but fortunately increased container traffic has offset most of the loss.
The truth is that we are in the midst of a massive chain reaction triggered by Mother Nature. A swath of corporate earnings have been squeezed and a lot of stocks badly beaten. As usual, though, there has been an overreaction, especially in the natural gas industry. North Americans have an insatiable appetite for energy and that is going to be satisfied by oil, coal, and natural gas for the foreseeable future. To quote Lyle Stein, CEO of respected Leon Frazer money management firm: "One of the great investment stories that will be talked about in years to come is who bought natural gas stocks in 2011-2012".
Tom Slee writes:
It's official: we have just lived through one of the warmest winters on record. Temperatures were a staggering 21% above normal, the highest since 1895. For many Canadians it was a welcome relief from clearing driveways and digging out cars. But it was bad news for the energy sector. A lot of companies, such as utilities and coal producers, depend on a long cold spell.
As a result, their 2012 earnings are going to suffer. Railways relying on coal shipments are feeling the pinch and midstream energy companies such as Keyera are now left with excess gas storage and servicing facilities. Even energy retailers have been meeting consumer resistance as home heating bills shrink.
To make matters worse, even before the current warm spell corporate profits were being squeezed by a glut of North American natural gas. It's currently trading at about $2 (all prices in U.S. figures) per thousand cubic feet (mcf), the lowest price for 10 years. In fact, gas inventories are bursting at the seams. It's an odd situation because energy prices normally move in unison. Traditionally there has been a fairly constant relationship between coal, oil, and natural gas prices. However, in this cycle oil has boomed and traded above $100 a barrel from February until last week while gas and coal have slumped. The last time natural gas prices were this low was in 2002 when oil traded at $20 a barrel.
Is it a permanent change? Some analysts and industry experts think so. They are convinced that the emergence of shale gas production is a game changer. According to their estimates this supposedly new, almost unlimited supply is going to solve America's energy dependence problems and keep gas prices at their present levels indefinitely. If so, conventional Canadian gas producers such as Encana and Peyto have serious problems.
Obviously, shale gas is an increasing factor in the market. It accounts for approximately 27% of American production already. President Obama has hailed it as whole new energy source capable of making the United States self sufficient. But is it really? For a start, there is far less economically recoverable supply than claimed. According to some producers we have 85 years of shale gas reserves at the present consumption rate. In fact, there are 11 years of proven deposits. Beyond that it's a lot of wet finger guessing. Surveys show perhaps another 20 years of "probable" supply in the present fields, maybe a further 22 years "possible" in potential fields, and an estimated 30 years or so in undiscovered fields.
More important, this is relatively expensive energy. Shale gas has been extracted since 1825 but it only became viable in the 1970s when the U.S. government poured money into its development. The process is expensive and complicated. If it were not, the private sector would have made it into a major industry years ago. It could become a whole lot more expensive if environmentalists are able to limit the destructive chemicals being used.
However, politicians and developers have successfully promoted shale gas as cheap and plentiful because it suits their purposes. They point to the fact that when natural gas demand collapsed in 2008, along with everything else, U.S. shale operators continued to drill as if price was unimportant. The truth is that much of that activity was required to meet lease and new pipeline contracts.
Since January, with gas at $2 per mcf, shale operators have been closing down their operations along with everybody else. It's now apparent that they need about $6 per mcf to break even, perhaps $7.50 as deposits decline. Arguably, shale gas will push energy prices higher, not depress them as demand picks up.
I think that the natural gas glut results primarily from the warm weather, a weak economy, over supply due to excessive and unwanted shale production, and the fact that oil companies are working full blast and producing gas as a by-product. A perfect storm!
One thing is certain. All this has combined to cast a pall over Canadian oil and gas stocks. Enerplus is down 45% from its 52 week high. Pengrowth is off 37% and Arc Resources recently plummeted almost 24% in less than four weeks. Keyera, hurt by tumbling propane prices, has slipped badly.
There are two immediate fears. If gas prices remain low then some companies may cut their dividends: NAL Energy has already reduced its annualized payout to $0.60 a share from $0.72 last year. Also, a lot of producers secure their lines of credit with gas reserves and these are shrinking in value. So, along with reduced income, companies are feeling a second cash pinch as banks reduce their loans.
The entire situation spells opportunity. I see the gas industry headwinds as temporal rather than structural. The weather will become more seasonable and investors are going to put shale production into perspective. It's an important development but not a sea change. The present North American gas prices are an aberration as last week's rally suggests. In Europe, natural gas trades at $7 per mcf while in Asia the price is closer to $10. As a result, American producers are moving rapidly to increase their exports.
At the same time you can already see supply tapering off. Companies are slashing their output. Currently there are only 624 rigs operational, the lowest number in 10 years. When inventories are exhausted and demand picks up, producers will be scrambling. The most pessimistic forecasters are looking for $3.75 per mcf next year. Stock market prices are likely to reflect the improvement long before then.
This is the time to gradually accumulate senior gas producer stocks while they are at bargain prices. This strategy allows you to participate in the eventual recovery. Choose companies with a proven track record and well hedged production that will protect them during the balance of 2012. Look for producers with substantial untapped credit facilities so that they can retain sufficient cash flow.
Encana (ECA) fits the bill with 56% of its production hedged, substantial unused credit, and a strong balance sheet. The shares are trading at well below their C$22 book value and at C$21.24, US$21.20 yield 3.8%. These are suitable for long-term investors seeking income and prepared to wait for capital growth. ARC Resources (TSX: ARX) at C$19.85 also offers excellent value with 65% of its gas output hedged and more than 50% of its credit untapped.
My own pick remains Talisman Energy (TLM, Financial) mainly because of the company's 50% oil and 50% gas production. We should see earnings growth this year as oil continues to trade around $100 a barrel and a surge in 2013 when gas recovers. This is one of my "Four best stocks for 2012" and my update follows.
Coal stocks are also cheap. A combination of the unusually warm weather, low-priced gas being used to generate electricity, and the closing of old coal-fired utilities has driven domestic coal prices lower. U.S. metallurgical output, priced at $380 a metric ton a year ago, is now at $200. Appalachian thermal coal is at $55 a ton, the lowest level in two years. Actual production is down 15% from 2011 levels. We are, however, seeing some signs of recovery thanks to an improving U.S. economy and the weather reverting to a more normal pattern. Moreover, the major international producers have been protected by foreign demand. China's steel production rebounded in March and Peabody Energy (NYSE: BTU), which is on our Recommended List, turned in a better than expected first quarter.
Even the railways have felt the impact of a warm winter because their business and coal production go hand in glove. CSX and Norfolk Southern get almost one-third of their revenues from coal, Union Pacific approximately one-fourth. In March, Burlington Northern had 130 train sets of coal cars in storage, a line of idle units almost 150 miles long. The rails are hurting but fortunately increased container traffic has offset most of the loss.
The truth is that we are in the midst of a massive chain reaction triggered by Mother Nature. A swath of corporate earnings have been squeezed and a lot of stocks badly beaten. As usual, though, there has been an overreaction, especially in the natural gas industry. North Americans have an insatiable appetite for energy and that is going to be satisfied by oil, coal, and natural gas for the foreseeable future. To quote Lyle Stein, CEO of respected Leon Frazer money management firm: "One of the great investment stories that will be talked about in years to come is who bought natural gas stocks in 2011-2012".
