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Six reasons why natural gas is better investment than oil

June 19, 2009 | About:
Todd Sullivan

Vitaliy Katsenelson

62 followers
Six reasons why natural gas is better investment than oil

1. Reserves deplete faster than oil (in general)

2. Oil/natural gas ratio: the price of oil divided by the price of natural gas is at an all-time high (or close). This ratio stands at 17 (historically it has been at about an 8 or so). Natural gas prices will go up, oil will decline, or both.

3. Also, natural gas is not a good hedge against the declining dollar (it is for the most part a domestic commodity) and storage capacity is more limited, thus not as admired by speculators as oil. This explains in part why it lagged the the spectacular performance of oil of late.

4. At $4, natural gas it is uneconomical to develop and look for new reserves.

5. No OPEC competition, LNG (liquid natural gas) imports are uneconomical at these prices.

6. Politically more favorable than coal.

7. After emission caps are implemented natural gas will become a cheaper alternative than politically and environmentally unfriendly coal.

About the author:

Vitaliy Katsenelson
GuruFocus - Stock Picks and Market Insight of Gurus

Rating: 1.7/5 (7 votes)

Comments

DaveinHackensack
DaveinHackensack - 4 years ago
Instead of just stating the price ratio, it would be more informative to flesh it out by explaining the difference in cost per BTU of oil and natural gas. Readers bullish on natural gas may want to look at this natural gas royalty trust: TIRTZ.OB.
Alex Garcia
Alex Garcia premium member - 4 years ago
LINE has a nice div yield, slight discount to BV. I also like EGY a magic formula stock. It has small minority interest in NG

I own EGY
Sivaram
Sivaram - 4 years ago
Dave and Alex, thanks for the suggestions.

How are the royalty trusts taxed? Do you pay your full income tax rate for distributions from them; or is it a favourable rate (like dividends)?

Ignoring a cyclical investing strategy of buying simply to be exposed to rising natgas prices, how do you value these trusts? Do these trusts have a terminal value of zero within a decade? Or are they able to acquire other assets?

Oil & gas royalty trusts are somewhat popular in Canada (the laws and structures are quite different here though) but I have always avoided them because these companies can theoretically end up as a zero once the resources are extracted. The companies will argue that they are capable of acquiring assets but I just wonder. Because of this concern, I have always favoured a "normal" oil & gas company.
DaveinHackensack
DaveinHackensack - 4 years ago
Sivaram,

Royalty trusts in the U.S. are a little different than the ones in Canada. Ones in the U.S. aren't allowed to acquire new assets (although it's possible that new wells will be drilled on properties that TIRTZ.OB already owns). I think the ones in Canada can acquire new assets. Also, their distributions do receive favorable tax treatment, though it's a little complicated. To simplify, there is no double taxation as there is with most dividend-paying companies (where the profits are taxed once at the corporate level and then a second time when they are received as dividends). Also, some portion of the distributions are often characterized as returns of capital.

You raise a good question about how to value royalty trusts. They generally don't terminate after a fixed time period, but clearly they will terminate when their resources are exhausted. When that will be is difficult to determine, as estimating reserves is often an art as much as a science. The two royalty trusts I own, BPT (mainly oil, out of Prudhoe Bay Alaska) and TIRTZ.OB (mainly natural gas, out of the Gulf Coast) I bought initially because they were on the Magic Formula list, and because they were based in the U.S. (which eliminates the political risk of expropriation, but not the political risk of new, confiscatory taxes). I also bought them because they fit with Jim Rogers's thesis of a secular bull market in commodities, and they seemed to offer some hedge against inflation. I couldn't tell you what their "intrinsic values" are, but I feel comfortable owning them here. I'll probably unload BPT in the next few years though, as the Prudhoe Bay field is getting a little long in the tooth.

Incidentally, I own EGY as well. I think there is more potential upside with E&Ps rather than royalty trusts, since E&Ps are inherently levered operationally, as all commodity producing companies are.
value_barbarossa
Value_barbarossa - 4 years ago
You know the only reason a company like TIRTZ.OB shows up on the MF is because the balance sheet doesn't count anything as assets except for about $2.5 million in cash. So in other words, they're not accounting for their assets which actually produce the income.

Since MF screens based on EV/EBITDA and ROIC (which I think is Assets - intangibles - goodwill - cash / EBITDA) you're getting a skewed ROIC # that shows pretty much infinite ROIC.

With all that said I haven't even looked at TIRTZ.OB (although I'm about to start), so this just relates to whether or not this company should legitimately be on the MF.
Sivaram
Sivaram - 4 years ago
Thanks for the info Dave.

I don't know what the current state of legislation in Canada is--the government cracked down on trusts because companies were avoiding taxes; in Canada, non-resource companies were also allowed to convert to a trust--but the Canadian trusts were somewhat similar in principle to the American ones. They avoided double taxation, with the corporation not paying any tax while the investor pays the full tax (not at the dividend tax rate.) That's why I was curious about the tax rate for the American trusts.

The Canadian trusts a few years ago (again, I'm not sure what hte current legal situation is) also had limitations of acquisitions of assets but it was more loose than the American trusts. I believe the American, as well as Australian, resource trusts are very strict whereas the Canadians were not.

My problem--this was a few years ago--was that the trusts seemed like they generated little shareholder wealth. The reserve life of the trusts were very low, with some having enough reserves for as little as 8 years of production, whereas a conventional E&P or an integrated would have 20 to 30 years of reserve life.

In addition, as you alluded to with the American trusts, the Canadian trusts also paid out a lot of 'return of capital' which some newbies probably took to mean a real wealth creation when in fact it is simply the company returning your a portion of your original investment.

Having said all that, given the huge sell off in commodities last year, it is possible that these trusts are trading below intrinsic value.
DaveinHackensack
DaveinHackensack - 4 years ago
Value Barbarossa,

"You know the only reason a company like TIRTZ.OB shows up on the MF is because the balance sheet doesn't count anything as assets except for about $2.5 million in cash."

I was aware of that, but it's worth pointing out for those who might not be: this applies to other royalty trusts that have appeared on the MF as well. Since they have negligible assets on their balance sheets, their ROIC appears extremely high.

value_barbarossa
Value_barbarossa - 4 years ago
Dave,

Apologies for stating the obvious.

I do find TIRTZ.OB interesting though. In fact I read the 10Q and skimmed the 10K.

I'm very interested by the idea of royalties in general since they offer pretty much pure free cash flow. (Look at Klarman's portfolio and you'll see he really likes royalties as well).

My big question about TIRTZ.OB is how do you value it? The royalties paid to TIRTZ depend solely on whether Chevron continues to produce wells on the leasehold from TIRTZ. Or at least this is my understanding from the 10K.

So if Chevron were to stop drilling, or shut in the current wells, would there be no additional income stream?
DaveinHackensack
DaveinHackensack - 4 years ago
Value Barbarossa,

Presumably, you'd value a royalty trust by estimating its stream of future royalty distributions and discounting them back to the present. For an idea of how how difficult this would be, check out the Yahoo! message board for another royalty trust I own, BPT. There's a commenter who writes in depth posts estimating what the next quarter's distributions will be based on average oil prices, weather (which can cause down times in production), changes in state taxes at the trust level, depletion rates, etc. Imagine trying to do that for the (estimated) life of a trust's reserves. Your estimate would probably be so far off as to be pointless. It probably makes more sense to base your decision to buy on your outlook for the underlying commodity, assuming the trust has at least several years worth of estimated reserves left.
LwC
LwC - 4 years ago
Anyone who is interested in natural gas might find an article in Friday's WSJ titled "Exxon Mobil's Weapons of Gas Destruction" interesting reading.

Excerpt:

"In Exxon's case, valuable liquids also produced in its Qatari projects take the market break even price of the natural gas itself 'towards zero...Factoring in processing and shipping costs, that gas can be landed in the U.S. for less than $2 per million BTU..." (Note: 1million BTU = approx. 1MCF).

Disclosure: I'm long natural gas

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