Portfolio Manager's Commentary
September 30, 2009
Kent Croft, President of Croft-Leominster and CIO of the Croft Funds
Russell Croft, Vice President of Croft-Leominster and manager of the Croft Funds
Manager's Commentary - 3Q 2009
Generating Investment Ideas: Natural Gas
At Croft Leominster, we are value oriented with a contrarian bent. Through extensive research, we generate investment ideas from a variety of sources. We continually monitor about 200 stocks, building portfolios of approximately 60- 80 companies that represent our best ideas, and typically hold them for 3-5 years. We are classic stock pickers who look at the stock market from the bottom-up.
As value-oriented investors, we look to buy stocks at 80-cents-on-the-dollar and are constantly searching for advantageous entry points. We believe every investment environment brings its own opportunities.
As we move forward into the fourth quarter and begin thinking about next year, we wanted to take an opportunity to outline the reasons we have an investment in North American natural gas producers. The United States has proven natural gas reserves of 211 trillion cubic feet (Tcf) and total reserves of 2,200 Tcf. This translates into approximately 100 years of supply at the current rate of consumption. This energy source is politically secure and a strategic national asset.
North American natural gas prices will trend higher over time due to growth in usage, political safety, and its global strategic importance. Over time, natural gas should trade at a price closer to its BTU equivalency relative to oil (6:1). At today's prices ($66 oil and $4.69 gas) the ratio is 14:1; meaning that natural gas is trading at a 58 percent discount to oil on a BTU basis.
One major source of growth in natural gas usage has been as a fuel for electric power plants. Electric power generation has gone from accounting for 19 percent of total natural gas demand ten years ago to around 31 percent today. The vast majority of new power generation coming on-line is natural gas fired and will continue to drive natural gas usage.
Natural gas is a particularly attractive fuel source when the potential for greenhouse gas legislation is considered: gas-fired power plants emit 40% less carbon dioxide per btu vs. coal fired plants.
We believe that the decline in drilling natural gas wells this year will lead to higher prices as supplies are constrained. As of late September 2009, the Baker Hughes gas rig count stood at 710, down 55 percent from the peak in September 2008. This decline in drilling activity has led to falling natural gas supplies, and we expect the decline to accelerate as declines from well depletion are not replaced. A rebound in the broader economy would increase demand for natural gas used in industrial applications and electric power generation, creating a supply crunch, if the rig count remains at the currently depressed level.
Companies we currently own:
- Southwestern Energy Inc. (SWN) is developing its 875,000 net acre position in the Fayetteville Shale in Arkansas. We expect SWN to increase production and reserves 25 percent per year over the next 5 years. SWN also holds 131,000 acres in the Marcellus Shale currently under development as the next leg of growth.
- Williams Co. (WMB) has operations in natural gas exploration and production, interstate natural gas pipelines, and midstream gathering and processing. Since 2004, Williams has drilled over 5000 wells to yield proved reserves of 4.5 trillion cubic feet of natural gas. We estimate Williams will grow production 8 percent per year over the next 5 years. Williams is one of the largest natural gas pipeline operators in the U.S., with 14,000 miles of pipeline.
- Ultra Petroleum Corp. (UPL) is a natural gas exploration and production company that operates primarily in Wyoming's Pinedale Field. Pinedale is the second largest natural gas field in North America and UPL is the dominant landholder. We estimate production and reserves will grow approximately 20 percent per year on average over the next 5 years. Primarily owing to geology, the company's costs are half the industry average. Additionally, UPL is in the beginning stages of developing its 171,000 acre position in Pennsylvania's Marcellus Shale, with the potential for a significant boost to reserves and production on an attractive cost basis.
- Atlas America Inc. (ATLS) currently holds 1 trillion cubic feet of proved natural gas reserves in Michigan. The company also holds 556,000 acres in the Marcellus Shale in southwest Pennsylvania which has the potential to increase proved reserves by a factor of 4 to 7 times. As ATLS develops this acreage, we estimate proved reserves and production will increase approximately 25 percent per year over the next 5 years.
(These are not specific stock recommendations. They are part of a diversified portfolio.)
