1/18/2012
Kent Croft, President of Croft-Leominster and CIO of the Croft Funds
Russell Croft, Vice President of Croft-Leominster and Portfolio Manager of the Croft Funds
Manager's Commentary - 1Q 2012
Investment Opportunity: Natural Gas
Overview
We believe that we are at the forefront of a shift in energy usage that will have pervasive global ramifications. Technological advances and new drilling techniques have unlocked vast U.S. natural gas reserves which allow for investments in the infrastructure necessary to satisfy demand both domestically and abroad. An abundance of gas will help the U.S. transition away from dependence on foreign oil and also provide a bridge towards a future of cleaner energy. The development of Liquefied Natural Gas (LNG) terminals will help globalize the North American natural gas market and have an impact on price and consumption worldwide.
Vast Supply, Depressed Pricing
At current levels, we believe companies in the natural gas industry are attractively priced and will benefit from secular trends over the next 3-5 years. While the major run up in the price of oil over the past decade can be attributed to increasing demand from the developing world coupled with a lack of new supply, natural gas in the U.S. has seen supply growth with falling demand. As mentioned above, new drilling technologies have allowed the development of large shale gas formations which have added significantly to supply. The U.S. has proved natural gas reserves of roughly 211 trillion cubic feet (Tcf) and total resources of 2,200 Tcf which equals about 100 years of supply at the current rate of consumption. Priced at around $2.50/thousand cubic feet (mcf) currently in the U.S., gas trades below the industry’s average cost of production (roughly $4.50/mcf), which has two significant effects- high-cost producers stop producing and industry capital is directed away from gas fields and towards oil prospects where profits are much higher.
Beyond supply, the other main culprit behind the current depressed natural gas prices has been a weak overall economy and slow recovery since the financial crisis that began in 2008. Because oil is easily and inexpensively transported via tanker, it trades on a global marketplace. Gas, however, is primarily transported via pipeline and therefore overseas supply and demand are a small factor in the U.S. natural gas market. Driven by emerging markets, overall oil demand has recovered since 2008 while U.S. natural gas demand has remained stagnant. Two of the three main U.S. natural gas end markets are industrial applications and power generation; therefore a stronger rebound in the broader economy is necessary to significantly increase domestic demand and prices.
On the global front, emerging market demand, slowing growth of nuclear power, and rising transportation usage should drive solid consumption growth. The International Energy Agency (IEA) recently stated that global natural gas use may increase by 50% by 2035, allowing it to overtake coal as the second largest source of energy worldwide. As demand increases, we would expect the gap between natural gas and oil to narrow on a British Thermal Unit (BTU) basis. A barrel of oil has about 6 times the energy content in terms of BTUs as compared to 1 mcf of natural gas. At current prices ($100/barrel of oil and $2.52/mcf of natural gas), natural gas trades at an 85% discount to oil on an energy equivalent basis in the U.S. This means the same amount of energy can be purchased for 85% less via natural gas as compared to oil. This discount is the largest it has been since deregulation of the U.S. natural gas market began in the 1980s.
Globalization of LNG Market
We expect oil’s premium over natural gas to decline over time as the liquefied natural gas (LNG) market globalizes. For example, the spot price for natural gas rose above $16/mcf in Japan near the end of 2011 vs. $11/mcf at the beginning of the year, and at these levels the economics of U.S. exports are compelling. More exports would add upward pressure on domestic pricing. The Asia-Pacific region has increased their natural gas consumption at greater than 7% annually over the past 5 years with higher expected growth due to the vacuum left in Japan by the Fukushima nuclear crisis. There are currently 10 active nuclear plants in operation in Japan now compared to 44 at the start of 2011. Natural gas also trades at more than double the U.S. price in Europe, so there is opportunity in exporting there as well.
Major energy companies such as Dominion, Exxon and Apache have announced new LNG export terminal projects to help feed the increasing worldwide demand. Eight separate projects for LNG export terminals have been submitted to the U.S. Department of Energy for approval with combined proposed capacity equal to 18% of current U.S. production. In Canada, five separate projects have been proposed with capacity greater than 20% of current Canadian production. The Kitimat LNG facility in British Columbia owned by Apache, EOG Resources, and Encana is currently under construction, has received necessary permits, and should begin providing LNG to Asia Pacific beginning in 2015. It is unlikely that all of these facilities will make it into operation but the scale is such that the export terminals that do get built are likely to have a significant impact on North American natural gas demand.
Private Investment in Domestic Infrastructure
One of the most encouraging recent developments regarding natural gas usage in the U.S. has been the various joint ventures and partnerships announced between large energy players and niche natural gas infrastructure and technology providers. In September, Shell and Westport Innovations, a leader in natural gas engines, announced an agreement to provide an integrated commercial solution to the transportation industry where Shell would begin installing LNG fueling stations at some of its truck stops. This came on the heels of an announcement in July that Chesapeake Energy would invest $150 million in Clean Energy Fuels Corp. (CLNE), a builder and operator of natural gas fuel stations, to fund the development of approximately 150 stations at strategic truck stops along the major transportation corridors in the U.S. One month later CLNE signed a very similar $150 million deal to build more stations serving truckers, this time with a group of private investment funds providing the capital. These announcements highlight a key positive related to an abundance of supply of natural gas- companies now have the long term visibility that gives them confidence to make the necessary investments to build out the infrastructure needed to satisfy future demand.
Politically-friendly: Energy Independence, Employment, and Environmental Benefits
Government action could also play a significant role in spurring the demand side of the natural gas equation. High oil prices and a dependence on imports have resulted in much consternation and angst in the U.S. from both politicians and their constituents across the ideological spectrum. The bulk of the world’s oil reserves are held by countries with whom the U.S. consistently finds itself in conflict whether militarily, diplomatically, or economically. Oil dependence is often cited as the most glaring weakness for the U.S. from both an economic and security standpoint, and there are bipartisan efforts to make progress in reducing the nation’s thirst for oil. Natural gas, due to the immense reserves found within U.S. borders, has emerged as one of the most attractive options through which the country can offset total foreign oil demand over the medium- to long-term (98% of the natural gas consumed in the U.S. is sourced in the U.S. or Canada). Action here may include subsidies to build out the infrastructure (as a complement to the aforementioned private market activity that has already been announced) required for broader use of natural gas vehicles. Less than 1% of overall vehicles are equipped to run on natural gas today. The public sector has seen more penetration as 15% of the nation’s municipal fleets, buses, and trash collection trucks are currently powered by engines modified to run on natural gas. We believe this number will increase as at current prices natural gas powered vehicles save roughly 50% of the fuel cost of their gasoline- and diesel-fueled counterparts. Furthermore, we see natural gas as a more viable alternative than biofuels. Traditional biofuels will always face concerns surrounding the “food vs. fuel” debate which will only increase as populations grow amidst declining arable land and greater food shortage risks. Cellulosic biofuels still face significant research and development costs and time whereas natural gas is here now and plentiful. There are also employment benefits associated with producing one’s own energy sources. Shale gas has already created roughly half a million U.S. jobs and IHS Global Insight estimates that there could be an additional 870,000 U.S. jobs and $118 billion in economic growth over the next four years. This is very significant given the still-elevated unemployment numbers that have persisted since the economic downturn.
Not only is natural gas attractive politically in the U.S. from an economic and security standpoint, it is also generally backed by proponents of cleaner energy policies as a substitute for both oil and coal in power generation, transportation, and other industries. Natural gas fired power plants emit 40% less carbon dioxide per BTU compared to coal fired plants. Electric power generation has gone from 19% of total natural gas demand ten years ago to 31% today. Hostile regulations towards coal make the vast majority of new power generation very likely to be gas fired, increasing overall natural gas demand. Furthermore, the Japanese nuclear reactor meltdown caused by the tsunami and earthquake in March of 2011 has pushed various countries to consider reducing their use of nuclear power. Germany announced earlier this year that they would close all nuclear plants by 2022 and other countries are said to be considering similar plans which would increase aggregate demand for natural gas-based power. An interesting proponent of natural gas in the U.S. is Exelon’s CEO John W. Rowe. His company, who generates power for their customers via nuclear plants, has seen the rates they can charge driven down by cheap natural gas. Yet he contends that cheap natural gas is “good for America, not quite so good for Exelon,” and says shale gas is one of the most important energy revolutions of his lifetime from a cost and environmental perspective.
Merger &Acquisition Activity
We believe that a good indicator of future natural gas demand and pricing is transaction activity between energy companies. Merger, acquisition, and asset sale activity has picked up over the past 18-24 months suggesting those in the industry have a positive outlook for natural gas prices going forward. Exxon Mobil paid $31 billion for natural gas giant XTO at the end of 2009 and around the same time commissioned a new $15 billion liquefied natural gas project in Papua New Guinea to provide natural gas to fast-growing Asian markets. Japanese commodity trader Marubeni Corp., China Petrochemical Corp., and Total SA of France have all made substantial purchases of U.S. shale acreage. In 2010, Chevron agreed to pay $4.3 billion for Atlas Energy Corp., a company with natural gas resources in Pennsylvania’s Marcellus Shale. In July, mining giant BHP Billiton announced a deal to acquire Petrohawk Energy Corp. and its 3.4 trillion cubic feet of primarily natural gas reserves for $12.1 billion. We believe that the recent announcements of new LNG export facilities by major energy producers bode well for the future export demand outlook as well.
Investment Risks
The main risk to companies in the natural gas industry is the potential that depressed natural gas commodity prices last longer than expected. For this reason we prefer well capitalized producers with lower relative operating costs. The second major risk is that the environmental effects of fracking are not completely known and, if found to be more detrimental than expected, could reduce the amount of recoverable shale gas.
Information in this commentary regarding market or economic trends or the factors influencing historical or future performance reflects the opinions of management as of the date hereof. These statements should not be relied upon for any other purpose. Past performance is no guarantee of future results, and there is no guarantee that any market forecast or trend discussed herein will be realized. Although the information presented herein is based on sources believed to be reliable, such information is not guaranteed to be accurate and is subject to change.
This material should not be used as a primary basis for making investment decisions. Consider your own financial circumstances and goals carefully before making any investment decision.
