For most of the past three years, the fastest growth in the energy patch could be found offshore and overseas. Natural gas prices have been weak, and US and Canadian drilling activity is driven largely by gas, not oil. Therefore, companies with exposure to North American gas markets have vastly underperformed the broader energy indexes.
The list of underperformers includes contract drillers and services firms that serve producers in these markets. As gas prices topped out in late 2005, drilling activity moderated, which meant less demand for various sorts of equipment from drilling rigs to drill pipe. And, of course, exploration and production (E&P) stocks producing gas for sale in North America also experienced headwinds as their main product became less valuable.
But a key shift is now underway. As Iâ€™ve noted in The Energy Letter and At These Levels, North American natural gas prices are finally rising again; inventories of gas in storage are now approaching normal seasonal levels, and a colder-than-expected winter is driving demand.
And gas prices are even higher in Europe and Asia. That means that companies with the flexibility to ship gas in the form of liquefied natural gas (LNG) arenâ€™t sending shipments to the US. In fact, according to the Energy Information Administrationâ€™s (EIA) data, US LNG imports in November--the latest month for which we have accurate data--fell to the lowest level since 2002. Thatâ€™s further tightened supplies.
A rapidly improving environment for gas prices has reawakened a host of North American natural gas-levered firms; for the first time in three years, I see more opportunity in these stocks than in the more internationally focused companies. The key to investing in North American energy stocks is simple: Focus on unconventional reserves.
I highlighted unconventional reserves in the most recent issue of The Energy Strategist. Hereâ€™s a quick review.
Broadly speaking, the term unconventional (or nonconventional) refers to any field that canâ€™t be produced economically using traditional well technologies. Unconventional gas production already makes up close to 40 percent of US gas output. And that number is only going to rise in the coming years. Check out the chart below for a closer look.
This chart depicts US production broken down by source. The chart shows historical data going back to 2004 and projections out to 2030 from the EIAâ€™s most recent report.
As you can see, not only is unconventional production the most important single source of gas in the US, itâ€™s also one of the only sources thatâ€™s likely to show real growth in the coming years. And as recently as 2000, conventional gas production was far higher than unconventional production. These reserves have come to dominate the US gas market.
An example of an unconventional natural gas reserve is the Barnett Shale of Texas. Natural gas doesnâ€™t exist underground in giant caverns; instead, itâ€™s trapped in the cracks, crevices and pores of a reservoir rock. The Barnett Shale contains a huge amount of gas trapped underground, but the pores and cracks in the reservoir arenâ€™t well connected. The Barnett Shale lacks permeability, meaning thereâ€™s no way for all that gas to flow through the reservoir and into a well.
But there are ways to improve a reservoirâ€™s permeability. In the case of the Barnett Shale, producers use a technique known as hydraulic fracturing. Basically, this involves pumping a liquid into the reservoir under tremendous pressure; this liquid actually cracks the reservoir rock, creating channels through which the gas can flow.
E&P firms with acreage in key unconventional reserves such as the Barnett Shale have been reporting strong gas production growth. Thereâ€™s very little exploration risk in these unconventional reserves; the gas is widely distributed. And as key producers gain experience drilling and fracturing wells, theyâ€™ve been able to boost productivity and reduce costs.
E&P firms are certainly one way to play the growth in unconventional natural gas production. Another way is to focus on infrastructure: companies that own the pipes and processing facilities needed to produce, transport and deliver all that gas.
The problem with US natural gas infrastructure is that itâ€™s ill equipped to cope with strong growth in unconventional gas production. Although the presence of gas in areas such as Barnett Shale and the Rockies has been known for decades, producers have only started targeting these plays recently. Historically, most US gas production has come from conventional reservoirs such as the shallow waters of the Gulf of Mexico or parts of Appalachia and Canada. Not surprising, US gas pipelines are set up to carry gas from these traditional reservoirs, not from the Rockies and Barnett.
This creates a big problem for producers. Check out the chart below for a closer look.
Natural gas traded on the New York Mercantile Exchange (NYMEX) is based on gas delivered to the Henry Hub, a major gas pipeline interchange in Louisiana. Other key hubs in the US are the Katy Hub in Texas, the New York Hub, the Chicago Hub and the Cheyenne Hub in Wyoming. The graph below shows the current prices at some major US gas hubs compared to the Henry Hub.
Note that, when the numbers in this chart are negative, gas is trading at a discount to Henry Hub. Positive numbers indicate gas is trading at a premium to Henry Hub.
Gas trades at wildly different prices in different hubs of the US. In particular, gas near major consuming markets such as Chicago and New York tends to trade at a premium to gas near major centers of production. Even more interesting, gas in the Rockies (the two Wyoming hubs) tends to trade at a large discount to Henry Hub gas.
The prime reason gas in the Rockies is so cheap is that thereâ€™s no way to move that gas out of the area. As noted earlier, unconventional gas production from the Rockies is growing quickly, but there just arenâ€™t enough pipelines to move all that gas volume. Companies with gas in the Rockies arenâ€™t realizing full NYMEX prices for their gas because thereâ€™s a regional glut of gas there.
The solution to this problem: more take-away capacity. Literally, companies need to build pipelines to move gas out of regions with growing production to markets where the gas is in high demand. Firms with the capacity to do that can actually take advantage of regional pricing discrepancies.
In its fourth quarter conference call last week, E&P Chesapeake Energy made a point of noting this issue. The company has ramped up its drilling activity in the Barnett Shale area of Texas sharply in recent years; Chesapeake would like to drill even more aggressively. However, one key limitation on growth is that there just isnâ€™t enough gathering line capacity to handle all its production. Gathering lines are small-diameter pipelines that hook up individual gas wells to intra- and interstate pipeline networks.
Bottom line: Producing unconventional gas isnâ€™t just about drilling more wells. To handle all the growth, companies also need to build gathering lines, pipelines and processing facilities. Building gas infrastructure is a booming business.
Many of the nationâ€™s largest pipeline firms are organized as master limited partnerships (MLP). MLPs pay no corporate-level income tax and pass through the majority of their cash flows to holders as distributions. (Yields on the pipeline MLPs we cover in The Partnership average roughly 7 percent at this time.) The best-placed pipeline MLPs are benefiting from the unconventional boom by building new pipelines and processing facilities to handle all that production.