Hydrocarbons
have become the lifeblood of this modern era. And with a huge economic incentive for
finding and extracting them, drillers have scoured the world in search of
this finite resource. When they
do find it, there is nothing more thrilling than bringing this raw form of
energy to the surface.
The most famous
extracted hydrocarbon is in liquid form, known as petroleum, or crude
oil. With the next most common
form being gaseous, known as natural gas. Crude oil has of course long been the
superior hydrocarbon. In fact,
until the last half century or so oil was really the only hydrocarbon with
any commercial worth.
Interestingly
throughout most of history natural gas’s utility, and occurrence, had
been totally misunderstood. In
the days of yore gas was more of a mystical element. On occasion lightning would strike a
surface seep, causing an explosion and/or igniting a large flame. Amusingly ancients would regard an
event like this as spiritual, and built temples or
shrines at the sites of these occurrences. As time wore on some cultures were
able to harness gas’s energy to varying degrees, but never on a grand
scale.
One of the
biggest historical challenges with natural gas was transportation. In the 1800s a handful of big cities
in the US figured out how to pipe in local sources to fuel their street
lamps. But up until about World
War II, there was no way to transport it effectively. With no network of pipelines, storage
facilities, or processing plants, natural gas was for the most part a useless
byproduct of oil drilling.
In the past
drillers that came across primary gas fields usually left them alone. And even when they did find primary
oil fields, they still had to deal with the accompanying gaseous
hydrocarbon. The drillers were
ultimately forced to discard the natural gas, by venting it into the
atmosphere or flaring it.
Natural
gas’s fortunes finally started to change in the late 1940s. And by the 1960s the US had developed
the world’s first large-scale natural-gas infrastructure. Advances in technology allowed the US
to innovate in pipeline design and storage, and by the time the 1970s rolled
around this network consisted of thousands of miles of pipe.
With the transportation
of natural gas becoming viable on a commercial scale, a huge wave of
innovation permeated the consumption side of this hydrocarbon. And as a result it had quickly become
a popular and indispensable form of
energy. Natural gas is now piped
directly into residential homes for central heating and as fuel to run
appliances, manufacturers are using it to power their plants, and utilities
use it to generate electricity.
The natural-gas
revolution obviously greatly increased demand, and thus created a market for
this commodity. And as time wore
on it was no longer a mere afterthought to oil. Primary oil drillers gained an
economic incentive to capture their gas, and many other drillers went on to
make gas their primary business.
The many
excellent natural-gas companies that had risen up saw demand for their
primary product greatly increase over the years. Per the U.S. Energy Information
Administration (EIA), US natural-gas consumption saw a four-fold increase from 1950 to 1970. And after a lull in consumption into
the early 1980s, it has been slowly on the rise ever since. In 2010 US consumption came in at a
record 24 trillion cubic feet.
In the last 50+
years the natural-gas industry has gained incredible strength and
stability. And with a recent push
towards cleaner-burning fuel, consumption is expected to continue to rise in
the years to come.
This gas love
fest has naturally led to rising prices over time. Once the government started easing
regulation in the 1970s, thus creating a more fluid market, prices went from
relatively fixed at about $0.16 in the 1960s to average $0.50 in the 1970s,
$2.08 in the 1980s, $1.92 in the 1990s, and $5.07 so far in the great commodities bull of
the 2000s. Natural gas’s
explorers, producers, and servicers had found a cozy niche in the energy
markets.
But alas, the
natural-gas industry would be in for a huge wake-up call just as things were
starting to really heat up in this secular commodities bull. As you can see in the chart below,
natural-gas prices have been diverging from big-brother oil and the rest of
the energy complex. And this
divergence is in a direction that has caused wailing and gnashing of teeth
for many drillers.
Oil, the king
of all commodities, has had an incredibly-strong run off its $10 lows in
1999. Global demand for this
hydrocarbon is up nearly 50% in the last 25 years. And when you consider the unprecedented
rise of Asia, demand will stay strong ad infinitum. With demand so strong, supply has
struggled to keep pace as the drillers just haven’t been making enough
large discoveries to comfortably secure pipeline for the future. The 10-year chart above clearly shows
how this imbalance has had an effect on prices.
Nearly the
entirety of the energy complex has been flying in the upwash
of oil’s momentum. And as
you can see, natural gas was no exception. From the beginning of 2002 to their
apexes in mid-2008, oil and gas had respective gains of 593% and 418%. But though the going was good for both
of these energy powerhouses, they had become severely overbought in their
spectacular parabolic ascents.
At $145 oil and
$13 gas, a healthy correction was imminent. And in the summer of 2008 oil and gas,
along with nearly all commodities, entered into major corrections. Unfortunately commodities ended up
getting sucked into the fear maelstrom brought on by the global financial
crisis. And what was supposed to
be a simple healthy correction to rebalance sentiment ended up being a
full-blown bloodbath.
As measured by
the venerable Continuous Commodity Index (CCI), most of the panic selling in
commodities had been exhausted by the time 2009 rolled around. And oil’s bottoming in February
capped off a mind-blowing 76%
decline to sub-$40 prices that hadn’t been seen since 2004.
So with the CCI
hitting its panic low in December, oil hitting its low in February, and most
of the rest of the commodities group hitting their lows around this same
time, you’d think natural gas’s low would also fall in somewhere
around then. But provocatively,
gas decided to buck the commodities trend.
Natural gas
kept on falling, and fell hard until it finally reached bottom in September
2009. By the time all was said
and done, gas had fallen a staggering 86%
from its 2008 high. And its
precarious price behavior throughout most of 2009 signaled that there was
much more to this panic plunge.
Upon reaching
its lowest point since 2001, virtually wiping its entire bull-to-date gains,
natural gas finally caught a bid.
And it tripled in just a few
short months. But while this fast
rise was quite spectacular, it was merely a smoke screen. And judging by what has played out
since the beginning of 2010, there is no doubt that this commodity is in the
midst of a structural reckoning.
To put
gas’s price action in context, first consider oil’s post-panic
fortunes. From its 2009 low, oil
has mounted a powerful recovery. And even with today’s shaky
stock-market action, it is still holding strong near $100 in a nice tight
uptrend. Natural gas’s
trend on the other hand tells a completely different story. After its quick pop to $6, it has
nestled into an alarming two-year downtrend. Amazingly gas prices are currently
where they were back in 2002, and are down
8% over the exact-same period where oil is up 113%.
So what’s
going on with natural gas? Well
in looking at the chart, it’s clear that gas is no longer in
oil’s upwash. It has diverged to the downside and is
now trading on its own merits.
And these merits represent a major shift in fundamentals that anybody
attuned to the energy scene is plainly aware of.
Simply put,
this shift is a byproduct of radical innovations in the geosciences,
horizontal drilling, hydraulic fracturing, and more. And the result of this shift was the
unearthing of massive natural-gas resources that have easily taken off the
strain of whatever economic imbalance there was thought to be.
The biggest
game changer is those resources found within deep-underground shale. Massive discoveries in the Barnett,
Marcellus, Haynesville, and Eagle Ford shale fields among the many have
really given a boost to US gas resources. According to the latest EIA report,
there is now well over 800t cf of technically recoverable shale-gas resources in
the US. And many experts believe
this to be quite a conservative number.
With these recent shale-gas discoveries, it is now believed that the
US has 100+ years of natural-gas
supply.
And this US
success of course has global implications. Since the US uses about one-quarter of
the total global supply and gas is priced in US dollars, domestic happenings
greatly color the world markets.
And since the US produces about 90% of its own consumption needs (with
most of the rest coming from friendly-neighbor Canada), it doesn’t rely
on foreign supply. Unlike in oil,
foreign gas producers have little pricing power. And in this current situation, gas
prices are naturally going to fall.
Ultimately from
a strategic perspective larger inventories and lower prices are a big boon
for the clean-energy initiative.
But these fortunes haven’t been great for drillers’
margins. While there are still
plenty of companies that can thrive at these lower prices, there’s no
denying the fact that natural-gas exploration and production has lost some of
its appeal in recent years.
For this reason
many of the drillers that saw the writing on the wall have made their way
back to “old reliable”.
All the while that natural gas had been gaining popularity in recent decades, oil’s attractiveness remained steady and
unwavering. And unlike gas,
oil’s fundamentals are still wildly bullish.
And
provocatively the formula for success in natural gas’s boom has opened
up vast opportunities for oil drillers, especially in the US. In September I wrote an essay on the
renewed US oil boom, in
which I discussed the emergence of shale-oil drilling. Utilizing horizontal-drilling and
hydraulic-fracturing techniques pioneered in the shale-gas push, drillers are
now able to profitably tap shale oil.
And with the
large shale-oil reservoirs in the US, shale-oil drilling now represents one
of the biggest production growth areas in the entire oil industry. Even better is shale oil won’t
really make a material dent in global supply. Drillers can therefore go after the margins
and not worry about their success altering oil’s fundamentals (and thus
prices) too much. In the US
especially, given the choice drillers have been ditching gas and targeting
oil. And these shale-oil drillers
are in line to make fortunes, which has naturally served stock investors
quite well.
Speaking of
stocks, the impetus for this essay was some findings that came out of a major
in-house research project looking at the universe of mid-cap oil stocks
trading in the US and Canada. We
wanted to focus on oil due to its superior fundamentals to gas, with our goal
to pick out the dozen most-promising stocks in which at least 50% of their
reserves, production, and revenues were from oil. And we found an amazing group, with
each stock profiled in detail in our latest research report.
As part of this
research we discovered that mid-cap exploration and production companies
really are the sweet spot of the oil-and-gas industry. These companies throw down some
serious capex relative to their size, exhibit
incredible growth rates, and yet are still small enough to where a discovery,
acquisition, or asset sale could completely transform the look of their
portfolios. And interestingly in
the process of this research we found that many of the stocks in this mid-cap
group, including some of our favorites, are gas-to-oil converts.
In looking at
their histories we found that some of these companies were actually
gas-centric not too long ago.
However when faced with lower margins on their gas projects, along
with the dangling carrot of higher margins in newly-illuminated oil plays,
they were quick to transform their business models.
Some of these
companies are now among the elite mid-cap oil
producers. They’ve
accumulated sizeable leaseholds in some of the hottest up-and-coming fields
in the US, and are positioned to greatly leverage oil’s bull. And at Zeal we’ve been
recommending that our newsletter
subscribers go long in several of the stocks profiled in our popular report.
One company we recently
recommended has already been acquired for a quick 44% realized gain in just
over two months. And the rest of
our positions ought to perform quite well over their trade durations. To get the fascinating fundamental
profiles of each of our favorite mid-cap oil stocks, buy your Zeal report
today. And to find out which of
these stocks we are recommending along with cutting-edge market analysis,
subscribe to our acclaimed weekly or monthly
newsletters today.
The bottom line
is oil has long been the hydrocarbon of choice for the drillers. But with natural gas stepping into its
own about a half-century ago, and quickly becoming an indispensable energy
source, the drillers found themselves with options. And gas drillers have found amazing
success. Unfortunately, this
success has recently gotten ahead of itself.
Unlike oil,
natural gas is now abundant relative to demand thanks to what’s been
found in large shale reservoirs underlying the surface. And gas’s radically-changing
fundamentals have put downside pressure on its price. These lower prices have made drillers
think twice about which hydrocarbon they go after. And with the prospects of lower
margins in gas and higher margins in oil, many have refocused on oil. In today’s environment
oil-centric drillers ought to greatly outperform in the energy-stock sector.
Scott Wright
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Thoughts, comments, or flames? Fire away at scottq@zealllc.com . Depending on the volume of feedback I may
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Zeal Research (www.ZealLLC.com)
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