A Look Inside The Natural Gas Pipeline

By Matt Cavallaro | January 04, 2012 AAA

Drillers have been so successful at developing natural gas resources over the past few years that a huge build up of inventories plunged futures prices 31% in 2011. The remarkable domestic supply of oil that these drillers have been able to produce simply hasn't been met with enough demand. How much longer will investors have to wait for the explosive growth potential of natural gas to be unleashed? (For related reading, see Natural Gas Industry: An Investment Guide.)

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Energy Independence
It may not be a long wait if dirt cheap natural gas prices remain so, compared with more expensive energy sources around the world. West Texas Intermediate (WTI) crude oil gained 8% during the year, and relief doesn't seem to be on the horizon. Oil is currently hovering near $100 per barrel on geopolitical unrest and Iran's latest round of saber rattling. The natural gas market is waiting for the reality of wealth transference to unfriendly regimes, and the enormous economic benefits that would derive from tapping the abundance of natural gas reserves in North America to make its way down the mainstream pipeline.

If a secular trend is playing out, where dirty, expensive energy sources like oil and coal gradually lose favor, cost effective cleaner burning natural gas stands to benefit. There's a growing consensus, albeit amid stiff resistance, that a practical push toward energy independence in the United States begins with natural gas. Proponents like hedge fund billionaire T. Boone Pickens are leading the charge for a transition away from foreign oil. (To learn more about investing in natural gas, read Oil And Gas Industry Primer.)

Natural Gas Powers Up and Down
The New Year couldn't come soon enough for many natural gas investors. The United States Natural Gas Fund (ARCA:UNG) plummeted along with natural gas prices, down around 48% for the past year. Houston-based Southwestern Energy Company (NYSE:SWN) explores and drills for natural gas and crude oil. Down about 16% for the past year, Southwestern's significant exposure to natural gas prices and geographical asset concentration has pushed the stock to around its 52-week low. Chesapeake Energy (NYSE:CHK) is down a similar amount, about 15% this past year.

Within the natural gas patch, Williams Companies (NYSE:WMB) managed to separate from the pack, rising about 34% in 2011. Williams, an integrated natural gas company, moves forward a lot thinner after the spinoff of its oil exploration and production unit, WPX Energy. There won't be an initial public offering (IPO), as was previously expected, for the holding company. That's unfortunate because the IPO would have generated cash inflow which could have been used to buy assets. Amid the upheaval, management was still able to grow total revenues from $2.6 billion last quarter to $2.7 billion for the quarter ending September 2011. (For more information, read Strategies For Quarterly Earnings Season.)

The Bottom Line
Williams wasn't the only natural gas company that excelled in 2011. Liquefied natural gas company Cheniere Energy (AMEX:LNG) gained around 35% over the past year and El Paso Corporation (NYSE:EP) nearly doubled over the same time frame. Will these companies that did well, despite dirt cheap natural gas prices, continue to do so? Or would investors find more value with companies that corrected along with natural gas prices?

This may not be the question that investors interested in natural gas exposure should be considering. Instead of picking winners and losers, investors would be best served by letting the macro environment dictate the approach. The existing glut of supply has hammered prices, and domestic demand isn't where it should because Washington, D.C. simply hasn't made natural gas a priority. This will constrain natural gas stocks across the board.

Powerful utility and chemical company lobbyists are persuading Washington, D.C. to stall on natural gas, for obvious competitive reasons. Additionally, many environmentalists actively oppose natural gas. They believe the process of fracking compared to drilling for natural gas will contaminate the ground water. There is no consensus yet as to whether fracking poses undue environmental hazards. What is not disputed is the fact that natural gas burns about 50% cleaner than coal and 30% cleaner than oil. Natural gas is clearly a better option in these regards. Moreover, the Environmental Protection Agency recently set new emissions standards for pollutants like mercury. A viable solution for companies that could be negatively impacted by a regulatory penalty is to transition to cleaner burning natural gas.

The political reality is that there probably won't be much legislative action to address the domestic demand side for natural gas until after the 2012 U.S. Presidential Election. There is reason to believe that movement on price is possible in the short-term. The need abroad for cheap alternatives to high-priced crude oil is already showing signs of perking up the natural gas demand side. Also, now that winter weather is finally starting to take hold, following an unseasonably warm autumn, total energy demand will pick up. Higher oil prices would bode very well for natural gas stocks because it would help renew the populist push for alternatives to costly foreign oil. If natural gas prices do show some buoyancy, the momentum is with a trim company like Williams that has a strong 3% yield and targeted dividend growth rate of 10 to 15% over the next few years could deliver steady returns to investors. For growth, Cheniere is worth considering. (For related reading, see Uncovering Oil And Gas Futures.)

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At the time of writing, Matt Cavallaro did not own shares in any of the companies mentioned in this article.

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