Under the Radar: Trouble Zone for Natural Gas
Friday February 28, 3:01 pm ET
By Christopher Edmonds, Special to RealMoney.com
With natural gas trading above $8 per million British thermal units and selling near $20 on some spot markets, investors might have reason to seem excited about the prospects for natural gas stocks. And as financial publications discuss the impending shortage of fossil fuels, there must be a reason to be pumped about the prospects of this sector.
Not so quick. Although I continue to believe in the long-term bullish story for natural gas, the fact is, spiking natural gas prices aren't good for long-term demand.
Already, industrial firms, which are large consumers of natural gas, are considering slashing production because of high costs. For example, WHX (NYSE:WHX - News), the owner of Wheeling-Pittsburgh Steel, is shuttering or reducing operations at three plants in Ohio because of soaring gas prices. The company is used to paying about $5 per MMBtu. Now, with spot natural gas prices trading as high as $28 per million cubic feet, it doesn't make sense to keep the mills running.
Other companies like Steel Dynamics (NasdaqNM:STLD - News) are beginning to run mills at night and on weekends to get cheaper energy prices. Terra Industries (NYSE:TRA - News) stopped production at two fertilizer plants because of high natural gas prices, and the company has reduced production at others.
Though the evidence is only anecdotal, early reports suggest higher gas prices are having an impact on demand. Consumer heating demand can mask some of the weakness, but the longer prices remain high, the greater the chance they'll fall hard.
Stock Tells
As gas prices have soared, many natural gas exploration and production stocks have been subdued in their response. The Philadelphia Stock Exchange Oil Service Index has climbed more than 12% in the last month, but exploration and production names, especially those levered to natural gas, haven't participated with such vigor. One of the largest independent North American natural gas producers, Anadarko (NYSE:APC - News), has gained just 1% in February. In fact, the American Stock Exchange Natural Gas Index is up less than 1% in the last month.
A number of reasons explain why the exploration and production stocks haven't lifted with commodity prices and even, to a lesser extent, the service names.
First, investors simply don't believe that current commodity prices are sustainable. Prices have sprinted higher as a result of a number of short-term factors, including fear of war, rapidly declining oil supply and a winter that has been colder than those in recent years. While those factors have combined to create robust commodity prices, equity investors don't believe stocks should be priced based on short-term phenomena.
Second, there exists a belief that exploration and production companies face an uphill battle when it comes to increasing natural gas production. With most 2002 production data now in, the average E&P company saw natural gas production slip in the past year at a rate of about 6%. The decline may hasten, as many companies suggest the natural gas industry is "prospect poor." More difficult drilling opportunities with lower yields mean production costs rise and margins fall.
Until there's a clear sign that gas prices have stabilized, E&P companies -- some of which could see finding and development costs increase by 25% to 50% -- have little incentive to increase spending, and production is stalled.
The lack of drilling and new supply has contributed to pushing gas prices higher. Hence, the waiting game continues, and signs suggest that the longer gas prices remain elevated, the higher the probability that industrial demand craters, potentially bringing natural gas prices tumbling down. The chance of a precipitous decline increases as winter comes to an end and the support of consumer heating demand erodes.
That has many investors staying away from natural gas stocks, at least until there's a reaction to falling natural gas prices. However, the fact the stocks haven't run with commodity prices may provide some comfort for current investors that the stocks won't drop when commodity prices correct.
Long-Term View
The longer-term view remains favorable for natural gas exploration and production companies, especially those with good prospects that can keep costs down and are focused on natural gas production. Names like Encana (NYSE:ECA - News), with a significant presence in Alberta shallow gas, and Energy Partners (NYSE:EPL - News), with a growing presence in the Gulf of Mexico, are examples of companies that should benefit from the increasing need for new natural gas supply.
In addition, we should begin to see additional consolidation of both companies and assets. The Devon (AMEX:DVN - News) purchase of Ocean Energy (NYSE:OEI - News) is a sign of the times. Similarly, the recent shopping spree by Chesapeake Energy (NYSE:CHK - News), buying assets from Oneok (NYSE:OKE - News), El Paso (NYSE:EP - News) and Vintage (NYSE:VPI - News), should provide decent returns as the company continues to expand its base in the midcontinent region. Consolidators have the advantage of both scale and expertise.
Long-term, the outlook for gas is powerful. However, with all the hype and recent ramp in natural gas prices, the commodity price is much too frothy, risking not only downward pressure on gas demand but also serving to pressure a fragile economy.
The longer prices remain artificially high, the greater the chance gas prices fall hard. If that happens, all bets for the energy markets are off. And that's not to mention the larger impact on the economy.
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Christopher S. Edmonds is vice president and director of research at Pritchard Capital Partners, a New Orleans energy investment firm. He is based in Atlanta. At time of publication, neither Edmonds nor his firm held positions in any securities mentioned in this column, although holdings can change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. While Edmonds cannot provide investment advice or recommendations, he welcomes your feedback and invites you to send it to Chris Edmonds. |
