North American Natural Gas: The Next Investment Boom
by Joseph Dancy, LSGI Advisors, Inc.
Adjunct Professor, SMU School of Law
December 16, 2003
We reach the end of the 2003 natural gas injection season with natural gas storage volumes at near record levels. As we begin to draw down on these supplies during the heating season fears of an impending disaster have for the most part abated.
Spot prices of natural gas, as determined by the futures market, are fluctuating around the $5.00 per thousand cubic feet (mcf) level – well below record levels.
But don’t be fooled by appearances – the United States has reached a fundamental transition point with regard to natural gas. We are at the end of an era. For a number of reasons the probabilities strongly favor much higher natural gas prices, higher volatility, and higher electric rates. The natural gas bubble is gone, and it may be a decade before the market stabilizes.
For reasons set out below, companies and investors in the United States will allocate a significantly higher level of capital expenditures toward the natural gas sector than they have in the past – and it should create incredible opportunities for investors.
Thirst for Natural Gas
Americans use 22 trillion cubic feet of natural gas each year. Until the late 1980’s the country was essentially self-sufficient in natural gas. But environmental constraints contained in the Clean Air Act of 1990 insured a growing market share for natural gas powered equipment, and consumption began to outpace production.
Canada stepped in to make up the difference. Around 14% of the natural gas used in this country is imported from that country. But imports from Canada have stabilized and are projected by many analysts to decline over the next few years
The sectors that consume natural gas have changed markedly. For decades, most natural gas was used for industrial production. Many petrochemical and plastics companies designed plants to run on cheap natural gas which was used as a raw material and as a fuel source.
But higher prices in the last three or four years has cut industrial demand quite severe. Plants have shut down, switched to other fuels, or moved offshore. Demand in the industrial sector has declined over 10% in the last few years according to the Energy Information Administration. The easy consumption cuts by industrial users have already been made – future cuts will be much more difficult.
Natural Gas Power Plants
The power sector is also a major source of natural gas demand – but in this sector demand is growing. In the 1980’s the U.S. power grid’s generation capacity was 30% greater than needed. This margin dropped in half as the demand for electricity in the U.S. increases on average around 2% annually. Much of the increase in demand was met with existing coal or nuclear power plants, but eventually the incremental demands of consumers required new plants to avoid potential brownouts – and many of these plants have been built in the last 5 years.
Coal plants – many of which were added or expanded in the 1970’s - had met most of the incremental need for generation capacity in the 1980’s but they are dirty – emitting particulates, mercury, sulfur dioxide, and other contaminants that are difficult and costly to remove from the exhaust gases. Natural-gas-fueled power plants are much cleaner burning, and the capital expenditures for such plants are lower than for coal or nuclear fired plants. As a result of the clean burning nature of the fuel ninety-eight percent of the electric power plants that have been built in the last five years in this country are fueled by natural gas. As a result electric power companies' usage of natural gas jumped by an incredible 25% in the last five years!
The capital expenditures on such power plants is not insignificant: one expert estimates that over $100 billion has been spent on natural gas power plants over the last four years – sunk costs which insure a healthy demand for natural gas (see chart at right).
This country's digitally driven economy is expected to increase electricity demand by 30 to 35 percent by 2010 according to some experts. Going forward this incremental demand for power generation will rely on natural gas as the near-exclusive fuel to meet the electricity needs of the U.S. economy.
Commercial and Residential Demand
The combined demand in the commercial and residential sector of around 8.2 trillion cubic feet a year (tcf) exceeds that for power generation as well as for industrial use. The majority of demand in the commercial and residential sectors is for space heating – meaning the demand is cyclical with winter the period of peak demand.
The strong economy during the last decade has boosted new home construction, and most of these new homes are heated with natural gas. Housing data shows that, from 1991 to 1999, two-thirds of the new homes and more than one-half of the new multi-family buildings constructed were heated with natural gas. Further, the average size of these new houses was 25% larger than a decade earlier, increasing the potential for natural-gas consumption during colder weather. (Chart source: Andrew Weissman, Energy Ventures Group L.L.P.)
At the present time more than 56 million homes, or 55% of all U.S. households, use natural gas, a figure that has increased in recent years. According to the AGA's 2001 Residential Natural Gas Market Survey, natural gas captured 70% of the new home market, electric heat captured 27%, followed by heating oil at 3%. In addition, an increasing number of households install gas fireplaces, outdoor grills and other amenities.
On the commercial side, the number of commercial gas customers also increased from 4.6 million in 1995 to 5.1 million in 2000. Natural gas consumption in this sector rose by 6% during this time period. Due to the cyclical needs of the residential and commercial sectors, natural gas storage reservoirs assist utilities in meeting peak winter demands. Today we have almost 3.15 trillion cubic feet of natural gas in storage – and are in the third week of winter season withdrawals (see red line in the EIA chart – gray shading is 5 year highs and lows).
Withdrawals from storage will correlate closely with cold weather conditions that encourage space heating, especially in the gas hungry Midwest. Last year – in a winter only 1.2% colder than normal – we withdrew a record 2.55 tcf from storage. This record withdrawal was a surprise to many, reflecting the increased demand from space heating in the residential and commercial sectors. Because many storage reservoirs are irreversibly damaged if less than around 0.5 tcf is kept as working gas in the formations, the record drawdown last year caused natural gas prices to spike.
The natural gas market is heavily influenced by demand during two seasons: summer (when electrical demand peaks for air conditioning units) and winter (when demand peaks for space heating). The severity of the upcoming winter season will speak volumes as to where natural gas prices will head, short term.
The Iceman Cometh
Last month Barron’s ran an article in their commodity section entitled "The Iceman Cometh" – a catchy title that discussed the impact of the "Pacific Decadal Oscillator" (PDO) on long term worldwide weather patterns.
Using extensive databases and computers to examine historical weather data the PDO was discovered by researchers in 1996. "Pacific" refers to the slow fluctuation of water temperatures in the northern Pacific Ocean, "Decadal" refers to a trend lasting multiple decades, and "Oscillator" means that pattern moves back and forth between phases.
PDO is similar to El Nio/Southern Oscillation of the tropical Pacific. While El Nio and La Nia have been recognized for more than a century, the PDO is a recent discovery. Consequently, its effects are not as well known outside the scientific community. Data indicates that the PDO has a cycle of 20-30 years. One phase produces hot/wet weather in North America and the other cold/dry weather. When the PDO is in a "cool phase" it drives frigid Arctic air southward into the United States in the winter season.
According to researchers we have just finished around 20 years of the warm cycle and are in the early stages of a cold cycle. Scientists in the U.S. Geological Survey's Earth Surface Dynamics Program observed a hot/wet regime from 1900 to 1941; cold/drought from 1942 to 1977; hot/wet from 1978 to the late 1990’s; and now the phase is trending back to cold/drought.
If this trend is accurate we will have colder winters and need to consume more natural gas. Natural gas companies should benefit from the increased demand. PDO "is a dangerous weather pattern -- one that is conducive to Arctic outbreaks," according to Joe Bastardi, senior forecaster at AccuWeather. He expects the PDO to deliver a cold and snowy winter to the United States, with temperatures 1 to 2 degrees below normal. With computers and extensive databases Bastardi claims that long-range forecasting is becoming more of a science and not just guesswork.
Using a slightly different methodology Raymond James & Associates recently addressed the weather issue in a study which reviewed the last 104 years of historical weather data.
The researchers reached the conclusion that there is less than a 20% probability of a significantly warmer than normal winter in the U.S., with a 30% probability that the winter will be cool enough to cause natural gas prices to rise substantially.
Domestic Natural Gas Production: At a Crossroads
While it is difficult to evaluate the validity of any short term weather predictions two facts are clear: (1) demand for natural gas is increasing overall, especially in the generation, commercial, and residential sectors, and (2) North American supplies of natural gas have been declining. A recent Raymond James & Associates survey indicates that third-quarter U.S. natural gas production decreased 3.1% year over year, according to a study of 46 U.S. gas producers who account for 56% of total U.S. gas production. "The decline rate actually appears to be accelerating," Raymond James noted.
"Much like in the 1970s when oil production continued to fall, regardless of how many rigs were drilling, we think we are nearing (if not at) a similar crossroads in the U.S. natural gas supply picture," the analyst noted. If there is any doubt regarding the supply issue, it should be dispelled by the National Petroleum Council’s recent report to Secretary of Energy Spencer Abraham. The report concludes:
North America is moving to a period in its history in which it will no longer be self-reliant in meeting its growing natural gas needs; production from traditional U.S. and Canadian basins has plateaued. Government policy encourages the use of natural gas but does not address the corresponding need for additional natural gas supplies. . . .
Producers in North America are finding that the production decline rate in new wells has almost doubled in the last several decades. This reflects the smaller prospects being developed, and the fact that many of the larger reservoir structures have been developed with the advent of sophisticated 3-dimensional (3d) seismic technology in the late 1980’s.
Note the sharp decline rate in the chart (deep orange) – and the amount of production that will need to be discovered in existing and new fields to replace the depleted reserves.
"Supply is not going to be meeting demand," said David Parker, President of the American Gas Association (AGA). Previous supply outlooks "were much too optimistic."
Moving Forward
Supply and demand trends point to a market with the clearing price for natural gas will be much higher than it is now. High storage levels will help meet demand during the winter season, but be aware that storage supplies less than 20% of total demand. The remaining 80% of winter demand will be met from our declining North American production resource base.
Over $100 billion has been spent on new gas-fired generating units over the past four years – and residential space heating demand has expanded significantly with the building boom. This increase in demand represents a draw that will be relatively inelastic - and the price needed to reduce demand to meet shrinking supply might be much higher than many folks realize. Price volatility most likely will increase with upward price pressures, as it has in the recent past (see chart left).
Longer term liquefied natural gas (LNG) is a viable alternative on the supply side – but such projects at least five years away. In the meantime, as Fed Chairman Alan Greenspan noted this summer, higher natural gas prices can be a major drag on the U.S. economy.
A recent report by the Dallas Federal Reserve Bank studied the natural gas issue and found no studies on the impact of higher prices on economic activity. But it could be as significant, or more so, than past increases in crude oil prices.
--------------------------------------------------------------------------------
NATURAL GAS SERVICES GROUP (NGS - $5.66, NGSWS - $1.40)
A "STRONG BUY" IN THE NATURAL GAS COMPRESSION SECTOR
As natural gas wells are produced the underground reservoir pressure generally declines with time. This reduction in pressure is part of the "decline curve" noted in the previous article. Lower pressures at the wellhead generally mean lower production volumes.
From a producer’s standpoint a well can be "reworked" or "re-completed" in an attempt to address the declining pressure and production. Both of these options entail significant costs that often are not considered economically feasible.
As an alternative the producer can install a "compressor" at the wellhead or in the field gathering system. The wellhead compressor is a small engine that increases the pressure and volume of gas delivered to the pipeline. Compressors can be purchased or rented by producers, but many producers prefer to rent units due to the periodic maintenance that is required - and the fact that once a well is depleted the rental unit can be returned.
Public companies in the compression segment are dominated by several mid capitalization firms including Universal Compression (UCO), Weatherford
(WFT) and Hanover Compressor (HC). These firms generally concentrate on the larger, higher horsepower, engines. The only public company we are aware of that focuses on the smaller, lower horsepower engine niche, is Natural Gas Services Group (NGS).
NGS serves a unique niche by offering natural gas producers their choice of compressors rated between 50 and 500 horsepower for either sale or lease. Producers "size" their equipment based on the characteristics of the formation, the number of wells being produced, and based on the line pressure of the pipeline gathering system into which they deliver the product.
As a field is developed and gradually depleted the wellhead pressure declines. As such, it is common for most efficient size of the compression unit to change over time. The advantage to a producer of renting equipment (versus purchasing) is that if equipment becomes outmoded or unnecessary it can be returned to the lessor, or replaced.
From an economic standpoint most producers find the economics strongly favor the installation of compression at many of their producing locations. The compressor tends to substantially increase cash flow, and the relatively high natural gas prices increase the return on investment while shortening the period until payout.
NGS lease contracts generally run for a set period of time, usually one to two years, then month to month after that. In general, once NGS equipment is installed it remains on the wellsite until the well is depleted or until different equipment is needed due to pressure changes at the wells or in the collecting pipeline. So the stream of leasing revenues has been stable in the past.
Much of the NGS compression equipment utilizes the "rotary screw" compressor design. This design is especially flexible in meeting the producer’s needs. Characteristics of a field change over time, and the rotary screw design allows the inlet and outlet pressures to be easily modified. Reciprocating engines work well for high horsepower requirements, but lack the flexibility and reliability of the rotary screw design.
As an added plus for both NGS and the producer, emission limitations and reporting mandated under the Clean Air Act are generally avoided with engines smaller than 500 horsepower. This substantially reduces the cost of environmental compliance. While a number of private companies exist that rent or sell compressors, NGS has a broad geographical footprint and can meet many of the maintenance, repair, and horsepower needs of the natural gas producer in a timely fashion. At current natural gas prices, downtime can be extremely costly to a producer, so service and inventory are factors that are considered in making the leasing decision. NGS is also well positioned to take advantage of the development of alternative natural gas sources like coal bed methane (CBM) formations. From almost nothing a decade ago, CBM wells now constitute around 10% of U.S. production – a figure that increases every year. Due to the low pressures of most CBM wells, small rotary screw compressors have the flexibility to optimize the volumes of natural gas delivered into a pipeline.
It is significant that CBM wells can produce for decades – and most compressors once leased and installed remain in place and are serviced and maintained by NGS. So NGS obtains an incredibly long stream of rental payments in these CBM fields. The company has found its equipment in demand in CBM fields, especially in New Mexico.
NGS is a micro-capitalization firm, profitable and growing, and in our opinion very well positioned in the natural gas compression sector. In the nine months ended September 30th, revenues increased 12.1% from year earlier levels. More impressive was the fact that leasing revenues increased by over 50% from year earlier levels.
NGS management has focused on expanding the leasing revenues since it provides a stable stream of cash flow to the firm, however the gross margins on sales tend to be a bit higher than for leasing. At the end of September NGS has 371 compressor units in its rental fleet, up from 274 units a year earlier.
Going forward, NGS recently added personnel to focus on ramping up sales volumes now that the leasing stream has been established.
NGS recently obtained a $10 million line of credit that will allow them to expand their rental compressor fleet by 40% - with no dilution to the shareholders. This line of credit presents the company, and the shareholders, with some very attractive upside potential should the natural gas sector draw the attention of investors like we think it will in the near future. Any business that relies on commodity pricing faces the risk that low commodity prices will adversely impact their business. NGS is unique in that natural gas prices have little direct impact on NGS’s leasing activities. Even if natural gas prices should fall significantly NGS should still obtain revenues from the rental units which are required to physically deliver the natural gas into the pipeline (no compressor, no production, and no revenues to the producer in many cases).
On the other hand, should natural gas prices increase significantly (like we think they will) NGS will lease and sell more units as producers strive to maximize production rates and as they develop alternative sources of natural gas such as methane reserves from coal bed formations. Going forward we are very bullish on the natural gas sector, as noted above, and we view Natural Gas Services Group as a firm that has strong upside potential with little downside risk.
********************************************************
Article URL: financialsense.com
I own a small amount of NGS also, but have been waiting for it to get to a more reasonable multiple of earnings before adding more. |
