OT
June 24, 2000
Natural gas price increases fuel investment opportunities
Joe Dancy, co-editor of the IFC and editor of The Lone Star Growth Investor members.aol.com, provides the following article. AudioInvestor.com provides an audio version of the interview. Click here if you would prefer to listen to the interview. Below is his write-up.
The U.S. natural gas market enters the month of June with prices at the highest level since deregulation. Prices have surged recently to over $4.00 per million British thermal units (MMBtu). These prices are up from the $2.25 per MMBtu level a year ago.
Ken Hoffman, manager of the Orbitex Strategic Natural Resources Fund, noted that the outlook for natural gas companies looked so good, an analyst "could not even dream up stories like this" (see our interview with Hoffman, where he discusses some natural gas companies he finds attractive, at theaudioinvestor.com....
Natural Gas Prices Driven By Demand
Behind the rise in natural gas prices is a buildup, and a potentially serious shortfall, of supply. This is the result of disappointing natural gas exploration efforts and surging gas demand for use in power generation. Natural gas storage inventories have been historically used to meet demand, especially during peak periods, but injections so far this spring into these natural gas storage caverns have been running well below last year's pace - in some cases 15 to 20 percent.
The weak injection rate so far this season reinforces the pricing pressure. Injections will need to ramp up this summer to meet the minimum acceptable levels for next winter's heating season. Meanwhile, new electrical generation units - mostly natural gas turbines - will begin to come online to meet growing electricity demand.
In many markets, the lack of new generation capacity has left systems with little reserve for use during periods of peak demand - and if we experience a hot summer, demand from air conditioning loads could cause serious challenges to some systems. In fact, California and Michigan have already experienced problems with their electrical supply, and warnings of further brownouts or related problems have been recently issued by regulators in Washington.
In addition to the demand created by power generation, the stringent air quality provisions in the Clean Air Act Amendments of 1990 have made natural gas the fuel of choice for many applications. The cost of environmental controls on internal combustion equipment can be substantial, giving natural gas a decided advantage over alternative fuels.
A warm summer could add to the natural gas deliverabilty concerns
While a huge amount of natural gas reserves exist in Canada, it will be years before pipelines are completed to deliver it to the U.S. markets. Around 85 percent of the natural gas used in the U.S. is produced domestically. The remainder is imported from Canada.
The forces that have pushed the gas market to the $4 level are not a surprise, and have been building for some time.
Crude oil prices remain firm in the light of the accelerating global economy and demand for oil products - especially in Asia - makes switching from natural gas less attractive. Further, demand for natural gas used in power generation is highly inelastic, and a warm summer could add to the natural gas deliverabilty concerns.
A recent Energy Information Administration (EIA) study indicated that U.S. natural gas demand will jump 3.5 percent in 2000, and will rise another 4.1 percent in 2001. These increases follow anemic growth of less than 1 percent in 1999, when oil prices remained "reasonably competitive" against gas in industrial applications, and as a fuel for electric power plants.
The EIA expects natural gas price increases through the summer and into next winter, as demand growth in the industrial and power sectors continues to outstrip production gains.
Experts Predict Shortages, Price Spikes
"The bottom line on our U.S. natural gas forecast is that supply and demand is tightened to the point where average gas prices should generally stay above $3.50 [per thousand cubic feet] as suppliers struggle to meet U.S. gas demand," according to a recent study by Raymond James & Associates.
Raymond James is one of the biggest bulls on the Street, according to a recent Petroleum Finance Week article, and raised its U.S. natural gas price forecast for 2000 from $3 to $3.55 per Mcf. It notes that "we expect gas prices to remain well above the $3.50 level over the next 12 to 18 months." The consulting firm expects severe upward price spikes this winter. Its model suggests that the United States will enter the heating season with 2.3 trillion cubic feet of gas in storage, more than 20 percent below storage levels at the beginning of the 1999-2000 winter heating season.
David Garcia, of First Union Securities, notes that "once the summer season begins, nominally in June 2000, we believe it will become all too evident that there is simply not enough natural gas available at the wellhead to (1) meet traditional industrial base-load requirements, (2) meet expanding summer demands and (3) rebuild storage for the winter of 2000-2001, even assuming continuation of warm weather patterns."
Richard Spears, principle of Tulsa's Spears & Associates, states that, based on its surveys, natural gas firms have been producing "pretty well flat out" for the last 12 to 18 months. Spears notes that "we are in uncharted waters with regard to the natural gas market, for which there is no precedent."
Domestic drilling activity cannot easily ramp up to meet demand, according to Spears, since most equipment supply firms are running at capacity now and have been running at this level for some time. These firms are having difficulty finding qualified personnel and equipment. This situation is not expected to change any time soon in the drilling sector.
Key Production (NYSE: KP)
Because of the developments in the natural gas market and the positive outlook for prices, we are adding Key Production Company (KP 16 1/2) to our Model Portfolio . Key is an independent energy company engaged in the exploration and production of oil and gas in the continental United States, primarily in the Anadarko Basin of Oklahoma, north Texas, the Mississippi Salt Basin, South Louisiana and Northern California.
In the first quarter of fiscal year 2000, revenues almost doubled from year-ago levels - and earnings increased more than six-fold. KP reported net income of $0.34 per share for the first quarter of 2000, compared to $0.05 per share a year ago. Revenues increased to $19.3 million in the first quarter, from $10 million a year earlier.
Strong crude oil commodity prices in 2000, and very low oil prices in 1999, drove the variance between the year-to-year quarterly results. Crude oil prices sank to $11.22 per barrel in the first quarter of 1999, then surged to $26.94 per barrel in the first quarter of 2000.
With regard to future crude oil prices, we expect these to remain firm due to the fact that many Asian economies are recovering strongly. Any excess supplies produced by OPEC will be quickly absorbed by these growing economies. Europe and Latin America are also continuing to grow, adding additional demand to the mix.
Key is selling at a price-to-earnings ratio of 12.8
Most of Key's revenue increase in the first quarter was from crude oil sales, which increased by $6.8 million. Gas sales increased by $2.3 million, and plant product sales rose by $.2 million. The average realized gas price was $2.43 per Mcf in 2000, compared to $1.75 per Mcf in 1999.
In first quarter of 2000, revenues came from the following product mix: 54 percent oil, 44 percent gas and 2 percent plant products. Key's 74 percent drilling success ratio on wells is excellent. As the natural gas market firms, we expect this mix to change, and for natural gas production to account for the majority of KP's revenues.
Key has a market capitalization of $190 million, which classifies it as a small cap firm. Based on our estimate of earnings, Key is selling at a price-to-earnings ratio of 12.8, and at a price-to-book ratio of 2.3. On the downside, the debt/equity ratio is a relatively healthy 0.7 - but the free cash flow generated from the healty product prices can be used to handle these obligations.
As the market for natural gas continues to strengthen, we expect this firm to continue to do well, with revenues increasing an additional 25 percent or more moving forward. With 11.6 million shares outstanding, we think the additional revenues will make a substantial contribution to the bottom line. |
