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- Don D., California
Between a Rock and a Gassy Space
Investors aghast at profits lost due to BP PLC’s (BP) gulf oil leak may want to protect their money from the energy industry’s other big spill: the flow of ink extolling the millions to be made from the shale gas revolution.
First, here is a short primer on the shale gas industry. For years geologists have known that certain very dense rock formations (shales) were likely to bear hydrocarbons, but drilling the formations yielded very little, because the rock was so tight that only a tiny fraction of the oil or gas in the deposit made it to the wellbore. About thirty years ago, a small Texas outfit called Mitchell Energy started experimenting with “fracking” the shale formations: pumping fluids into the wells at very high pressure in order to shatter the rock, creating passageways for the hydrocarbons to flow to the drillhole. In 2002, Devon Energy (DVN) bought Mitchell and ramped up its shale drilling program, especially in the Barnett formation west of Fort Worth, Texas.
Eight years later analysts are hailing shale gas as the solution to the United States’ crippling energy problems. Small onshore exploration companies have been in a full-fledged leasing scramble for some time now, racing to build positions in the Haynesville, Marcellus, Fayetteville, Woodford and Eagleford shales, among many others. And now the big money is following suit. Exxon Mobil (XOM) gave a huge vote of confidence to the industry in December, when it announced that it planned to purchase XTO Energy for $41 billion. A steady trickle of smaller deals soon followed confirming that shale gas investment was hitting high gear. Royal Dutch Shell PLC (RDS) is paying $5 billion for East Resources, a big player in the Marcellus shale. Private equity firm Kohlberg Kravis Roberts had purchased a $350 million stake in the company only a year before Shell’s buyout. Total SA (TOT) bought a piece of Chesapeake Energy’s (CHK) Barnett shale operations for $2.25 billion; Mitsui (MITSY) acquired a third of Anadarko Petroleum’s (APC) position in the Marcellus for $1.4 billion; and Reliance Industries paid $1.7 billion to Atlas Energy (ATLS) for a stake in its Marcellus holdings.
Large institutional investors are plunging in as well. Asian sovereign wealth funds China Investment Corporation, Temasek Investment Corporation (Singapore), and Korea Investment Corporation were the biggest buyers in a recent combined sale of $900 million worth of Chesapeake Energy preferred stock; other investors included the Chinese private equity fund Hopu Investment Management.
So with major domestic and international companies and funds rushing to get a piece of the shale gas boom, and the financial press hailing it as the savior of the energy industry, should the retail investor be saving his or her lunch money to throw at shale-related investments?
Time to Invest?
Maybe, or maybe not. Investors with an eye on the commodities markets will know that, after hitting a record high around July of 2008, natural gas prices collapsed and have been trading at very low seasonally-adjusted levels since, by some measures the lowest since 2002-2003. This is due in part to destruction of industrial demand caused by the financial crisis and the recession. But the severity of the gas price collapse is also closely related to the abundance of supply caused by the success of ever better shale gas drilling techniques. The boom in shale gas production, therefore, has been partly responsible for a collapse in the profits of companies that produce it.
As a result of these poor near-term conditions, the stocks of natural gas focused exploration and production companies (E&P) have been trading at about two-thirds of their (likely inflated) 2007-2008 highs, with the more aggressively hedged outfits, such as Newfield Exploration (NFX) and XTO Energy, faring better than their more spot-price exposed counterparts. Indeed, the E&P companies have in general learned their lesson on the subject of hedging; analysis by Credit Suisse First Boston analysts show that 51% and 25% of estimated 2010 and 2011 North American natural gas production is hedged, respectively. This should help create a little more earnings stability for the gas producers. In fact, conditions generally look better for the industry, with factory demand perking up on signs of a nascent recovery.
That said, we still do not think that natural gas E&P companies are a good equity investment right now. Industry proponents point to the huge potential reserves of natural gas (some 80 plus years of domestic, clean-burning fuel to power the country as it makes a transition from a fossil fuel based economy) and argue that an increase in the use of the fuel will inevitably raise the price of gas E&P stocks. Indeed, the supply side is the strong point of the argument for natural gas. The problem is rather the demand side. Natural gas has been such a volatile commodity over the last decade that sellers have had a hard time driving demand for the fuel up materially, because potential buyers are wary of excessive variability in their fuel costs. Consumption of natural gas has thus been flat since about 1995, fluctuating within a range bounded by 21 trillion and 24 trillion cubic feet per year. Federal energy policy is likely to place a premium on increasing the use of natural gas for power generation, which one might expect to drive up valuations for natural gas E&P companies. The problem for retail investors is that these valuations are already rather full. The Value Line Diversified Natural Gas Industry’s composite 2009 P/E ratio was 12.9, above that of the Petroleum (Producing) Industry, even though oil and natural gas prices reached historic levels of divergence during 2009. The valuation differential was even more pronounced in 2006-2009.
What’s more, the natural gas E&P companies are rushing to gain more exposure to oil as a hedge against weakness in gas prices. Natural gas big boys Chesapeake Energy and Devon Energy have been emphasizing their oily assets in investor presentations. Companies with leases in the Williston Basin’s shale oil areas have been bumping rig counts there while curtailing them in gas plays. Meanwhile, the leasing rush in the Eagleford shale is due in part to that basin’s oily reservoirs. Finally, acquisition activity seems to confirm the move to oil: gas producer SandRidge Energy (SD) announced a deal to buy oil-rich rival Arena Resources (ARD) in April.
So with valuations looking full, supply-demand dynamics unfavorable, energy legislation uncertain, and the E&P companies themselves moving into oil, is there any way to profit from the emergence of the shale gas industry?
The answer is yes. The emergence of shale gas has woken up a sleepy portion of the energy industry. But for gas to increase as a share of the nation’s energy supply, and for the price of gas to become more predictable for both buyers and producers, the gas storage, transmission, and power plant infrastructure has to be overhauled and expanded. The increase in supply caused by the emergence of shale has filled gas transmission lines and storage facilities nearly to capacity. To give one appalling example of infrastructure limitations, North Dakota, a major oil and gas producing state, has no natural gas storage facilities. Producers in that state were forced to flare (burn off at the wellhead) a third of the natural gas produced in that state in 2008. Even now, 17% of the gas produced there is burned off into the sky. Unsurprisingly, this prompted transmission companies to flood into the state with $1 billion worth of plans and permits to build storage, compression and pipeline infrastructure to move the abundant gas to markets further east. In the United States overall, the Energy Information Administration (EIA) reported that 84 projects and 4,000 miles of natural gas pipeline were built in 2008 (the last year of available data). What’s more, the same report estimates that nearly 10,000 miles of transmission infrastructure were likely to be constructed in the next three years (2009-2011), a number that is certain to be out of date and too low by now.
The companies making these investments are often gas transmission utilities, but investors should take a special look at energy distribution Master Limited Partnerships (MLP). MLPs generally charge by the amount of gas (or oil) transported and so are only indirectly affected by the ups and downs of gas (and oil) prices. What’s more, MLPs must pay out a high fixed percentage of their income in the form of distributions (dividends) and have certain tax-deferral advantages. Finally, as the gas infrastructure build-out goes on, these businesses should experience above average, and relatively less risky, growth. Enbridge Inc., Kinder Morgan (KMP), Magellan Midstrean Partners (MMP), and Inergy, L.P. (NRGY) are all solid choices within this group.
Another good way to play the shale boom is to invest in the construction companies that will build the needed gas infrastructure. Within this group, we like domestic power plant builder Foster Wheeler (FWLT) and the much smaller MasTec (MTZ). MasTec purchased Wisconsin-based Precision Pipelines about a year ago, moving into the gas infrastructure space. The largest and best diversified company within this group is Fluor (FLR). These and other heavy construction companies usually follow the energy capital expenditure cycle, but are also more diversified than the pure E&P companies. They thus are a good way to try to capture shale upside while insulating oneself against the downside.
Finally, investors might want to consider the oilfield service companies that specialize in serving the shale gas drillers. In that group, we like CARBO Ceramics (CRR), which provides ceramic proppant. Proppant is injected into the shale reservoirs, along with the high-pressure fluids, and remains in the cracks after the fluids are removed, in order to “prop” open the cracks in the shale. Traditionally, sand was used as a proppant, but CARBO has shown that hydrocarbon recovery is materially improved when its ceramic proppant is used. In the first quarter, CARBO not only sold all of the proppant it produced, it sold completely out of its stored inventory. The company has a new plant starting production by the end of the year.
The shale gas industry is going to have to force demand for its product to increase by keeping its supply steady and simply weathering the low price environment until such time as the transmission infrastructure can get built out. But investors should not have to wait around for these companies to turn a profit, enduring dizzying ups and downs in stock price. For the retail investor, we see better return in the pipeline partnerships, with their less risky profiles and solid dividend payouts.