January 13, 2012

Energy Market Imbalance Could Transform Entire Industries

In the last five years, the spread between oil and gas prices has materially widened, in what looks to be a persistent shift in a critical market relationship. The effects are potentially far-reaching across a value chain that touches industries including energy, utilities, chemicals and transportation, not to mention geopolitics.

The Opportunity

The most important factor that has driven the change in spread behavior has been the emergence of shale as a significant source of natural gas supply. In recent years, shale has transformed the domestic natural gas industry from a state of decline to accelerating growth in both production and reserves. Without the link to global markets that has supported crude oil, domestic gas prices are depressed by this unanticipated excess supply.

Investment Approach 

Industries that source energy from natural gas and deploy it in markets where pricing is based on crude oil will successfully capture the spread. Therefore, to identify the beneficiaries we must follow the gas from the shale (upstream), through processing and pipelines (midstream) to its end use (downstream)–that is, consider the entire value chain.

Upstream access to shale gas requires ownership or leasehold rights to the reserves, access to specialized equipment, and the capability to apply the production technology. In the current environment, a key differentiator among reserves is the presence of natural gas liquids. Exploration and production companies whose rights are concentrated among liquids-rich deposits are advantaged because they may improve the economics of the well such that it can deliver solid returns even at very low natural gas prices 

Natural Gas Liquids (NGL) occur naturally in gas deposits with varying degrees of concentration. They are most prevalent in certain shale plays, including the Bakken (N.D.), Eagle Ford (Texas) and the southwestern Marcellus (Pa.). The most common NGLs co-produced with shale gas are ethane, propane, butane and pentane. Chemically, NGLs are hydrocarbon chains that are longer than natural gas but shorter than crude oil. They are used as petrochemical feedstock and as fuels for heating, cooking and transportation. Given their composition and uses, NGLs are a substitute for refined crude oil, and their pricing is linked to crude oil rather than natural gas.

With production tied to natural gas (abundant), but pricing tied to crude oil (scarce), NGLs are a play on the oil-gas spread. As such, each segment of the natural gas value chain is likely to be advantaged to the extent it touches this market, for as long as the oil-gas spread remains at elevated levels.

In the upstream, energy services companies who can deliver the new drilling technologies to unlock the promise of the shale plays and companies that deal with the waste stream of shale gas production, including recovery, recycling and disposal of the fracturing fluid are well positioned to benefit from this trend. Environmental regulation of this process is expected to become more onerous, and service providers who can stay abreast of changing requirements will be advantaged going forward.

In the midstream, natural gas may be gathered, fractionated, or stripped of its liquids content, stored, and ultimately transmitted via pipeline to its end use markets. This area is interesting for several reasons.

First, the existing midstream infrastructure was primarily built for access to conventional gas basins rather than the newer shale plays. This puts a premium on any assets already deployed in proximity to shale gas. It also creates opportunity for new investment at relatively high returns with a significant degree of safety, because well operators are willing to provide long-term guarantees in advance of construction in order to secure the capacity to handle anticipated production growth. In the pipeline and storage areas, direct commodity exposure is limited, but the elevated spread is driving volume growth as other market participants seek to capture the arbitrage opportunity.

From an equity markets perspective, more limited commodity exposure may actually be an advantage to the pipelines, which will see growth from volumes and new capital projects, without the risk of a material earnings impact on any moderate narrowing of the spread. For this reason, we view the pipelines as “growth utilities” offering the stability of regulated, nondiscretionary offerings together with the prospect for accelerating business growth, reminiscent of the electric utilities in the post World War II period as the U.S. built out its electric grid.

Downstream gas is used primarily for home and commercial heating, and electric power generation. Gas is likely to gain market share over time, particularly in power generation, as environmental and safety regulations raise the cost to operate competing coal and nuclear power plants. Ultimately, this should advantage gas-fired plant operators.

Putting It Into Practice

We believe that the major beneficiaries from the various market dynamics detailed above are companies in the following sectors:

  • Major owners and operators of midstream processing and pipeline assets;
  • Gas utilities with substantial resource holdings in shale plays;
  • Waste management companies that provide environmental services at well sites;
  • Chemical manufacturers that can leverage domestic natural gas/NGLs to compete globally;
  • Barge operators that transport petroleum-based liquids and other equipment used in shale-based oil and gas production;
  • Oil tanker operators with a specialty liquefied natural gas transportation fleet.

In summary, the persistent widening of the spread between oil and gas is creating enormous markets across a variety of industries. Through our emphasis on thematic investing, we are focused on identifying undervalued securities that we believe stand to benefit as companies capitalize on the energy arbitrage opportunity.

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