From Mississippi to Pennsylvania and Ohio to Kansas, there’s a gold rush in the natural gas market.
In little Williamsport, Pa., population 30,000, city officials say they have never seen such an economic boom. Long lines at restaurants and sold-out local hotels are the result of 115 new businesses being created over the past three years as natural gas companies come to town to set up shop. Williamsport is now the seventh-fastest growing community in the United States, according to the U.S. Bureau of Economic Analysis.
In southwest Mississippi, prospecting for oil and gas has created 13,000 full-time jobs and more than $500 million in salaries over the last four years alone. Out in south-central Kansas, the story is no different. Land that sold three years ago for $30 an acre is now fetching $3,000, as oil company officials buy up millions of acres of mineral rights.
“Fracking,” or hydraulic fracturing, has revolutionized the search for natural gas in the United States. Using advanced techniques that allow prospectors to drill not only down but sideways through deep shale rock, natural gas explorers are reaching huge pools of otherwise untapped gas, bringing tax revenue, jobs and economic rebirth.
A 2011 study authored by the consulting company Pricewaterhouse Coopers estimates that shale gas recovery might result in one million new manufacturing jobs by 2025. Another study by IHS Global Insight, a country and industry forecasting firm, found that 34% of natural gas harvested in the U.S. is now shale gas, up from 27% in 2010, and projected the figure will grow to 60% in 2035.
With all of this new economic activity also comes investing opportunity. And there is more than one way to play the market. Investors might choose to buy shares in Chesapeake Energy (CHK), a huge player in the natural gas shale market, or a traditional giant like ConocoPhillips (COP). Smaller energy companies just getting their start in the market or service companies like pipeline providers are another way to invest in the sector.
Tyler Kocon, a portfolio manager for Split Rock Private Trading in Duluth, Minn. sees the biggest investing opportunities in smaller companies with under $1 billion in market cap value. He likes Synergy Resources (SYRG), a domestic oil and natural gas exploration and production company, with just 168 wells primarily operating in Colorado, Wyoming, Kansas and Nebraska.
These companies are attractive in part, Kocon says, because they present good buyout opportunities for larger firms. “[They go from] one well to two wells, and all of a sudden they grew 100%,” Kocon says. “That’s what is so exciting about these companies. We think they present themselves as fantastic buyout opportunities for larger companies like Exxon.”
Still, smaller companies without proven records of performance can present greater risks, and Kocon is well aware that he is investing in a volatile sector. “Without a doubt, it’s the riskiest portfolio that we’ve run,” Kocon says.
Corporate performance isn’t the only risk to consider when investing in this sector. Environmental groups oppose “fracking” because they say water used in the drilling process is contaminating water tables and releasing methane, a harmful greenhouse gas. Hydraulic fracturing differs from traditional drilling in that wells are dug deeper and drills are pointed sideways to break up pockets of shale that in turn release latent gas reserves. During the drilling process, millions of gallons of water are pumped down into the drilling holes. The pressure from the water aids in breaking up the shale. Oil companies contend that the contaminated water is so deep at that point — thousands of feet below the surface — that it can do no harm, but many environmentalists believe otherwise.
“The environmental side of it is very scary,” Kocon concedes. “That is the biggest threat to this portfolio. The first time someone messed up with disposal or pumping … would be devastating for our portfolio and other people’s holdings.”
Environmental concerns aren’t even the greatest threat to this investing area, however. Greater threats loom in historically low prices of natural gas and questions about how the industry presents its current assets and future prospects.
Thanks to new drilling techniques, the price of natural gas has sunk to 10-year lows. In 2010, there were 487,000 wells producing natural gas in 30 states, according to the U.S. Energy Information Administration (EIA), the statistics branch of the U.S. Department of Energy. All of this new drilling, however, has pushed down prices to one-third the level of 2005. This has been great for consumers, who have seen lower electricity bills, but it is a mixed blessing for manufacturers.
For one thing, oil and gas companies that once built their plants overseas are now building again domestically. Moreover, U.S. companies that use products created from natural gas, like plastics, are seeing a huge price advantage over international competitors.
But just as high oil prices are pushing up the price gasoline and enriching oil conglomerates, so too the low price of natural gas is hurting the drilling companies. The Nasdaq Natural Gas Index (XNG) has dropped 7.1% over the last year while the S&P 500 has risen about 10%. As a result, oil and gas companies are cutting back on their drilling in some of the biggest natural gas plays, like the Marcellus Shale that stretches from New York to West Virginia and the Barnett Shale in Texas.
Simon Rosenberg, a portfolio manager and analyst at Snow Capital Management, a boutique investment firm outside Pittsburgh, Pennsylvania, says he sees “fertile ground” in the natural gas sector. The fourth-warmest winter on record has left producers with an oversupply of fuel, Rosenberg explains, but it’s a mistake to believe that means natural gas price will continue to fall.
“Gas is now trading 60% below its marginal cost of production, 85% below the cost of oil on BTU-equivalent basis, and substantially below the cost of coal,” says Rosenberg. “In the long run, we believe market forces will drive demand higher through substitution of other fuels and reduce production to a rate that balances demand.”
Producers will carry out that reduction by cutting output, a process that has already started. “Once the supply response becomes evident, we expect the price of gas to recover and the shares of natural gas exploration and production and oil service companies to recover along with it.”
The greatest risk for investors, though, may lie in attempting to assess just how much natural gas exists and how much can be extracted at a profit. For example, earlier this year the EIA cut back its estimate for the amount of gas contained in the Marcellus shale. Just one year after predicting that Marcellus held 410 trillion cubic feet of natural gas, the agency cut its forecast by two-thirds, to 141 trillion cubic feet, in January 2012. In that same report, the agency reported there was a total of 480 trillion cubic feet of natural gas in all of the United States, a reduction of almost half of an earlier number of 830 trillion cubic feet.
And those are the official estimates. An investigative report by the New York Times in June 2011 found that companies may be overestimating the size of their reserves and overstating the productivity of their wells. Worse, hundreds of industry emails obtained by the paper cast the search for natural gas in shale formations in a highly negative light. Industry insiders compared the current craze over natural gas prospects to the dot-com rush of the late 1990s. One went so far to compare shale plays to Ponzi schemes because “the economics just don’t work.”
Central to the concerns among these industry participants is the long-term viability of the plays themselves. In simple language, the wells are running out of oil and gas faster than expected. It is common for drilling sites where gas is extracted with the “fracking” method to have highly productive initial years and then slowly declining later years. A geologist at Chesapeake Energy, the second largest producer of natural gas in the United States, told a federal energy analyst in March 2011: “Our engineers here project these wells out to 20-30 years of production and in my mind that has yet to be proven as viable. In fact, I’m quite skeptical of it myself when you see the [percentage] decline in the first year of production.” Indeed, the Times report found that less than 20% of the wells in three major shale formations are likely to emerge as profitable and less than 10% of some 9,000 wells surveyed had recouped their costs within seven years.
Rosenberg, for one, says it may be difficult to calculate how much natural gas the U.S. holds, but that it surely is a lot. To his mind, the data on production decline rates “clearly support” predictive models used by the industry to determine resource flows over time. “One can certainly not argue that the resources do not exist in large quantities,” Rosenberg says. “Whether that is more or less than original estimates is beside the point.”