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Natural gas continues to attract favorable attention as a key energy source for the United States. To better understand what trends are affecting the market for natural gas and stock in the sector, we turned to four industry experts:

  • Kent Croft, chief investment officer of Croft Funds in Baltimore;
  • Ted Davis, co-portfolio manager of the Fidelity Select Natural Gas Fund in Denver;
  • Mark Hanson, CFA, an energy-sector strategist with Morningstar in Chicago; and
  • Jason Wangler, senior vice president of Wunderlich Securities in Houston.

Research: Natural gas is often cited as a key factor in America’s quest for energy independence. Do you agree with that assessment? And what potential upside do you see for the gas sector for short- and intermediate terms?

Kent Croft, Croft Funds: We are very bullish on the prospects for natural gas as a key source of domestic energy consumption going forward for the following reasons: We have an immense domestic supply, and it is attractive to both sides politically to assist the industry and reduce foreign energy dependence. Natural gas is cleaner than coal and cleaner and cheaper than oil and should take share in power generation and transportation. Domestic energy production will generate significant jobs directly and even more indirectly by making U.S. industries more competitive due to cheaper input costs.

We have always seen natural gas as a long-term trend that will take time to fully play out. In the short-term, we believe natural gas prices and the stock prices of companies operating in the space will continue to be volatile. But we are mostly bullish, as we believe that the price of the commodity remains depressed versus the long-term fair value.

Rig counts are expected to be down about 40% in 2013 and are currently about 75% lower than the previous highs seen in 2008. Natural gas has taken major share of the power generation market from coal, and industry experts expect this to persist. Transportation infrastructure continues to be built out, and there has been good news flow regarding natural gas infrastructure builds on major highway corridors. Cheap natural gas prices have made it more difficult for expensive alternative energy solutions to gain a significant foothold in the U.S.

Ted Davis, Fidelity: We believe [the answer is] yes. We’ve discovered an enormous resource in shale gas in North America over the past, call it, 10 to 15 years. It’s very economic. It’s low cost, so it can be extracted at very competitive prices compared to any other gas resource in the world. So, as a function of that, we are believers that natural gas will play a very important part in the energy renaissance in the United States.

Mark Hanson, Morningstar: I disagree with the sentiment in the short- and medium-term, but believe it could be credible that natural gas ultimately helps America become energy independent in a decade or more. A lot rests on incentives.

For example, if the U.S. consumes 18 million barrels of oil a day, most within the transportation sector, the heat equivalent would be more than 100 billion cubic feet of natural gas a day. The infrastructure required to handle not only the interstate transportation of natural gas, but also the “last-mile” transportation pipelines and the fueling stations themselves, would require tens if not hundreds of billions of dollars of investment.

If demand could be incentivized by government tax credits, for example—either for consumers to buy natural gas-powered vehicles, or manufacturers to build them, or infrastructure providers to construct pipelines and fueling stations—it could help catalyze the transition to natural gas. But it would be a long process, regardless of the amount of money thrown at the problem (think of how many years would need to pass before the existing gasoline-powered auto/truck fleet would churn). So I’m far less bullish on the wide-scale substitution of natural gas for crude oil in our economy.

Jason Wangler, Wunderlich Securities: I don’t know about energy independence, [since] that would [likely] be a long time, ten-plus years at least, away—if ever. But certainly, it could be a huge driver in reducing the importing of energy into our country.

The upside is basically four-fold in that it allows the U.S. to use resources that are sourced from our country (keeps money in the country by reducing imports), would reduce energy costs given the huge spread between natural gas and oil pricing, likely would reduce emissions and pollution, and could also create some stability in natural gas prices that would be a welcomed sight given the huge inventory of the commodity we now have.

In the short- and intermediate-terms, I don’t believe there is much in the way of tangible upside, in that actual sizeable demand increases like natural gas-fired plants, cars running on compressed natural gas (CNG), exporting liquefied natural gas (LNG), or other things would take years to develop. But longer term, it could be a huge economic driver for the country.

How do you expect the gas sector to perform in the intermediate- and long-term?

Croft: We believe that natural gas will see very large domestic demand increases over the medium to long term for the following reasons:

Cheap energy: Despite the recent increase in price, 1 mcf of natural gas still trades at about a 75% discount to a barrel of oil on a British thermal unit (BTU) basis, and we see this spread falling over time.

Power generation: Power plant’s consume roughly 36% of the country’s natural gas production now versus less than 20% in the early 2000s. This jumped 20% in 2012, and the International Energy Agency (IEA) estimates that natural gas will add 36.6 gigawatts (GW), while coal loses 25.6 GW by 2016.

Transportation: As the infrastructure is built out, we expect natural gas to see increased penetration beyond just municipal fleets and into long-haul trucking and consumer vehicles. (Only about 1% of vehicles in the U.S. were equipped to run on natural gas in 2012).

Domestic manufacturing: As industrials see the competitive benefits of cheaper energy costs in the U.S., we expect growth in domestic manufacturing and hiring. Exports will be a key driver of increased demand as LNG facilities become operational later in the decade. It was estimated that LNG exports could make up roughly 20% of the U.S. and Canadian’s annual natural gas production. Natural gas sells for over $16/mcf in Japan and $11.70/mcf in Europe as of February 2013.

Davis: In the short and intermediate terms, we do believe that we found the bottom in natural gas prices this past year. And directionally, we think that prices ought to be supported by improving supply and demand pictures.

We’re reasonably sanguine on prices. And from a supply standpoint, looking at some of the more attractive natural gas names out there with attractive resources that are low cost, we think some of those could be very interesting investments going forward.

What it really is going to require now is to honestly create the demand for the resource, and that adjustment is slowly being made. We’re moving towards building export terminals. We are moving towards adding chemical-processing capacity that uses natural gas as a feedstock and various other methods through which our manufacturing sector can take advantage of this resource.

So, longer term, we think that the demand will be created but it takes some time. We think that, broadly speaking over a long-term picture, natural gas will be well supported by increased demand over time.

Hanson: I estimate the marginal cost to produce natural gas in the United States at $5.40 per mcf. Under normalized demand conditions, this implies significant price upside for natural gas over the next few years.

I see incremental demand from power generation driving a pickup in consumption over the next few years. I believe that supply can generally respond within one to two quarters once prices pick back up, but with a limited number of rigs in operation. Also, with many E&Ps continuing to chase liquids-rich plays, the lag between a pickup in natural gas prices and a pickup in supply could be longer than many expect.

Wangler: I would expect the intermediate- and long-term natural gas sector to benefit from longer-term demand increases through the [greater] assimilation of the product by the public, given it is a cheaper and cleaner fuel that is actually produced here in the US.

These are all strong points for the commodity to be used more and more here in the U.S., as in my view it can be the production that weans us off of oil and transitions us to even cleaner, potentially reusable fuels in the future.

How do you recommend investors position themselves to make profits from natural gas stocks for the intermediate and long term?

Croft: Our main focus is to use near-term volatility to make investments in companies exposed to natural gas at attractive prices in the following areas. We tend to focus on low-cost producers with significant reserves who can stay above break-even at depressed prices and manage their business until the natural gas-demand function improves …

We look for value in companies with “hybrid” models that may have some acreage for exploration and production but also other businesses that offer some diversification benefits … We also like companies that provide natural gas services such as pipeline construction or operations.

Davis: It’s [about] holding the stocks that have control over the most attractive resources. What we do is try to research the individual assets for each one of these companies and understand who owns the low-cost resource and who can effectively exploit and bring that resource to production to take advantage of natural gas demand in the future; and as a function of that, investors who are positioned in the companies with those strong resources ought to benefit over time.

Hanson: Focus on the low-cost producers with lots of runway for growth and a balance sheet that should be able to survive the inevitable volatility in natural gas prices that will occur over the next few years.

Wangler: Investors who have a long-term view and can withstand near-term issues, I think, would be wise to get into natural gas names with strong balance sheets (so they can also withstand the tough times), as there is simply too much of the product for us to ignore it as a beneficial resource. That means we should focus on how to better use the product (i.e., increase demand for it), which would result in a better price for it as well. Obviously, both more stability and better prices for the product would benefit natural gas stocks.

Could you share any issues that you think investors should be aware of that could influence natural gas prices—and, hence, the sector—on the upside and downside over the next 12 months?

Croft: The overall strength of the U.S. economy and that of North America as a whole will have a significant effect on natural gas prices as more economic activity means more near-term consumption.

Davis: Weather is always a factor. As much as weather played a negative impact this past year, it’s actually playing a positive impact in cleaning up the supply and demand balance over the past couple of months. March [2013] is shaping up to be one of the coldest March’s on record.

People always have to be mindful natural gas is a very volatile commodity, and weather does play an important part in the short-term supply and demand picture, which can have a meaningful impact on pricing of the commodity but also [on] the equities themselves.

Hanson: The upside—if rig count doesn’t pick up soon, based on historical rig count-supply-price cycles (we’ve identified five distinct cycles since the early 1990s), supply should fall and provide a boost to prices. Any move by the Environmental Protection Agency to oversee hydraulic fracturing could increase costs and therefore prices, as would any unfavorable change to the current federal tax code for oil & gas producers. The downside—weather is a huge wildcard for natural gas demand, and therefore prices. 

Wangler: Overall, I look for the next 12 months to be more of a stabilization period for natural gas as it settles at (low) prices and the growth of the production begins to slow; and then as we proceed out the natural gas supply likely is more tempered while demand could incrementally grow.