Selective Opportunities in Natural Gas

Two experts share where they see the best prospects for both growth and profits in the sector.

[Editor's note: These comments are part of the May 2016 Investment Section, an advertorial section in Research Magazine, sponsored by NW Natural, ONE Gas and Southwest Gas.]

Research: Where do you see natural gas and energy prices overall heading in 2016?

Rob Desai, energy analyst & CFA, Edward Jones: Following the precipitous fall in prices since summer of 2014, we see both oil and natural gas prices higher in the second half of 2016, but for different reasons.

For oil, we believe supply declines in the U.S. and other OECD countries will offset increases from OPEC, primarily Iran. This, combined with increasing global demand, leads us to believe the current oversupply will move closer to a balance over the next year.

Additionally, talks of a production freeze from OPEC and certain non-OPEC countries could help support prices, although we believe the effect will be more psychological than an actual change in future supply.

For natural gas, we believe the past mild winter was the primary driver of low prices, so a combination of both lower activity and the potential for a normal or even a cold winter could influence prices higher by the end of the year. With that said, we don’t see natural gas prices returning to levels seen in 2014 due to high inventories and the increasing efficiency of drilling for natural gas in shale formations.

Matt Tucker, vice president and senior analyst of engineering & construction and diversified utilities, KeyBanc Capital Markets: We see natural gas prices rising into the mid-$2 range and oil prices rising into the mid-to-high-$40 range by year end, fairly similar to consensus expectations. That said, we think it is wiser to assume that we cannot accurately forecast energy prices and that prices will remain volatile, and to select investments that we think can still perform well in that type of environment.

What is your outlook for increased U.S. exports of natural gas, and how does your outlook influence your investment strategy?

Desai: The exporting of U.S. natural gas is one of the main drivers we see for higher prices when compared to today. While we see domestic demand for natural gas increasing over time, the U.S. has abundant supplies with relatively low extraction costs and the best infrastructure in the world. Exporting helps to supplement that domestic demand and should help prices over time.

The one caveat is, given low international oil and gas prices, we see few export facilities being built that do not already have long-term contracts in place. This could limit the increase in demand provided by exports over the long term.

With that said, we like both midstream companies tied to and companies with direct LNG-export exposure that do have long-term contracts in place. In an environment of lower cash flows due to low commodity prices, these projects with long-term contracts should provide much-sought-after increases in cash flow.

Tucker: We view U.S. natural gas exports in two primary categories: pipeline exports to Mexico and LNG exports, primarily to Asia and to a lesser degree to Europe. We think visibility is strong on increasing exports to Mexico, where there is significant and growing demand for cheap U.S. shale gas in the power generation and industrial sectors.

There are several major pipeline projects to transport gas into and within Mexico that have recently been constructed, are currently under construction or are planned to be built within the next two to three years.

These pipelines come with long-term contracts with Mexico’s state power company, and the rights to build, own and operate them are subject to a competitive bidding process, providing attractive growth opportunities for certain U.S. midstream companies that choose to participate.

We think the outlook for U.S. LNG exports is more mixed. There are a handful of LNG export projects under construction that will come online over the next two to three years, but there are also major projects coming online in places like Australia and Russia.

With global supply looking like it will exceed demand over the next several years, and lower oil-linked LNG prices making U.S. exports less competitive, it’s unclear how much these U.S. facilities will be utilized in the short- to mid-term. There are several more U.S. projects currently under development; but we think most of these will be deferred over at least the next two to three years, and many will likely be cancelled.

What are the key factors or trends (apart from exports) that will influence natural gas stocks in the short- and medium-term?

Desai: In the short term, we view current historically high inventory levels as a potential headwind. Following the mild winter and resulting lackluster demand for residential heating, current inventory levels combined with a relatively normal summer could lead to natural gas hitting its maximum storage level.

We view this as a potential negative for pricing, although we believe this is partially priced in at today’s levels. On the other hand, as the summer comes to an end, a colder winter could help to alleviate pressure on natural gas prices.

Over the medium-term, in addition to exports, we believe the two biggest drivers for natural gas prices will be increasing usage of natural gas for power generation and as an input for chemicals production.

Demand for power generation is being driven by increasingly stringent emissions standards for power plants. Almost all new generation is either natural-gas fired or some form of renewable energy. We expect this trend to continue.

For chemicals, low natural gas and natural gas liquids prices have helped to lower input costs, while demand for chemicals and plastics has remained relatively steady. The result is a good operating environment for chemicals producers, and we are seeing capital flowing to new chemicals projects all around the world.

Tucker: Clearly, natural gas prices will influence natural gas stocks, particularly those with direct commodity-price exposure. Outside of prices and exports, broader capital markets conditions will have an important influence.

For natural gas utility stocks, low interest rates and broader market volatility have been driving strong performance in early-2016 for those investments that pay relatively high dividends and are viewed as relatively safe. Additionally, low interest rates have been a key factor (among others) driving a lot of M&A in the sector, which also supports valuations.

To the extent that interest rates remain low and stable, these stocks should continue to do well; but when rates start rising sustainably, they will likely underperform.

For producers and midstream companies that have direct commodity exposure, the strength of their balance sheets and their access to capital at reasonable costs will have a lot of influence over how those stocks perform.

On a more fundamental level, we think it will be interesting to see how the evolution of the U.S. power generation fleet plays out. We expect power generation demand for natural gas will grow regardless, but market share gains by renewable resources continue to outpace expectations.

We think this could continue, particularly with the recent extensions of the wind production tax credit (PTC) and solar investment tax credit (ITC), posing downside risk to current natural gas demand growth projections.

What should investors consider in seeking profitable natural gas investments in the short- and medium-term?

Desai: In the short term, we believe one of the most important aspects for any energy company is its financial position. With low commodity prices and broad expectations of a “lower for longer” commodity price environment, many companies have limited access to external capital.