Natural gas exporting could lift prices.

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.

As a result, we believe companies that have the ability to avoid potentially expensive debt or equity issuances by either spending within their own internally generated cash flows or reducing spending to compensate are well positioned in today’s environment. These companies tend to have investment-grade credit ratings and lower-than-average debt levels when compared to peers.

In the medium term, in addition to a strong financial position, we believe companies that have the ability to increase spending to take advantage of price increases can benefit. A strong financial position, either cash on hand or access to capital markets, will allow companies to ramp up spending while others must remain cautious.

In addition, those with lower-cost production or sizable backlogs of projects have the capacity to spend when it is possible.

Tucker: It is important for investors to understand the specific nature of their investments’ exposure to natural gas prices. Given the difficulty of predicting the direction of natural gas prices with much accuracy, we recommend investing in companies and sectors that benefit from the overall abundance of natural gas supply in the U.S., which is likely to keep U.S. natural prices low relative to the rest of world, even if they rise somewhat in the short- and mid-term.

This would include investments related to industries that use natural gas as an input cost, such as petrochemicals or regulated natural gas power plants, and those with exposure to the transportation of natural gas volumes rather than to natural gas prices, such as fee-based pipelines and regulated natural gas utilities.

In particular, we see attractive investment opportunities within the relatively small group of publicly traded engineering & construction (E&C) companies that build large-diameter natural gas pipelines, as we see a significant spending cycle coming up over 2016–2018 with several major projects that have solid customer commitments and well-capitalized sponsors.

Even if some of these projects are delayed for regulatory reasons or even cancelled, we think demand for large-diameter construction capacity could outstrip supply, creating a very favorable environment for contractors.

We also think the recent trend of consolidation in the LDC space will likely continue, providing support to natural gas utility stocks.

How has the drop in energy prices affected natural gas development in the United States?

Desai: The significant drop in both oil and gas prices has had a profound effect on overall energy activity. The simplest way to see this is the drilling rig count from Baker Hughes.

The number of drilling rigs targeting natural gas at the end of the year was less than half of those at the beginning. Even more amazingly, at the end of 2015 the number of natural-gas-focused drillings rigs was down almost 90% from the peak over the last decade.

Lower prices have led to lower cash flows for companies exposed to natural gas production. Even companies that have historically hedged production are now exposed to these lower prices.

These lower cash flows have led to credit-rating downgrades across nearly the entire energy sector. As a result, companies don’t have access to capital to spend on resource development.

In addition, development in related areas, like building pipelines and gathering and processing systems, has slowed significantly.

Tucker: The affects vary rather significantly depending where you look within the natural gas value chain. Upstream, drilling activity has slowed, although production has remained fairly resilient. Within midstream, demand for gas gathering and processing infrastructure has also slowed considerably.

By contrast, we are seeing significant development of mainline natural gas pipelines driven by existing bottlenecks in takeaway capacity from key shale plays, and by increasing demand from the development of natural gas power plants, petrochemical facilities, LNG export infrastructure and exports to Mexico.

Natural gas utilities continue to ramp up investments in their pipeline infrastructure, with the blessing and even encouragement of their regulators, as low natural gas prices create headroom on customers’ bills for the recovery of these investments.

How did the natural gas companies that you follow perform in 2015?

Desai: The natural gas companies we follow underperformed both the S&P 500 and the energy sector as a whole. The primary driver of this was low natural gas prices and low oil prices that negatively impacted wet gas areas, or those with significant natural gas liquids production.

The natural gas producers that we follow were directly impacted by low natural gas prices as hedges rolled off towards the end of the year, leaving cash flows significantly constrained amid increasing credit pressures. This then bled over to related areas like midstream, where historically stable pipeline companies also underperformed.

We believe the main driver of this was volumetric risk on gathering and processing assets, counter-party risk due to potential customer bankruptcies and limited access to capital for companies that had previously relied on debt and equity markets to fund growth.

Tucker: The diversified utilities stocks we follow, which own both electric and natural gas utilities (and minimal or no merchant power generation) fell by an average of 14% in 2015.

Coincidentally, the E&C stocks we follow that have significant exposure to natural gas infrastructure also fell by an average of 14% in 2015, although there was far greater dispersion within this group than among the utilities.

Did those 2015 results differ significantly from your pre-2015 expectations? If they did, what factors caused the unexpected results?

Desai: We had modest to slightly negative expectations for natural gas producers going in to 2015. Natural gas prices were relatively high in 2014, and we did not expect them to continue in 2015 due to increasing production and low extraction costs. With that said, prices fell more than we expected and producers underperformed our expectations.

We view weather and inventory builds at the end of the year as one of the main drivers of this underperformance. Credit concerns and credit rating downgrades also played a role.

Midstream companies that operate natural gas pipelines and gathering and processing systems underperformed our expectations in 2015. We expected these stocks to be negatively impacted by lower energy prices, but we also expected the companies with long-term, fee-based contracts in place to hold up better than they did.

The credit-rating downgrades of many producers caused counter-party risk to be a major concern for midstream companies with contracts in place. It is still to be seen how producer bankruptcies affect contracts, but so far court rulings have been negative for midstream companies.

Additionally, lower commodity prices bring in to question the long-term growth of the midstream industry. If prices remain low, there is likely less need for new infrastructure.

Tucker: The performance of the diversified utilities did not differ significantly from our expectations given their relatively high valuations entering the year; however, if we had known the 10-year U.S. Treasury yield would actually decline slightly during 2015, we likely would have predicted a stronger performance for this group.

The performance of the E&C stocks we follow was weaker than we anticipated entering 2015, largely because these stocks had already declined materially in sympathy with oil prices at the end of 2014, and we did not at that point anticipate the “lower for longer” scenario that has played out since.