What Investors Should Know About Buying Into Natural Gas

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Natural gas has been going through a renaissance in the last few years, with increasing use in the U.S. and around the world. In this week's episode of Industry Focus: Energy, analysts Sarah Priestley and Taylor Muckerman go over the most important things that investors should know about the natural gas industry today.

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Find out why natural gas production has spiked in the past few years in America, how and why natural gas consumption is expected to grow into the future, some of the lesser known uses for natural gas, a few companies from all the steps along the production pipeline that you might want to check out, and more.

A full transcript follows the video.

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This video was recorded on Nov. 16, 2017.

Sarah Priestley: Welcome to Industry Focus, the show that dives into a different sector of the stock market every day. Today, we're talking energy and industrials. It's Thursday, the 16th of November, and we're going to be discussing the U.S. natural gas market. Joining me in the studio is the one and only Motley Fool Canada premium analyst, Taylor Muckerman. Taylor, thank you very much for coming in!

Taylor Muckerman: Yeah, it's great! How's it going?

Priestley: It's been too long.

Muckerman: I know. You found some all-stars to sub in for me.

Priestley: [laughs] Not at all. So, after a pretty long and hot summer, maybe not for all of our listeners but definitely in the D.C. area, it was a very long and hot summer, it's finally getting colder here, and I think they're predicting colder weather for the rest of the East Coast. I've had my heating on for a couple of weeks now. Are you a hold out, or do you go straight to the heating?

Muckerman: I don't know if my heat has come on yet. I don't think it has. It's been 67 in the house.

Priestley: You're not in control?

Muckerman: It's a condo, so we take advantage of the building being generally warm. We only have one exterior facing wall. So far, I think we're just living on everybody else's heating bill.

Priestley: Sounds nice. Speaking of heating -- see what I did there -- we're getting into peak demand for fuels because of winter and heating and everything, so we thought it would be seasonally appropriate to talk about natural gas. Natural gas has experienced a boon recently as a result of the shale revolution. It's now one of the least expensive forms of energy available in the U.S. Last year, the U.S. was the world's largest producer. We put out 750 billion cubic meters of gas, the second highest reported output level ever. The majority of which, upwards of 90%, is consumed domestically, which makes it the second most heavily consumed to energy source in the country. So, for people who might not be familiar, which honestly includes myself, how is natural gas extracted?

Muckerman: Yeah, we don't talk about it a lot.

Priestley: Yeah, it's not sexy.

Muckerman: Oil and renewables are generally what's going on with the show. The revolutionary way that it's been extracted is very similar to oil, the shale drilling and fracking. You see it in different basins. When you think about oil, you generally think Eagle Ford, the Permian in Texas, the Bakken in the Northern Midwest. But natural gas generally comes from the Marcellus and Utica Shales in the Appalachian, Ohio region different areas of the country, but similar in terms of how it's being extracted. Obviously, different equipment, but the general idea is still the same, drilling down into these now unconventional reservoirs, and horizontal drilling still being used here, and fracking, so, creating the fissures in the soft rock and flooding it with either CO2 or water or other chemicals and sand or silicone proppants to keep those fissures open, and let the good times roll. And also, like oil, these are quickly declining well, so they're drilling a lot more than they typically would with a conventional reservoir, which has a lot longer life. So, it's very similar to why we've had such high oil output in this country.

Priestley: Is it similar in terms of the supply chain, as in the elements that you have in oil, the extractors and the people that transport? Is it kind of set up in a similar way?

Muckerman: Yeah, very much so. You have companies that go out, exploitation and production companies, and then you have the Halliburtons and Schlumberger's of the world that still do some drilling for natural gas as well. Also, there are peers in that equipment and services sector. Then, you have the gathering and transmission companies, so, the pipelines, and then the refiners. So, very similar. Then, you have the exporters now, with LNG coming online down in the Gulf Coast.

Priestley: Is that liquid natural gas?

Muckerman: Yeah. Basically, almost freezing natural gas so it compresses down into a much more condensed state, so you can then load it onto cargo ships, keep it refrigerated at that extremely cold level, so then you dock in whatever country decides to buy it and load it off the ships into pipelines. They slowly heat it back up, so it expands, and then off it goes into pipelines to heat other homes in Europe, China, Japan. And there are other countries that export as well, Australia being one of them, with a lot of their offshore LNG facilities, and a few others. But the United States is really coming online now. Cheniere Energy is the first with their Sabine Pass facility in Louisiana.

Priestley: I know it's getting big in Europe. I remember there was a new that had been built that was very high-tech with liquid natural gas, and then it went unused for a number of years, but I think it's getting turned back on.

Muckerman: Yeah, it's been an industry in flux since the early 2000s. The Sabine Pass facility was actually built to be an energy input facility, and then all of the sudden we find out how to drill shale, so that was no longer needed. They never even imported any LNG, I don't think. They spent billions of dollars to build it. The company almost went belly up. Charif Souki, the CEO, I think I mentioned on this show, the book The Frackers, there's a lot of material in that book dedicated to him. He came in and was like, "We're reversing course." He found people to loan them the money, they flipped the script and turned it into an LNG export facility, and it was the first one to export LNG out of the country last year in 2016. There's handful of others that are approved and under construction that should be coming online this year and next year, and then a whole list of companies that are pending approval or just haven't started construction yet. So, there's going to be a lot of exportation of LNG out of this country over the next five or 10 years.

Priestley: Smart guy.

Muckerman: No doubt. And then they ousted him right after they started exporting LNG last year. He's starting another company. Yeah, he's no longer there to reap the rewards. Although, I think he still has a decent amount of shares involved.

Priestley: Interesting. As we mentioned in the intro, the U.S. consumes a lot of what we produce, but the expectation is, we're going to produce more than we can use, as you were talking about. I found an interesting stat when I was doing some research for the show that said, in the past 10 years, the U.S. has used 2% less energy, but natural gas consumption is up 28%. So, essentially, natural gas is getting a bigger slice of pie. Obviously, it's cheaper, it's cleaner. I think its commercial application is growing. The reason that's a good thing is because obviously it reduces seasonality. But, do you expect this to continue? Do you expect it to become a bigger and bigger slice?

Muckerman: Yeah, when you talk about that, in the summer of 2006, it was about 25% of our electrical generation that came from natural gas. Coal was in the mid-40% range. That's quickly reversed course over the last decade, natural gas overtook coal as the No. 1 power source in the United States within the last couple of years, and now accounts for a third of all generation, a couple of percent higher than coal. A lot of that has to do with, A, the price of natural gas collapsed in 2008 and 2009 right along the same time that oil did. Oil rebounded after that, natural gas has not. It's still in a long-term decline, not nearly as dramatic as it was over those couple of years but it's way more cost-competitive for a lot of regions rather than coal. And, like you mentioned, much cleaner than coal. Even though it's a fossil fuel, it burns much more cleanly. There's a lot of talk about the extraction of natural gas releasing methane into the atmosphere, but a lot of companies are trying to develop technology to capture that so that the extraction is no longer as harmful as some people say it is to the environment. So, once that's dealt with, if it is, then you could see even more folks drilling natural gas, because we didn't have the pipeline capacity, they were caught off guard. So, a lot of it was flared, it was burned off into the environment. That was made illegal, so they had to subdue some of the extraction so they weren't burning this natural gas at the well site. But, pipelines are coming online and we're starting to see infrastructure catch up to the supply boom. Prices are still pretty low. They averaged about $3 per million British thermal unit over the last 2 years. For frame of reference, it was in the mid-to-high teens in 2005-06. So, pretty dramatic fall, and a lot of that is the reason why we're seeing so many plants switch over from coal to natural gas, and new plants being built to utilize natural gas to supply power. 

You, you mentioned commercial and industrial applications. Hundreds of billions of dollars are being spent on the petrochemical side because you can fractionate this natural gas into ethane and butane and propane. Those have practical applications outside of just heating your home or powering your air conditioner in the summer. Basically, I would say well over 50% of the things you touch and see every day have ethane or propane or butane involved. Plastics wouldn't be what they are without natural gas and the ability to fractionate that into a thing, which is then turned into propylene and things like that. A lot of scientific names, but with growth of the population and the growth of the use of plastics, you talk about the movie The Graduate, plastics, plastics, plastics, that's the future, I think, for natural gas. If renewables chip away at its use in the power sector, the use on the industrial and commercial side has a bright future.

Priestley: Yeah, that's a very good point. I think it's interesting, the collapse. It's probably driven a lot of efficiencies, as it has done in the oil industry, too. And the thing that got us onto this topic was, you sent me an article about the robo pipeline which is being built by Energy Transfer Partners, they spend $4.2 billion on this pipeline. It's taken three years to build. And it should be online in early 2018, with enough energy to power 30 million homes. The thing that's kind of interesting about this is, it's reaching regions that previously were underserved. That's my understanding. For investors, the good thing about that is, it gives you a geographical diversity that oil and gas does not. With Hurricane Harvey that happened, the risk was mitigated somewhat, but you are exposed to those kind of events. Whereas, I feel like, correct me if I'm wrong, but if you're talking about pipelines and natural gas, you're spreading that risk a little bit.

Muckerman: A little bit, not only from the geographic perspective, but also from the commodity perspective. If you see electric vehicles continue to rise not only in the U.S., but also globally, with countries like France and China and Canada saying they're going to be done with petrol-powered vehicles by 2040 at the latest, for some of the countries, you could kind of hedge your bets a little bit if you want to stay invested in fossil fuels and get exposure to natural gas. China is going to be a huge growth driver for natural gas demand through LNG and its own internal production. Supposedly, they have the largest natural gas reserves of any country underneath the ground. The United States is right there among the top, as well. And certainly, you're going to see this continue to ramp up with countries pulling back on nuclear power and coal. Natural gas has a little bit longer runway for demand in growth than oil probably does. And you mentioned regions that were previously untapped. The New England area was vastly underserved for natural gas transmission. One of the first companies and only companies that you could use to gain exposure to that Spectra Energy, and Enbridge (NYSE: ENB) snapped them up, late last year or early this year, they finalized the deal. Enbridge, I don't want to put a percentage on it, but they were drastically close to 100% oil transportation. Spectra was the exact opposite, natural gas. So, now that they're combined, they're the largest pipeline company in North America. Overtook Kinder Morgan. Very nicely split between oil and natural gas.

Priestley: And you're starting to see an increase of M&A activity in the industry as people are realizing that this is a viable growth opportunity. One example will be Shell's, was it a $70 billion to buy Britain's BG group?

Muckerman: Yeah, that was a big deal. That was an international play on natural gas and LNG.

Priestley: And that's definitely expanded their exposure to the market, particularly in Europe. So, the industry is starting to gain a bit of traction.

As you mentioned, prices hovering above the $3 mark today. The EIA is predicting about a 1% increase in demand annually, so there's definitely a growth trajectory. Do you think this is definitely a turnaround moment for the industry? Or do you think there's more volatility to come?

Muckerman: It's tough, because there's a lot of play here. You talk about increase in pipeline infrastructure, that obviously allows folks to produce more, because there's greater takeaway capacity. But then, 1% demand globally isn't the whole heck of a lot to rest your investing hat on. Then, renewables chipping away. But I think natural gas has more staying power than oil. I just worry about investing in the producers of natural gas. There's greater upside there, but there's also high risk, high reward kind of deal with those folks. And there's a lot more of them, so, you have to do your due diligence a lot more than you might typically with a giant pipeline or energy services company, which is how I tend to invest in energy in general, not just natural gas. But, if you want to look at the growth, I think North America is a great place to start. We're expected to be the largest fossil fuel exporter by somewhere in the 2020s according to the IEA, and a net exporter of energy next year. So, that opens up some different doors than we've seen traditionally here in the United States where we've consumed most of it that we've produced, as well as import a lot of natural gas from Canada and oil from Canada and oil from Mexico and the Middle East. Where we are right now, the industry is still going through a lot of change. But if you see all these projects get built on the Gulf on the petrochemical side, I think that's going to add a lot to buoy the price of natural gas and give it some diversity rather than just relying on super cold winters and super-hot summers. You have seen the price of natural gas go up a little bit in the last week or so with the cold spell that caught people off guard. But if you look at the futures market, they still expect the price of natural gas to remain rather subdued. 

So, unless something catches it off guard, you're going to want to stick with the very efficient producers that have prime acreage. Or, you can invest in the pipelines. Or, if you believe in the boom coming of LNG exportation, Cheniere Energy has not only the Sabine Pass facility that they're so expanding, they have the Corpus Christi plant in Texas that they're going to be firing up in the next couple of years. Then, Sempra Energy has a Texas-based facility as well coming online. I don't have the exact year, but it's within the next couple. Then, Dominion Energy with their Cove Point facility in Maryland, that's the only East Coast facility under construction. So, maybe a little bit better exposure to the European market there, a little less travel time than going around Florida and up that way. So, there's certainly some areas to take advantage of the different pockets. Exxon spending a ton of money in the Gulf to blow out its infrastructure on the petrochemical site. Dow Chemical doing the same thing. (unclear 17:35) very active, almost coming back from the dead of bankruptcy late in the 2000s. The stock is on fire recently. Pure play on petrochemicals, where is Exxon very diversified. Shell is spending a bunch of money in that area as well. So, there's different ways to target it. I might be a bigger believer long-term in natural gas than oil, though.

Pipelines, you have Kinder Morgan. Enbridge, like I said, with that Spectra Energy acquisition. I was a Spectra Energy shareholder. Sad to see it get bought, but still happy to see it be a going concern within a great company like Enbridge. I just wanted that natural gas-specific exposure. It's kind of diluted now with Enbridge's oil pipelines that they have. But, Williams and their MLP, Williams Partners, much more focused on natural gas and the pipelines. Energy Transfer Partners, like you mentioned, with that big Rover growth project coming online pretty soon. People want to look at some producers, Chesapeake Energy, Cabot Oil & Gas, Range Resources and EQT Corp would be a good place to start. But like I said, you're going to see some higher volatility with those folks versus the pipeline companies. Which are going to pay a more sustainable dividend, generally, and those take or pay contracts where they're almost guaranteed the money for the producers from the producers to transport the natural gas -- even if they don't fuel the pipeline to their prescribed capacity, they still owe that money, and they're long-term contracts. So, greater visibility in the cash flows, and that's what we're all about here at The Fool, is cash flow. So, the greater visibility into that, the better, I think.

Priestley: If somebody is looking to capitalize on this industry, would you advise looking more toward the infrastructure developments in the pipelines as opposed to the extractors?

Muckerman: Personally yes, but everyone is different. There's definitely money to be made in the producers. I'm just going to give a caveat there to be more careful. Obviously, everyone should do their due diligence when investing. I just think that it takes a certain level of understanding and risk tolerance to justify investing in some of these producers, especially if you expect prices to stay rather low. Obviously, I don't see prices collapsing like they did in 2008-09, which suggests there might be some asymmetric upside with limited downside. But, lower for longer is going to hurt all these companies. And if that's the case, you could just be riding for the dividend rather than seeing some share price growth with these pipelines that are going to see greater resource transportation as production rises.

Priestley: There's one thing to mention, we are not the first people to talk about natural gas in the investment world. So, the P/Es are a little bit high at the moment, too.

Muckerman: Earnings are also kind of suppressed, which drives that multiple a little higher. And with a cyclical industry like this, some people suggest that a high P/E is a time to buy into it, because earnings could be depressed, and share prices just might not have caught up yet. But, once the earnings turn around and start to rise, you see the P/Es start to shrink a little bit, earnings might be turning before the price does. If you focus really hard on the P/E ratios and the charts, that's what people suggest about cyclical industries like this -- wait for that high P/E start to roll over into a low, and that's the time to buy, as earnings start to fire.

Priestley: Yeah. One question that I have for you is, a lot of these wells that have been offline are coming back online. I think, in the Northeast, it's something like almost a third of wells that have been off since 2014 are being reactivated. How much do you think this has to do with general optimism and investment in infrastructure, and how much do you think it has to do with President Trump's campaign promise around energy and unlocking some of the potential, reducing the regulation? Obviously, that's going to factor in.

Muckerman: I would put a 0% on President Trump's claims. Nothing to do with him. This industry is going to roll with or without him. It has been for many years before him. If you look at the net job growth after the recession, without the energy sector, it's basically flat if not negative. So, this sector and industry have been on fire for a long time. I think that added takeaway capacity is encouraging companies to flip the switch on these wells, along with the wells that they've drilled but haven't fracked yet, because fracking is generally the most expensive stage. You see the same thing with oil right now. A lot of wells drilled but not fracked, so, drilled but not completed is what you're going to read. And at one point earlier this year, that was at an all-time high for oil. It was still very high for natural gas. They're just waiting for prices to turn around. And you've seen that happen in oil. These companies that started to frack those wells, and it's basically, they've been holding their thumb over the hose kind of, and once they start to frack these, that's supply that's ready and willing to spurt out of the ground. They don't have to go out and find it, they don't have to go out and drill for it. All they have to do is frack it. And, I say "all they have to do" in as light of a way as I can, because it's still very serious and it takes some time, but not nearly as much time as the entire process. So, same thing with natural gas. If prices start click up like they have over the past week or so, it could slowly start to remove that thumb. Natural gas is already flowing, there's just a tiny little barrier there. So, that could keep prices subdued until you reduce that inventory of drilled but not yet completed wells.

Priestley: Yeah. And that's the key point with all of these commodities right now, is moderating the supply.

Muckerman: Unfortunately, we're not a cartel. These companies are all chasing that dollar, and they don't want to give up their slice of the pie. That's why we're in the position that we're in now, is everyone started using the same technology at once with cheap debt, and now we're sitting on mountains of shale oil and natural gas.

Priestley: Which is good in a sense.

Muckerman: Great for the citizens, tough for investors.

Priestley: Yeah, absolutely. Thank you so much for teaching us all, and me, about natural gas today.

Muckerman: Yeah, cheers!

Priestley: I'm sure you'll be back on the show.

Muckerman: [laughs] I hope so. Unless we get terrible ratings on iTunes, then I'll silently bow out of the rotation.

Priestley: [laughs] Well, that's it from us today. If you would like to get in touch, please feel free to email us at industryfocus@fool.com, or tweet us @MFIndustryFocus. If you don't want Taylor to bow out of the race, please give us a shout out. As always, people on the program may own companies discussed on the show, and The Motley Fool may have formal recommendations for or against stocks mentioned, so don't buy or sell anything based solely on what you hear. For Taylor, I'm Sarah Priestley. Thanks for listening and Fool on!

Sarah Priestley has no position in any of the stocks mentioned. Taylor Muckerman owns shares of Enbridge and Halliburton. The Motley Fool owns shares of and recommends Enbridge and Kinder Morgan. The Motley Fool recommends Dominion Resources. The Motley Fool has a disclosure policy.