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A Different View of Who Will Profit from the Coming Changeover to Natural Gas

Saul is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

It seems apparent that natural gas will provide a lot of the future energy in the United States. Natural gas is cheap compared to gasoline or diesel. In fact, it’s at near record low prices. It’s very, very plentiful in the States. It’s less polluting than gasoline, and it’s much less polluting than coal.

This has caused a lot of enthusiasm about the future of two companies who are profiting from cheap natural gas. These are Clean Energy Fuels (NASDAQ: CLNE), which is building a network of natural gas refueling stations on the major highways used by the trucking industry, and Westport Innovations (NASDAQ: WPRT), which builds the natural gas engines to power the trucks that will use these refueling stations. While their sales are rising, both of these companies are still losing money. The hope is that as their sales continue to rise they will become more and more profitable. 

On the other hand, with natural gas prices near multi-year lows, the gas-producing companies are bleeding money and are shunned for the most part.

However there’s something else to consider. The low price of natural gas means more gas use, and more use of natural gas means the price of gas may not continue to stay so cheap.

First of all, producers are cutting back production. The higher-cost producers especially are losing money on what they sell at these extremely low prices. This in itself can start to push the price back up. 

Secondly, what will happen to the price of natural gas as Clean Energy Fuels and Westport become more successful and sell more natural gas and the trucks that run on it?  That's another factor pushing the price up. 

And General Electric (NYSE: GE) announced in July that it is working with Chart Industries and the University of Missouri to develop an inexpensive ($500) home rapid refueling station for natural gas automobiles. Think what lots of natural gas automobiles could mean for the use of natural gas, and its price. 

And consider that other companies are developing terminals where they will compress and export liquid natural gas (LNG) from the United States, where the price is roughly $2.75 as I write this, to Europe or Japan, for instance, where the price can be as high as $10.

So far, only Cheniere Energy (NYSEMKT: LNG) has won approval to build an LNG export terminal. However other major companies such as Dominion Resources have applied for export permits as well.

Once these terminals are built and start functioning, we’ll likely see massive exports of LNG out of the United States. This will be great for natural gas producers and it will add a lot of drilling jobs. However, it will certainly raise the price of natural gas here. The price has been limited up to now by our inability to ship our glut of natural gas to the higher price markets abroad, causing natural gas to pile up in the U.S. and become incredibly cheap.

And coal-burning plants are gradually converting to natural gas because it’s cheaper, and because with natural gas they don’t have all the hassles of fighting the air pollution from coal. If more coal-burning plants keep converting to natural gas, can you guess what influence this is likely to have on the price of gas? 

With all these factors pushing up demand for natural gas, the price of natural gas will rise. It may not rise immediately as some major natural gas producers such as Chesapeake Energy and Ultra Petroleum (NYSE: UPL) say they are already holding back on production because of the low price. This held back production can come back on the market. But eventually, the price will rise. In fact it may rise considerably.

If the price of natural gas rises too much (because of a lot of exporting, for instance) natural gas will no longer be quite as compelling an alternative to petroleum products for trucks and cars. 

Considering that Clean Energy Fuels and Westport Innovations are both currently losing money in spite of business models that benefit from the current low gas prices, they don't have much of a cushion. They are far from a sure thing. If the price of natural gas keeps rising, people may slow down on ordering new natural gas truck engines from Westport Innovations and the growth of Clean Energy’s refueling stations may slow. Both of these companies' futures (which are dependent on cheap natural gas) can suffer from their own success. It's a real conundrum.

So how CAN you profit from the future of natural gas?  It seems there will more demand for it and the price will rise. The obvious choice would be a company that drills for natural gas almost exclusively, a company that is the low cost producer, a company that is already quite profitable even at these extraordinarily low gas prices where other companies are losing money, a company that has huge reserves (in comparison to its size), and a company whose price is severely depressed at present due to the extremely low prices of natural gas.

That would be Ultra Petroleum ($22.70), which despite its name, drills for natural gas, not petroleum. 

Low prices for natural gas are great for Clean Energy Fuels and Westport Innovations but are terrible for producers. Higher prices for natural gas (which seem inevitable) will be not so good for Clean Energy, but great for a producer like Ultra Petroleum. 

Here’s what Ultra Petroleum did in the June quarter, in spite of these record low prices for natural gas. 

They had an operating cash flow of $190.6 million, or $1.25 per share!

Their adjusted earnings were $55.1 million, or 36 cents per share.

They had great adjusted returns in the quarter: 67% cash flow margin, 19% net income margin, and 20% return on equity. That’s incredible in a market like this.

They reduced their capex budget by half for 2012 from 2011 because of the low prices. They expect to reduce it further.

They are expecting their production to decrease intentionally in future quarters. They are deferring completion of newly drilled wells (in other words, they’re not starting to draw gas from them). They say that all they need is an increase of 15 cents per Mcf in selling price to pay for the cost of keeping them closed, and then reopening them later at higher prices. They’ve also reduced drilling. Note that reduced drilling should mean increased operating cash flow, and probably increased earnings, as their functioning wells will continue to produce, but they will spend a lot less money.

They say they are focused on profit, not production, and are conserving their valuable assets. They don’t want to pump away their gas at cheap prices. They won’t pick up spending until they see $5 gas. They expect to see $4 gas in 2013 and $5 gas in 2014. They see their stock price doubling with $4 gas.

To me, that’s the way to go when gas prices are unsustainably low. Why should I bet on the companies that are benefiting from the low gas prices, but are losing money anyway? I'd rather invest in a company whose stock price has been beaten down irrationally by the low gas prices, in spite of being quite profitable. It's ready to spring back. Commodity prices are cyclical and simply don’t stay down forever.

SaulR80683 owns shares of Ultra Petroleum, and has no positions in the other stocks mentioned above. The Motley Fool owns shares of Ultra Petroleum and Westport Innovations and has the following options: long JAN 2014 $30.00 calls on Ultra Petroleum, long JAN 2014 $40.00 calls on Ultra Petroleum, and long JAN 2014 $50.00 calls on Ultra Petroleum. Motley Fool newsletter services recommend Clean Energy Fuels, Ultra Petroleum, and Westport Innovations. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.If you have questions about this post or the Fool’s blog network, click here for information.

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