I have been getting a lot of questions lately about natural gas prices, so this seems like a good time to update the picture. This is a sneak preview  of a more comprehensive report that will appear in next week’s Energy Strategist.

Over the last 18 months my thesis has been that natural gas prices would have to move higher over the long term. But in December 2011, with natural gas prices above $3/million Btu (MMBtu), I predicted lower natural gas prices for 2012. The unusually warm winter that followed reduced demand even as shale production added to the supply glut, and the price fell below $2/MMBtu by April 2012. The average price for natural gas in 2012 was $2.75/MMBtu, the lowest in 13 years.

I did not feel that this low price could be sustained, so I began to recommend natural gas producers to investors. I wasn’t sure how long they would have to wait, but felt pretty certain that gas prices had to go up. We began adding natural gas producers to the various Energy Strategist portfolios.

In January 2013, I predicted a higher natural gas price for the year (not a very risky prediction after the lows of 2012). The average spot price for the year was nearly a dollar higher at $3.73/MMBtu, and our natural gas picks had an exceptional year.

In January 2014, I went back to the well once more and predicted higher average natural gas prices for the year. At that point natural gas inventories were still in fairly good shape, and it wasn’t yet obvious that the winter would be one for the record books. But I explained when I made that prediction that the year-to-year fluctuations in natural gas prices are heavily influenced by the weather. Gas prices surged in response to the cold winter, and year-to-date the average closing price of Henry Hub natural gas is $4.78/MMBtu. It will take a monumental collapse in the price of natural gas to miss my prediction for the year. But the price of natural gas has now fallen to $3.80/MMBtu, leading some to ask whether this changes my bullish long-term view on natural gas.

Making short-term predictions on natural gas prices is risky because natural gas is susceptible to seasonal and weather-related volatility, but my natural gas thesis isn’t based on such short-term drivers. It is based on long-term trends, and may require patience because of seasonal fluctuations. But I believe the patient investor will be rewarded.  There remain several long-term drivers on the demand side, and natural gas producers will have to aggressively expand production in order to keep up with growing demand.

Two large demand drivers in particular will be the growth of LNG exports, and the US Environmental Protection Agency’s (EPA) push to phase out coal.

While the US has increased natural gas production by 11.4 billion cubic feet per day (Bcfd) in just the past five years, there are 13 LNG export projects awaiting Federal Energy Regulatory Commission (FERC) approval with a total proposed capacity of 17.9 Bcfd.

Beyond the LNG export issue, the EPA has been clamping down on emissions from coal-fired power plants. This year the Energy Information Administration (EIA) estimated that 60 gigawatts (GW) of coal-fired power would be retired by 2018 as a result. While renewables will benefit, natural gas will be the primary beneficiary from this phaseout of coal power, because it is a reliable and still cheap power source that can meet the new emissions regulations.

These two factors point to strongly growing demand for natural gas in the years ahead, as does the growing demand for US pipeline exports to Mexico. This will put upward pressure on natural gas prices, spurring drillers to continue expanding production.

The risk for investors in this scenario is if production expands so rapidly that natural gas prices are crushed into the $2-$3/MMBtu range, as happened during an unseasonably warm winter in 2012. This price approaches the break even price for natural gas producers, in which case it won’t matter how much they produce. But this will in turn spur the demand for more LNG export terminals, since there would likely be a large differential between gas prices in the US and those in Europe and Asia. (There are also companies with logistical challenges in getting gas to market; this too will be discussed in next week’s Energy Strategist.)

So over the long term — three to five years out and beyond — I don’t believe sub-$4/MMBtu natural gas can be sustained, and that will benefit natural gas producers. Right now you can buy a September 2019 natural gas futures contract for $4.40/MMBtu. At that point we will have seen the start-up of LNG exports, and many more projects will be in the works. Natural gas will have displaced more coal. Even if we assume no stumbles on the supply side (which are always a possibility), it’s hard to envision natural gas at that price when 2019 rolls around.

That is the core of my thesis for why I believe select natural gas producers will perform well over the next five years.

What About the Short Term?

My investment recommendations are based on long-term drivers, because short-term events can temporarily reverse the direction of long-term trends. Abnormal weather can move prices dramatically over the short term, but its long-term effect tends to be limited. However, dramatic deviations from the norm can have some lingering impacts.

The last winter was unusually cold across the northern US — the coldest in at least 30 years. Natural gas demand spiked, natural gas inventories declined at the fastest rate in history, and the high-demand season ended with the lowest inventory levels in over a decade.

As a result, we entered gas injection season with a serious deficit, and it was clear that gas producers would need to produce at high rates for the next eight months to rebuild storage to normal levels. Historically, a significant deviation from the norm in gas inventories, up or down, affects natural gas prices for many months. As a result, I believed it highly likely that natural gas prices would trade at a premium to their values of a year ago. As I explained in a March article for Personal Finance: “For investors, this means natural gas producers will likely report better year-over-year results this year.”

But in recent weeks, natural gas prices have plummeted, leading one reader to write to me that I had been wrong about the direction of natural gas prices. Not so fast. First things first. Here is a seasonal analysis of natural gas prices over the past three years:

It’s clear that prices were spiking in February and March as inventories were depleted, but then in the four months following those spikes natural gas continued to trade at a premium from either of the past two years. This premium has almost always materialized in the past when inventories were pulled down to low levels, and the impact usually lingers for a year or more.

But over the past month that premium has been shrinking. So what’s been happening?

Two things. The first is that producers have been producing at higher rates than they were either of the past two springs — which is what I was counting on. Thus, on the supply side things look pretty good. (And with higher prices, this is translating into higher profits for gas drillers.)

But the bigger issue — as it was in the winter — has been unseasonable weather. Generally in the summer demand for natural gas spikes as utilities have to react to increased loads from air conditioners. This summer has been like this past winter — cooler than normal. In fact, this summer is flirting with record cool temperatures across many cities across the US, and that has reduced the demand for natural gas. This has allowed inventories to rebuild faster than expected and has reduced the fear premium that existed in early spring. Gas inventories are still well below normal for this time of year, but the potential for more cool weather has investors betting that inventories will be in good shape once high demand season begins:

Natural gas producers have been reporting higher year-over-year earnings as we have expected, but many have sold off over the past month on concerns about shrinking margins.

The natural gas price premium that in the past lingered for a year or more after such a deep inventory draw has now nearly vanished as a result of a very unpredictable short-term factor: An unusually cool summer.

Investing is about understanding risk and investing with the odds in your favor, and based on historical data, 9 times out of 10 this price premium generally lasts longer. If the summer had been normal or hot, the premium would have lingered into the fall, at which point it would have been time to start wondering about the next winter.  

At this year’s Investing Daily summit in May, I focused on the natural gas story, highlighting the long-term opportunity, but also cautioning short-term investors that natural gas shares were at that point already pricing in expectations of a lingering price premium. I provided some natural gas takeaways at the summit that are worth repeating here:

• Natural gas is in the early stages of a long-term growth phase

• Short-term investors should exercise more caution, as gas producers have surged recently

• Downside risk short-term would be an unusually mild summer followed by a mild winter

I still firmly believe the first bullet point, the second was good advice in hindsight, and the “unusually mild summer” has so far been the case. At this point I believe most of the short-term risk is gone, and that expectations of inventories returning to normal are built into natural gas prices. Of course I can’t predict the weather, which is one reason I dislike giving short-term investment advice.

For long-term investors, these seasonal fluctuations are not important. Over time, they will average themselves out, but the strong growth story here remains. For more details, including a focus on Cabot Oil and Gas (NYSE: COG), please see next week’s Energy Strategist.  

(Follow Robert Rapier on Twitter, LinkedIn, or Facebook.)

Portfolio Updates

Targa Comes Through Again

There’s no such thing as a good loss, but the recent energy sector pullback couldn’t have come along at a better time for the bulls. Without it, the disproportionate gains of May and June might have ramped into a true speculative frenzy. Now some of the reflexive buying of the big recent winners has been checked and the price strength has wavered, we get a chance to see how the sector responds to a modest sale.

Friday’s drilling left the SPDR S&P Oil & Gas Exploration and Production (NYSE: XOP) ETF at the lowest level in nearly four months and within spitting distance of its upwardly trending 200-day moving average. The downdraft came at month-end and during seasonal trading doldrums, helped along by a modest pullback in energy prices. All of this provided the convenient excuse for short-term selling rather than an imperative to dump positions, as would be the case if energy prices were to cave or energy earnings meaningfully disappoint.

In fact, the sector’s earnings have been strong and largely upbeat, an indication that the secular energy growth story is alive and well even though the bitter winter cold is just an unpleasant memory by now.

For proof look no further than last week’s report by Targa Resource Partners (NYSE: NGLS), which showed distributable cash flow continuing to more than double year-over-year, boosted by the fatter margin earned from processing booming Texas gas and oil production and the rising tide of lucrative liquefied petroleum gas (LPG) exports.

Revenue rose 43% in a year’s time, rapid growth in its own right but not as rapid as the margin Targa has squeezed from its strategic assets, including the second-largest fractionation capacity in a key gas processing hub and its ever-expanding LPG export terminal on the Houston Ship Channel.

Management commentary hinted that Energy Transfer Equity’s (NYSE: ETE) rejected merger advance this spring, which has served to lift the valuation of NGLS as well as its general partner Targa Resources (NYSE: TRGP), is unlikely to be revisited. But the performance so far this year suggests ETE’s interest was justified and the resulting revaluation of Targa’s equity not far-fetched. True, TRGP’s share price has run 51% year-to-date, but its operating affiliate NGLS is now forecasting 2014 EBITDA 30% larger than it had guided for six months’ earlier.

Add up TRGP and NGLS market capitalization and long-term debt and these still equal 16 times their increased EBITDA forecast of $975 million. That’s pricey for energy stocks and the broader market, but go compare that multiple with stocks in other sectors that are producing 40% revenue growth and doubling cash flow from sought-after assets, with only a relatively modest tailwind from higher commodity prices.

To this point, our June call to cash in some of the rapid gains seen since our TRGP recommendation in December is looking good. But we won’t hesitate to reload on this fast-growing GP should the discounting drag on. Those who haven’t already cashed out half their profits in this name could soon be looking at a buying opportunity.      

— Igor Greenwald