Natural gas will be the primary beneficiary of this phase-out of coal power because it is firm power that can meet the new emissions regulations. Renewables will also benefit, but they can’t provide the amount of firm power that will be needed at a cost competitive with that of natural gas.

These are only two of the factors that point to strongly growing demand for natural gas in the years ahead. This will put upward pressure on natural gas prices, which producers will attempt to exploit by continuing to expand production. If gas production continues to expand at the rate of recent years, the price of natural gas might be kept in check at ~$4/million Btu (MMBtu), but producers will make money as production expands. If production is unable to keep up with growing demand, prices will spike and producers will make higher margins on lower volume. Either of these scenarios is good for natural gas producers, unless the production for individual producers declines faster than prices increase.

The only real negative scenario for the industry is if production expands so rapidly that natural gas prices are crushed into the $2-$3/MMBtu range, as happened in 2012. This is in the range of the cost of production for most 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 as it implies a large differential will exist between gas prices in the US and those in Europe and Asia.

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. Presently you can buy a September 2019 contract for natural gas for $4.41/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. More chemical plants will have been built to take advantage of growing natural gas supplies. Even if we assume no stumbles on the supply side (which is a possibility), it’s hard to envision natural gas at that price when 2019 rolls around.

What About the Short Term?

My natural gas thesis is about long-term drivers, because short-term events can temporarily reverse the direction of long-term trends. For example, I have often talked about how the weather can cause short term fluctuations in the price of natural gas. If we see abnormal seasonal weather, it can impact prices dramatically over the short term, but this doesn’t factor into the longer-term factors that I believe will drive natural gas prices higher. However, the seasonal factors can have some lingering impacts.

This winter was unusually cold across the northern US — the coldest in at least 30 years. In response to the cold weather, natural gas inventories were pulled down at their fastest rate in history, and ended the high-demand season at their lowest levels in over a decade.

As a result, the US entered gas injection season with a serious deficit, and it was clear that gas producers would need to produce at high rates for 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. Therefore, I believed it highly likely that natural gas prices would trade at a premium to their values of a year ago, and natural gas producers would report higher earnings as a result.

In recent weeks, natural gas prices have plummeted, but they have maintained the year-over-year price advantage that I expected. Here is a seasonal analysis of natural gas prices over the past three years.

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. But why has the premium been shrinking in recent months?

Two things. The first is that drillers have been producing at higher rates than in either of the past two springs. Thus, on the supply side the situation looks pretty good (and with higher prices, this is translating into higher profits for gas companies):


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 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 meant that inventories are recovering faster than expected, and that 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. At this year’s Investing Daily summit in May, I highlighted the natural gas story and discussed the long-term opportunity, but I also cautioned short-term investors. I provided some natural gas takeaways that are worth repeating here:

• Natural gas 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 third also appears to have been on target. 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.

Case Study: Cabot Oil and Gas

Cabot is a good test for my hypothesis that low winter inventories would lead to higher quarterly profits for gas producers. As the EIA recently reported, the Marcellus Shale recently surpassed 15 Bcf/d of natural gas production, up from 2 Bcf/d just four years ago. The formation, mostly located under West Virginia and Pennsylvania, is the largest producing shale gas basin in the United States, and accounts for nearly 40% of US shale gas production.

Source: Energy Information Administration

Cabot Oil and Gas is one of the most prolific producers in the Marcellus, with 17 of the top 20 gas wells in the formation. Cabot is exactly the type of company that I expect to benefit from higher natural gas prices, and after the cold winter I expected them to report particularly good quarterly results relative to a year ago.

In Q1 of this year, Cabot announced that output would be flat in the first half of 2014 vs a year-ago as it shifted to multi-well pad drilling with longer lead times. Multi-well pad drilling involves placing several horizontal wells on a single well-pad, which provides significant cost benefits. Cabot’s share price pulled back on the production warning, and I took the opportunity to scoop up some shares because I believed higher gas prices would lead to higher profits even if production was flat in the short term.

Indeed, Cabot’s recently announced second-quarter earnings met my expectations. Highlights for the quarter included:

• Total production of 127.6 billion cubic feet equivalent (Bcfe), up 34% over Q2 2013

• Liquids production of 961,000 barrels, up 26% over Q2 2013

• Revenue of $533.2 million compared with consensus estimates of $517.6 million

• Earnings of $0.28 per share, 33% higher than Q2 2013’s $0.21 per share and topping analysts’ estimates by $0.03/share

• Total unit costs of $2.59 per thousand cubic feet equivalent (Mcfe), a 16 percent improvement over last year’s comparable quarter

Despite the excellent results the market largely yawned, for two reasons. One was the general decline in natural gas prices, and the expectation that this would hurt natural gas producers. The second is that natural gas infrastructure in the Marcellus is at present insufficient to give many producers access to the lucrative markets of the big cities in the northeast, and as a result Cabot has had to sell gas at nearly a $1/MMBtu discount to NYMEX settlement prices.

Both issues are short-term in my view. Gas prices will rise over the long haul, boosted by the longer-term fundamentals I have laid out, and the infrastructure in the Marcellus is steadily improving. In fact, one major project — the Constitution Pipeline — would connect Cabot’s gas to the major population centers of New York. While there is opposition to the pipeline, it is expected to gain FERC approval this fall and be in service by late 2015 or early 2016, and this should be a huge catalyst for further advances in Cabot’s share price.

Investors have so far taken a wait and see approach, and as a result Cabot is only up 2.4% from our initial recommendation and down 13% year-to-date. (My own position is down about 4%). Nevertheless, I believe that investors will eventually reward performance, and Cabot’s financial results for Q2 provided continued validation to my natural gas hypothesis (even though the share price doesn’t yet reflect it.)

Conclusions

My thesis last winter was that low inventories would lead to higher year-over-year natural gas pricing, and that has been the case through the end of July. Year-over-year profits for gas producers have been higher. But at this point, with much lower demand from utilities, it is less certain that the premium will soon return. If summer temperatures return to normal, the odds are much higher. Likewise, if this winter resembles last winter, we will see natural gas prices recover. But as recently as 2012 we had an unseasonably warm winter, and natural gas prices collapsed in response.

For long-term investors, these seasonal fluctuations are unimportant. Over time, they will average themselves out, but the strong growth story here remains. I am certainly a long-term buyer of natural gas companies at current prices.

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