From one year to the next, natural gas prices are notoriously dependent upon the weather. During last season’s extremely cold winter, natural gas prices spiked above $4 per million British thermal units (MMBtu), and stayed there for most of 2014 as natural gas producers raced to refill depleted inventories.

But then a mild summer reduced demand for natural gas from electric utilities, and those deeply depleted natural gas inventories were nearly back to normal when cold weather set in last fall. Following the mild summer, this winter started out a lot warmer than last winter, and as a result the natural gas storage situation continued to improve. Just last week the Energy Information Administration (EIA) reported that for the first time in more than a year working natural gas storage has surpassed the five-year average.

The improving storage picture put downward pressure on natural gas prices. The price fell below $3/MMBtu in January, and has been there almost ever since.

So, year to year natural gas prices can be extremely volatile, but there are longer term drivers in place that should see natural gas prices move up from the current range. I have written about two of these drivers in previous columns.

One is the opening of new liquefied natural gas (LNG) export terminals. The first will open late this year or early next year when Cheniere Energy’s (NYSE: LNG) Sabine Pass LNG export terminal in Cameron Parish, Louisiana begins shipping product. This will be important not only on the natural gas demand side, but also for investor psychology as there are several other LNG export terminals that will be completed and shipping by 2020.

The other driver I have discussed is the US Environmental Protection Agency’s (EPA) push to phase out coal. Last year the EIA estimated that 60 gigawatts (GW) of coal-fired power would be retired over the next few years, primarily in response to more stringent environmental requirements:


Source: EIA, Annual Energy Outlook 2014 Reference Case and Annual Electric Generator Report

While renewable energy will see some benefit as a result, natural gas will be the primary beneficiary of this phaseout of coal power, because it is firm power (i.e., power that is intended to be available as needed) that can meet the new emissions regulations.

Today I would like to talk about one more significant long-term driver: The renaissance of U.S. manufacturing that is dependent on natural gas. Last month Canada’s Methanex (NASDAQ: MEOH), the world’s largest methanol producer, began making methanol at its new 1 million ton per year plant in Geismar, Louisiana. What is interesting about this plant is that it was relocated from the company’s production site in Punta Arenas, Chile because of much lower U.S. natural gas prices. In addition, the company intends to relocate another plant from Chile to Geismar, and to grow its methanol capacity by 3 million tons over the next three years.

What does that have to do with natural gas? There are two things here that are noteworthy. Methanol is produced from methane, which is the primary constituent of natural gas. In theory, it takes a molecule of methane (CH4) to produce a molecule of methanol (CH3OH), which is the simplest alcohol, but because of side reactions and inefficiencies it actually takes a bit more than one methane to make one methanol. It ultimately takes about 30,000 standard cubic feet (SCF) of natural gas to make a ton of methanol. The eventual 4 million ton total capacity of Methanex in Louisiana will therefore consume about 0.5% of current annual U.S. natural gas production.

That may not sound like a lot, but it brings me to my second point. The cost of the relocation of these two Methanex plants from Chile was about $1.4 billion, but this is but a small fraction of the total amount being spent by the chemical industry to relocate and build new capacity in response to low U.S. natural gas prices.

In 2013 the American Chemical Society released a report called Shale Gas, Competitiveness, and New US Chemical Industry Investment: An Analysis Based on Announced Projects (PDF link here). The report describes the dramatic transformation in the global natural gas landscape as a result of expanding shale gas production in the U.S., and what that means for the U.S. chemical manufacturing industry:

Chemical companies from around the world have announced plans for a significant number of new projects to build and expand their shale-advantaged capacity in the United States. Through the end of March 2013, nearly 100 chemical industry investments valued at $71.7 billion had been announced. The majority are being made to expand production  capacity for ethylene, ethylene derivatives (i.e., polyethylene, polyvinyl chloride, etc.), ammonia, methanol, propylene, and chlorine. Much of the investment is geared toward export markets, which can help improve the US trade deficit.”

The report goes on to estimate that 1.2 million jobs will be created or supported during the investment phase, and 500,000 during the production phase. Much of this new chemical capacity will utilize the methane in the natural gas, but ethane is also being targeted. Ethane is the second-largest constituent of natural gas, and new ethane supplies have overwhelmed demand, sending the price plummeting. This in turn has made the economics of ethane derivatives manufacture (e.g., ethylene, polyethylene) extremely attractive in the U.S.

How will all of this new capacity affect demand for natural gas? The University of Texas’ Center for Energy Economics has estimated that the new petrochemical projects will boost industrial demand for natural gas by 19% to 31% by 2020. To put that in perspective, the projected increase in annual demand is around 30% greater than the annual net shale gas production that has been added during the shale gas boom.  

Of course some of these projects may be cancelled, but keep in mind that this is but one of several long-term drivers on natural gas prices. Between the new chemical manufacturing projects discussed here, the new LNG export terminals, and utilities switching from coal to natural gas, the only thing that can keep natural gas prices in check is continued strong growth of natural gas production. If natural gas producers fall short, gas prices will spike along with margins. If they manage to continue aggressively expanding production, they will grow profits by selling more gas, but at a lower margin. They win either way.

What does this mean for you as an investor? Good things come to those who wait. If you can look beyond the year-to-year fluctuations, the performance of natural gas producers in the U.S. (and Canada) is likely to be robust. Exercise patience, and the odds that you will be rewarded look very favorable.

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

Portfolio Update

CVR Refining’s Quarter to Forget     

U.S. refiners are already profiting handsomely from cheap natural gas, which is their second most important cost component after crude. Their share prices got beat up a bit last fall as refining margins shrank during the crash in oil prices. Once crude steadied in mid-January, those margins, known in the industry as crack spreads, have recovered sharply.

There’s no mystery as to the catalysts for the recent move. First, the glut of domestically produced crude continues to fill up available storage capacity, threatening to exhaust it sometime this summer. Second, lower fuel prices have stimulated notable growth in U.S. fuel demand, so that gasoline stockpiles, while relatively high, suggest nowhere near the same glut as exists in crude — unsurprising, given that refined fuels aren’t subject to the law banning most crude exports.

Unfortunately for CVR Refining (NYSE: CVRR), last week’s results concerned the last three months of 2014, when conditions were far less benign. Then, crack spreads shrank as crude retreated. The cost of renewable identification numbers certifying compliance with the ethanol blending mandates spiked. And on top of that the fluid catalytic cracking unit at the partnership’s Wynnewood, Oklahoma refinery suffered a 16-day unplanned outage. That not only resulted in significant repair costs but reduced fuel output in general and the production of high-margin distillate in particular.

The downside from this series of unfortunate events was summed up with a quarterly distribution of 37 cents per unit that was the second lowest in the partnership’s two-year public history. Even so, that represents an annualized yield of 8%.

So the downside, short of a demand-killing recession, doesn’t look all that scary. But does the upside warrant continued buying now that the unit price has run 34% from its mid-January lows? Yes, it does.

Near-term upside will come from the recently improved crack spreads, which could get wider still if crude were to suffer another decline. Output should be higher as well barring another accident.

Longer-term, CVRR’s plan to spin off a fee-based logistics MLP could have upside as well in the next year or two, and management is on the lookout for acquisitions that might make that IPO more appealing. Buy CVRR below $26.

Tomorrow’s issue of The Energy Strategist will have more on the refiners and the advantages the U.S. downstream and midstream sectors enjoy in the current price environment.            

— Igor Greenwald