Natural gas prices have been depressed for more than a year, and stocks levered to the fuel have turned in a mixed performance. This weakness has lead many investors to the unfortunate conclusion that natural gas isn’t an interesting investment story.

Nothing could be further from the truth. Gas is an abundant and environmentally friendly fuel that’s already revolutionizing key global energy industries such as petrochemicals. And natural gas is a far more viable alternative to oil in the transportation sector than any of the widely hyped alternative energy technologies.

The Rise of the State: Profitable Investing and Geopolitics in the 21st Century, a book I co-authored with two longtime friends and colleagues, Yiannis Mostrous and David Dittman, analyzes these powerful trends and details specific stocks that stand to profit from the changes underway. Published by FT Press, the volume is now available on Amazon.com and at your local bookstore.

The excerpt below will give you a taste of what to expect.

Natural Gas: The 21^st Century Fuel

The two main sources of demand for natural gas are electric power generation and industrial applications. The key question is why companies would choose to use gas to produce electric power, as an industrial fuel, or as feedstock rather than coal and oil.

In markets where natural gas competes with oil, gas’s main advantages are that it’s more readily available and cheaper. The following chart shows the price of crude oil compared to US and UK natural gas prices.

Source: Bloomberg

Natural gas is considered a regional fuel. The US, for example, has obtained its gas from a combination of domestic production and imports from Canada via pipeline. Although gas imported from further afield in the form of LNG has become a more meaningful component of North American supply in recent years, it’s still a relatively small part of the supply mix. Similarly, Europe has traditionally obtained most of its gas from North Sea production and via pipeline from Russia.

As a result, natural gas prices can differ widely between regions of the world. To reflect this, the chart depicts prices for both US NYMEX-traded natural gas futures and UK-traded ICE futures. ICE futures are traded in terms of British pence per therm, while US gas futures are traded in US dollars per million Btu (USD/MMBtu); the chart converts ICE futures and oil prices to USD/MMBtu for ease of comparison.

For most of the period covered by this chart, oil and US/UK natural gas prices were closely correlated, though crude typically traded at a slightly higher price than gas. But starting around 2006 the close correlation completely broke down—oil has consistently traded at a much larger premium to natural gas and, in some cases, the two commodities don’t even move in the same broad direction. This shift is largely structural rather than temporary. Global oil supplies are likely to remain constrained as older, mature fields see declining output and producers turn to more remote, technically complex and expensive-to-produce fields to fill the supply gap.

Supply bottlenecks in the global gas market are far less onerous. The rapid development of unconventional gas reserves has vastly improved the supply picture in the US. Meanwhile, several large LNG projects have come on-stream in recent years, adding to global supply and allowing consuming countries to diversify their supply from traditional pipeline sources.

The greater availability and reliability of supply mean natural gas prices will remain relatively cheap compared to oil. From 1996 through 2006 the ratio of US oil to US natural gas prices on an energy-equivalent basis averaged 1.2-to-1. From 2006 through the end of the decade, the ratio jumped to nearly 2-to-1. It’s likely that the recent experience will continue and the oil/gas ratio will remain high for years to come, encouraging the substitution of gas for oil where possible.

Enterprise Products Partners LP (NYSE: EPD) is one of the largest operators of natural gas processing and fractionation facilities in the US. When raw natural gas is produced, it consists primarily of methane but also contains a large number of other hydrocarbons collectively known as natural gas liquids (NGL). Some gas, known as “wet” gas, is naturally higher in NGLs, while other fields produce almost pure methane, known as “dry” gas. NGLs include propane, butane, and ethane.

Toward the end of 2009 and into early 2010, US petrochemical companies were retooling their facilities to allow them to produce more ethylene from gas-derived ethane and propane rather than oil derived naphtha. As of the end of 2009, Enterprise Products estimated that petrochemicals producers had added 100,000 barrels a day (bbl/d) of new capacity to crack ethane and propane to make ethylene; in many cases this was done by modifying their naphtha equipment.[i]

Ethylene is among the most important and most fundamental petrochemicals. The fact that chemical manufacturers are spending the money needed to revamp their plants to use ethane rather than naphtha strongly suggests that the higher crude-to-gas ratio is seen as a fundamental shift in the market, not a temporary change.

None of this means natural gas will completely replace oil in industrial markets. However, it is likely to gain market share, particularly in markets with plentiful supply. This list includes the US, where strong production growth from unconventional natural gas fields will sustain a large cost advantage for gas over oil for the foreseeable future.

Also, the Middle East is projected to see a large increase in industrial natural gas demand. Petrochemical production is far and away the dominant source of industrial demand for gas in the Middle East, and ethane-based ethylene and propylene from countries like Saudi Arabia and Kuwait have massive cost advantages over ethylene produced from naphtha in Asia. Total Middle East ethylene capacity is expected to grow from 16.9 million metric tons per year in 2008 to 28.1 million in 2012, while propylene capacity will increase from 3.5 million tons per year to 7 million over the same period.[ii]

Much of that chemicals production is destined for Asian markets. While natural gas looks likely to gain significant share from oil in the industrial market, the transportation market is more complex. Compressed natural gas (CNG) is routinely used to power vehicles, including passenger cars, buses, and taxis. Alternatively, larger vehicles can run efficiently on LNG; liquefying gas allows vehicles to carry more fuel and increase their range. But transportation is currently a tiny market for the fuel in the US. The American transportation sector consumes around 0.04 trillion cubic feet (tcf) of natural gas per year compared to the 4.77 tcf consumed in residential applications, 6 tcf for industrial uses, and 6.9 tcf for electricity generation.[iii]

Globally, it’s estimated that there are more than 7 million vehicles running on natural gas either in the form of CNG or LNG, up from less than 2 million in 2001.[iv] This represents a tremendous rate of growth and sounds like a lot of vehicles until you consider that there are more than 200 million passenger vehicles in the US alone and an estimated 600 million to 700 million globally.

Although the US has an abundance of natural gas, it’s not a leading market for natural gas-powered vehicles. Argentina is the world leader with 1.7 million natural gas vehicles, while neighboring Brazil has 1.56 million; South America accounts for nearly half the world’s natural gas vehicle market, with many operating as taxis in major metropolitan areas.

Outside South America, Italy is the leader in Europe, while CNG and LNG are also relatively popular in Russia, Iran, and India. The US, by comparison, has only around 120,000 such vehicles on the road today.[v]

Transport is a huge potential growth market for natural gas. The US consumes around 9 million bbl/d in the form of motor gasoline alone. On an energy-equivalent basis that’s more than 50 billion cubic feet (bcf) of natural gas equivalent per day. When you consider that total current US consumption is around 60 bcf per day, replacing even a small part of the gasoline market with natural gas would imply an enormous increase in total natural gas demand.

There are more than 200 million passenger vehicles on the road in the US alone; replacing or retrofitting even a small percentage of that total would be expensive and take years. Similarly, refueling infrastructure in the US, EU, and other major gasoline-consuming markets is set up to distribute liquid fuels through a vast network of gas stations. There are well over 100,000 stations in the US alone.

Converting these stations to offer CNG fuel would be a mammoth undertaking. There are only 339 CNG fueling stations in the US open to the public.[vi]

Nevertheless, it’s likely there will be greater use of gas as a transport fuel in coming years. The first markets to be penetrated significantly are fleet vehicles such as buses, taxis, and garbage trucks. Refueling such vehicles requires building only one or a handful of centralized refueling stations in a particular area. In 2006 about 15 percent of US transit vehicles were powered by natural gas, and that was estimated to save around 109 million gallons of diesel fuel annually. Penetration of fleet vehicles in other countries such as Argentina is even higher.[vii]

Besides cost, another advantage of using CNG in fleet vehicles is emissions. The US Environmental Protection Agency (EPA) estimates that vehicles using CNG cut carbon monoxide emissions by 90 to 97 percent, nearly eliminate particulate emissions, cut nitrogen oxide (NOX) emissions by 35 percent to 60 percent, and reduce carbon dioxide (CO2) emissions by 25 percent.[viii]

Cutting emissions of NOX and particulate matter provides significant near-term benefits such as reducing smog. Reducing pollution isn’t just a developed world issue, as some of the world’s most polluted cities are found in emerging markets; reduction of inner-city pollution caused by diesel engines has been a major motivation for countries such as India and China to encourage natural gas vehicles.

The true game-changing market for natural gas vehicles isn’t personal passenger cars or fleet vehicles but freight trucks. Building out infrastructure for truck refueling is a simpler matter than for passenger cars; a handful of stations located along key routes would suffice.

And this is a far larger potential market than fleet vehicles. It’s estimated there are around 8 million trucks on US highways burning around 2.5 million barrels of oil per day.[ix]

The most direct play on rising use of natural gas as a transportation fuel is Clean Energy Fuels (NSDQ: CLNE), the largest provider of LNG and CNG in the US and Canada. Clean Energy builds CNG and LNG fueling stations on behalf of fleet operators and then earns an ongoing revenue stream by selling the CNG and/or LNG fuel needed to power those fleets. The company was founded by billionaire T. Boone Pickens, and the oil magnate remains on Clean Energy’s board of directors.

[i] Enterprise Product Partners Fourth Quarter 2009 Conference Call February 1, 2010.

[ii] “Looming Mideast Olefin Production May—or May Not—Spell Oversupply,” Oil & Gas Journal, March 23, 2009, http://www.ogj.com/index/article-display/356853/ articles/oil-gas-journal/volume-107/issue-12/processing/looming-mideast-olefinproduction- maymdashor-may-notmdashspell-oversupply.html.

[iii] Annual Energy Outlook 2010, http://www.eia.doe.gov/oiaf/aeo/aeoref_tab.html (accessed February 27, 2010).

[iv] Nina Rach, “Special Report: Natural Gas Vehicles Gain in Global Markets,” February 16, 2009, Oil & Gas Journal, http://www.ogj.com/index/article-display/ 353339/articles/oil-gas-journal/volume-107/issue-7/general-interest/specialreport- natural-gas-vehicles-gain-in-global-markets.html, (accessed February 14, 2010).

[v] Ibid.

[vi] Ibid.

[vii] Ibid.

[viii] NaturalGas.org, “Natural Gas and the Environment,” http://www.naturalgas.org/ environment/naturalgas.asp#pollution (accessed February 17, 2010).

[ix] Bob Tippee, “TIPRO Uses Convention to Push Increased Gas Use,” Oil & Gas Journal, February 25, 2010 (accessed February 25, 2010).