Although natural gas prices have rebounded strongly in recent months, prices are unlikely to sustain the levels experienced from 2005 to 2008 in the next several years.

In 2005, the fracking revolution was in its infancy, and there were widespread concerns of impending natural gas shortages. The natural gas supply situation looks much different today. Proved reserves of natural gas in the US have grown by nearly 50% since 2005, according to the 2012 BP Statistical Review of World Energy. These additions to reserves came about largely thanks to advances in hydraulic fracturing (fracking) technology that pushed more of the vast natural gas resource in the country into the proved reserves category. (The resource is the total amount of natural gas in place, and the proved reserve is the amount that is economically recoverable at current prices.)

Proved natural gas reserves at the end of 2011 were 300 trillion cubic feet, equivalent to 13 years of US consumption at 2012 consumption rates. But a decade ago, this number was under 10 years of US consumption. The reason? US proved reserves have been increasing faster than the rate of natural gas consumption.

Unlike oil prices, which have regained much of their previous strength since the 2008 crash, natural gas prices have never rebounded to pre-crash levels. As a result, natural gas production is being shut in and drilling rigs continue to be redeployed into oil production. In 2008, there were over 1,600 rigs drilling for natural gas; today that number has fallen to just over 400. (Interestingly, U.S. dry gas production has so far not declined as a result — yet. One reason for this is likely the amount of associated gas that is being produced with shale oil.)

Source: Baker Hughes

While falling natural gas rig counts have helped firm up natural gas prices — which have in fact increased by over 30% in the past six weeks — these rigs can be shifted back into natural gas production as prices become more attractive to producers. This factor, combined with the decade-long trend of rising natural gas reserves, signals one thing: low to moderate natural gas prices for several years to come.

Some natural gas companies have performed well even as natural gas prices languished. For example, Linn Energy LLC (NSDQ: LINE) — one of our Best Buys — has outperformed because of their hedging strategy (Linn Energy has hedged natural-gas production through 2017 and oil through 2016). However, the natural gas production sector as a whole is likely to be challenged for a few years. We will continue to recommend outstanding companies in this sector, but there are several other sectors that should benefit from a period of sustained, low natural gas prices.

These sectors include:

• Companies that build out natural gas infrastructure
• Companies that produce vehicles that run on natural gas or provide services to convert natural gas vehicles
• Chemical companies that rely on natural gas as a major feedstock
• Utilities that are switching from coal to natural gas

Consider the current ratio of diesel prices to natural gas prices. At present, the spot price of ultra low sulfur diesel (ULSD) is $3.11 a gallon. In terms of energy content, that is $22.50 per million BTU (MMBTU). The current spot price of natural gas is $3.34 per MMBTU. (The retail price ratio of diesel to natural gas isn’t nearly that good, because natural gas gets marked up substantially for retail sale). For fleet owners or long-haul truckers, the case for converting to natural gas will be compelling in many cases.

A number of companies are involved in the build out of natural gas infrastructure or the production of natural gas vehicles. These companies represent purer plays than chemical companies or utilities that should also benefit from low natural gas prices.

Clean Energy Fuels (NASDAQ:CLNE) is ideally positioned to profit as fleets transition to natural gas. The company designs, builds, operates, and maintains fueling stations; supplies customers with compressed natural gas fuel, sells equipment used to maintain and operate natural gas filling stations, and converts slight and medium duty vehicles to run on natural gas.

CLNE has undertaken a project they call America’s Natural Gas Highway™, which represents a network of LNG truck fueling stations on interstate highways connecting major metropolitan areas coast-to-coast and border-to-border. CLNE currently fuels more than 25,000 vehicles daily and have to date delivered nearly 800 million gallons of CNG and LNG to customers. The company has also built more than 150 natural gas fueling stations, and purchased almost 60 LNG tankers.

This build-out has been expensive, and as a result CLNE is burning through a lot of cash. The company is not yet profitable, but revenues have grown in each of the last four years (and have more than doubled in the past three years). Expiration of a tax credit at the end of 2011 adversely affected earnings so far this year, and the share price has been volatile.

The company also faces competition from General Electric (NYSE:GE) and Chesapeake Energy (NYSE:CHK) who recently launched a system called CNG In A Box™, which is a plug-and-play on-site fueling solution that enables retailers to easily add natural gas fuel to their operations. Nevertheless, because of CLNE’s growth potential, we are adding it to our Energy Watch list this week with an initial recommendation of Hold, pending a sustained move toward profitability.

Another promising company is Westport Innovations (NASDAQ: WPRT), a leading provider of engine and fuel system technologies utilizing natural gas fuels. The company’s technologies and products cover the spectrum from light (less than 5.9 liter) through high-horsepower (greater than 16 liter) engines. The company has sold more than 30,000 natural gas and propane engines to customers in more than 19 countries.

Westport commercializes its technology in markets where demand for clean, low-emission engines is strong. The company currently has strategic alliances with three of the world’s top four engine producers and supplies or has strategic alliances with six of the world’s top 10 truck producers. In the light-duty market, Westport supplies or has strategic relationships with seven of the world’s top ten automotive original equipment manufacturers (OEMs).

Westport has three primary business lines: light duty trucks (LD), heavy duty trucks (HD), and a 50:50 joint venture with Cummins (NYSE: CMI) called Cummins Westport Inc. (CWI) that serves the medium to heavy-duty engine markets. At present CWI accounts for more than 50% of the company’s revenues, but all three business lines have demonstrated triple digit year over year revenue growth.

For the 2nd quarter of 2012, Westport reported revenues of $106.1 million compared with $44.9 million for the same period last year, an increase of 136%. WPRT also reported second quarter losses of $0.11 per share, beating the $0.30 consensus loss estimate of the 17 analysts covering the company. However, the stock has underperformed, as the adoption rate for natural gas switching has been slower than expected. Given Westport’s strong track record of revenue growth and established relationships with leading truck producers, we will add it to the Aggressive Portfolio. Buy below 28.

Note: Following publication of this week’s The Energy Strategist, I am placing a limit order for WPRT at $28 a share.

For Conservative Investors

For more conservative investors, one of the midstream-focused master limited partnerships (MLPs) is another way to bet on a rise in natural gas usage.

Conservative Portfolio holding Western Gas Partners LP (NYSE: WES) derives almost three-quarters of its gross margin from the Eagle Ford Shale in south Texas and the Niobrara Shale in Colorado and Wyoming. Both oil and gas production are increasing in these two plays, and WES is poised to benefit — particularly as demand for natural gas increases. WES currently trades at about 7% above our recommended buy target of $48 and would be attractive on any dips below that level. Buy Western Gas Partners below 48.

Eagle Rock Energy Partners LP (NSDQ: EROC) maintains upstream operations that involve production of crude oil, natural gas, and natural gas liquids (NGL) from properties in Texas and southern Alabama. The company’s gathering and processing business consists of 5,500 miles of gathering pipelines in the Texas Panhandle, East Texas, Louisiana, South Texas, and the Gulf of Mexico. Eagle Rock Energy’s  pipelines connect individual wells to processing facilities and to the US interstate pipeline network. The firm also owns 19 gas processing plants that separate propane and ethane from raw natural gas. Buy Eagle Rock Energy Partners below 12.

Enterprise Products Partners LP (NYSE: EPD) is the largest publicly traded master limited partnership (MLP) in the US. Their diversified business includes natural gas pipelines, offshore production platforms, oil pipelines, and tank barges. Roughly 70 percent of EPD’s revenue comes from pipelines and other assets that generate fees regardless of whether they operate at full capacity. About half of EPD’s gross operating margin comes from pipeline and services related to natural gas liquids (NGL). The company is engaged in projects in the important Eagle Ford, including 300 miles of new natural gas pipelines. EPD is in our Conservative Portfolio, trading at 7 percent above our buy target. Buy Enterprise Products Partners on dips below 50.

Avoid GTL

One category of companies that I would recommend investors avoid are those involved in gas-to-liquids (GTL) production. Some of these companies have been in the news lately, making claims that with natural gas below $4/MMBTU they can make diesel for $1.60 a gallon.

Certainly the technology is proven. Natural gas and coal (CTL) have been converted into diesel for decades. CTL was used during World War II by the Germans, when they desperately needed fuel for their military but had limited access to petroleum. Likewise, South Africa during apartheid turned to CTL. With sanctions restricting its petroleum supplies, South Africa used its large coal reserves to produce liquid fuel. Today South African Coal, Oil, and Gas Corporation—Sasol (NYSE: SSL)—operates a number of gasification facilities, including the 160,000 barrels per day (bpd) Secunda CTL facility in South Africa.

Royal Dutch Shell (NYSE:RDS.A) is also a major developer of GTL technology. Shell has operated a GTL plant in Bintulu, Malaysia, since 1993 (which I visited in 2010), with a current capacity of nearly 15,000 bpd. In 2011, Shell commissioned the 140,000 bpd Pearl GTL plant in Ras Laffan, Qatar—by far the largest GTL plant in the world.

But there are two reasons I would avoid companies whose primary focus is GTL, CTL, or BTL (biomass-to-liquids), and Shell’s experience with Pearl is instructive. The two major problems with any of the XTL technologies are that capital costs are extremely high, and a long-term, cheap feedstock supply must be secured. Shell’s initial estimate for the Pearl plant was $5 billion, but by the time the project was completed the costs were estimated to be around $20 billion.

With capital costs this high, a GTL plant needs 25 or more years of low natural gas prices, or at least a high oil/natural gas price ratio. In Shell’s case, they are getting the natural gas inputs for free in Qatar, and they based their investment decision on an expectation of oil at $40/bbl. At current oil prices the economics for their project look extremely good. In a case where natural gas prices have the potential to go substantially higher—and we can’t say what the situation in the US will be in 25 years—the economics for the process become much more uncertain.

Thus, while a GTL plant is a pure play on high oil prices and low natural gas prices, in most cases investors should be very cautious because of the possibility that natural gas won’t be cheap relative to oil for 25 more years. One exception arguably is Sasol, given that the capital for their plants was sunk when oil prices were far lower than they are today (and capital costs were lower), and therefore the rising ratio of oil prices to natural gas has made their CTL and GTL assets very profitable.