Why Equipment and Service Providers will Benefit from The Ongoing Natural Gas Revolution

WHY EQUIPMENT AND SERVICE PROVIDERS WILL BENEFIT FROM THE 
ONGOING NATURAL GAS REVOLUTION 


In our May 2010 report entitled “Investing in the Natural Gas Revolution” we concluded that there would be strong, long term global demand for natural gas, and that it would be a boon for this sector’s equipment and service providers in particular. The three main reasons for this secular bull market are cited below.

1. Natural gas is less polluting and more fuel efficient than either coal or oil. This is especially the case when compared with coal, its main competitor in the electricity sector. 
2. The development of liquefied natural gas has connected states with previously stranded natural gas reserves to major natural gas consuming countries 
3. New innovations allowing for the extraction of natural gas from previously inaccessible unconventional reserves have significantly increased the world’s supply of natural gas. 

This additional supply of natural gas, which has led to a drop in prices, will over the mid-to-longterm stimulate demand even further. Recent developments in the areas of demand and infrastructure further strengthen our original report’s main findings.

World Demand 
One of the main conclusions of the International Energy Agency’s (IEA) annual World Energy Outlook report, released last November, was that natural gas would be the world’s fastest growing fossil fuel over the next 25 years. This is a significant change from its long held position that the leading fossil fuel for the foreseeable future would be coal. The IEA, in it latest report, has gone as far as to say that natural gas could be entering into a “golden age.” The IEA predicts that global demand for natural gas will increase by 44% between 2008 and 2035, versus 36% for energy demand in general. The two charts below illustrate how significantly the IEA changed its outlook in the span of only one year.


United States 
The United States is in the midst of making a significant transition towards natural gas in the
electricity sector. Deutsche Bank predicts in a recent report that natural gas will account for 35%
of America’s electric power generation by 2030, significantly up from its current 23%. At the
same time, it forecasts that coal’s market share will fall from 47% to 22%.2.


The driving forces behind America’s switch to natural gas include:

• Ageing coal power plants: There are an estimated 60 gigawatts (GW) of coal plants over 60 years old that will need to be retired by 2020 at the latest. In addition to this, there are a further 92 GW of coal plants over 45 years old. Taken together, this represents 45% of America’s total current coal generating capacity.3 The older the coal plant, the less efficient it is and the more likely it does not have any pollution control equipment installed; thus making it more economical to close rather than to refurbish. 
• Regulatory pressures to reduce pollution. Even absent national carbon legislation, there are plenty of other regulatory developments at the state and federal levels that are undermining coal’s market position. They include stricter pollution laws in states, such as Colorado and Michigan, and the federal Environmental Protection Agency’s imposition of new limits on sulfur dioxide and nitrogen oxide emissions in 31 eastern states starting in 2014. Credit Suisse estimates that over 30% of America’s coal generating fleet has no emission controls at all; while another third lack either a scrubber for removal of sulfur dioxide or other controls for nitrogen oxides.4 The charts below show how much less polluting natural gas is than coal. 
• Building Costs. Building a new natural gas combined cycle plant costs about $1,230 per kilowatt of capacity, versus $2,890 per kilowatt for pulverized coal plants and $6,100 for nuclear plants. This includes the cost of building the required pollution-control equipment. Constructing a coal plant capable of eventually capturing and storing carbon dioxide underground would even further worsen coal’s competitive position.
• Lower natural gas prices. Another important factor is that U.S. natural gas prices have plunged over the last several years due to the discovery of massive new reserves. This has made natural gas competitive with coal, even without taking into account the extra costs coal incurs due to increasingly tighter environmental regulations. 
• Bipartisanship. While a Republican controlled House will significantly reduce the chances of a federal carbon dioxide bill coming into law, expanding the use of natural gas has strong bipartisan support among Republicans and Democrats. 

All this means increased U.S. demand for natural gas infrastructure 
In order for the U.S. to meet its growing demand for natural gas it will have to spend approximately $129 billion to expand its natural gas pipeline networks by 37,700 miles, or 10%-12% of its current capacity.6

China 
While the switch to natural gas is occurring considerably more slowly than in the U.S., there are growing signs that natural gas is also poised to gain significant market share in China.

• The EIA projects that 20% of the increase in global demand for natural gas over the 2008-2035 period will originate from China.
•  In October 2010, the Chinese government announced plans to increase the production and use of natural gas. The goal is for natural gas to meet 8% of China’s energy needs by 2015, up from its current 4%.8 Even at this higher level, China’s consumption of natural gas lags behind that of many countries. Natural gas accounts for about 27% of America’s energy mix, and 23% of the world’s.
• China is also making plans to increase its domestic production of natural gas from unconventional gas reserves. While China only has 2.46 trillion cubic meters of conventional natural gas reserves, it may have up 10 times that amount in unconventional gas deposits.10 The problem is that China currently does not have the technological means to tap these unconventional sources on a large scale. It is attempting to acquire this capacity by partnering with, or investing in, companies with the requisite technology. The most recent example is China National Offshore Oil Corporation’s $2.16 billion deal with Chesapeake Energy, one of the pioneers of shale gas drilling, for a one-third stake in a south Texas shale gas and oil field.
• The charts below show that China has consumed more natural gas than it has produced for three years counting and, as a result, is now a net importer of natural gas. In the past, when China has become a major net importer of certain commodities, such as oil or iron ore, price increases have followed. 

An official from China State Shipbuilding, China’s only LNG shipbuilder, projects that China may more than quadruple its imports of liquefied natural gas over the next six years. China’s LNG imports have already surged 66% in 2009 from a year earlier.

In order to facilitate its growing use of natural gas, China plans to triple the total length of its natural gas pipelines to 100,000 km by the end of 2015, up from 36,000 km by the end of 2010.13


India 
Several Indian energy companies have recently announced plans to expand their natural gas pipeline networks. Gail India plans to build 5,500 km of natural gas pipelines over the next 2-3 years;

Reliance Gas and Transportation Infrastructure plans to build 3,020 km of pipeline by the end of 2012; Gujarat State Petronet intends to expand its capacity by 7,601 km; and Gujarat State Petroleum is looking to build about 2,600 km of pipelines.

Investment Recap 
As mentioned, due to the growing global demand for natural gas, we are bullish on equipment and services providers active in the natural gas sector. Companies in this market include:

• BG Group, Fluor and Foster Wheeler, which develop LNG projects.
• GE and Caterpillar, which manufacture natural gas-fired turbines. 
• Air Products & Chemicals, which produces liquefied natural gas processing technology 
• Vallourec of France and Indian-based Welspun Gujarat Stahl Rohren, which build natural gas pipeline infrastructure 
• ENN Energy, China Gas Holdings (both of China) and Gujarat State Petronet, which are in the natural gas delivery business. 

http://www.nbc.ca/

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Natural Gas Industry: An Investment Guide

Investors looking for publicly traded natural gas companies to purchase are presented with a confusing amount of information that is particular to this industry. This can present a roadblock to understanding and analyzing the sector. Here are some explanations of some common concepts and terms that investors should know.

ReservesReserves are a general term that refers to the amount of natural gas and other hydrocarbons that a company has present on its properties. The industry categorizes these hydrocarbons as either proved, probable or possible reserves.

The most important category of reserves are proved reserves, which are defined as natural gas and other hydrocarbons that geological and engineering data demonstrate with reasonable certainty are recoverable from known reservoirs under current economic methods, government regulations, and operating conditions. The economics of the proved reserves must be determined using a 12-month average price using the price on the first day of each of the preceding 12 months.

Many natural gas companies will also present in marketing materials the amount of proved reserves using different prices than the ones mandated by the regulatory authorities. Investors should be conscious of what prices are used to calculate proved reserves when comparing different companies to each other.

Natural gas companies also have the option of disclosing the amount of probable or possible reserves to investors in regulatory filings, but since both these categories are less certain, investors should not rely on them too heavily. 

Reserves to Production RatioThe reserves to production ratio is a measure of the length of time it would take for a natural gas company to produce all of its proved reserves. The ratio is expressed in years and a higher ratio is generally better. Whiting Petroleum (NYSE:WLL) reported a reserves to production ratio of 13.9 years at the end of 2009. This is based on proved reserves of 275 million BOE and 2009 production of approximately 19.7 million barrels. This is an unrealistic static measure in some ways as a natural gas company is constantly adding to its proved reserves, and like all metrics this should be looked at in the context of other factors.

Basis DifferentialsBasis differentials refer to the regional price discounts that some operators experience when they sell natural gas into the market. These discounts are caused by many factors including the weather, natural gas pipeline capacity, regional demand and the quality of the hydrocarbons. Ultra Petroleum (NYSE:UPL), which is a major producer of natural gas in Wyoming, sells its production into a hub in the Rocky Mountain area. In 2009, the company received an average of 77% of the price of natural gas sold into the Henry Hub in Louisiana.

ProductionProduction is a measure of the amount of natural gas or other hydrocarbons that are produced from wells that a natural gas company has interests in. Since crude oil and natural gas liquids are measured in barrels, and natural gas is measured in cubic feet, there must be a way to convert each hydrocarbon to a standardized form of measurement so that the total production of a company can be analyzed.

The natural gas industry uses a measure called natural gas equivalents to convert any crude oil and natural gas liquids production. Each barrel of crude oil or natural gas liquids is converted to natural gas equivalents using a ratio of one barrel to six thousand cubic feet of natural gas produced. Here is an example of a conversion from Range Resources (NYSE:RRC) for 2009:

Type	Original		Converted
Natural Gas (Cubic Feet)	130,649,000,000		130,649,000,000
Crude Oil (Barrels)	2,557,000	6,000	15,342,000,000
Natural Gas Liquids (Barrels)	2,187,000	6,000	13,122,000,000
Natural Gas Equivalents			159,113,000,000

Range Resources produced 130.65 billion cubic feet of natural gas in 2009. The company also produced 2.6 million barrels of crude oil and 2.2 million barrels of natural gas liquids. After converting these oil and liquids at the 6,000 to 1 ratio, Range Resources produced 159.12 billion cubic feet of natural gas equivalents.

HedgingNatural gas companies also hedge production using collars, swaps, puts and other derivatives. This is done to reduce the volatility of cash flows associated with selling a commodity. Natural gas companies usually present this information in marketing presentations. In 2010, for example, Petrohawk Energy (NYSE:HK), hedged 62% of its estimated 2011 production, and 24% of its estimated 2012 production. (Find out how to stay on top of data reports that could cause volatility in these markets. 

EBITDAXNatural gas companies like to present a non-GAAP measure called EBITDAX when they report quarterly earnings. EBITDAX is an acronym that means earnings before interest, taxes, depreciation, amortization and exploration expenses. Some companies also exclude property impairments and non-cash equity compensation expense when presenting this measure. Here's an example of how Continental Resources (NYSE:CLR) calculated EBIITDAX in the first quarter of 2010.

Net income (loss)	$72,465
Unrealized oil derivative gain	$(19,676)
Income tax expense (benefit)	$44,410
Interest expense	$8,360
Depreciation, depletion, amortization and accretion	$52,587
Property impairments	$15,175
Exploration expense	$1,786
Equity compensation	$2,852
EBITDAX	$177,959

There's nothing wrong with looking at this measure as long as an investor understands that this is not the equivalent of free cash flow, and it should be looked at within the context of other metrics.

Finding and Development CostsNatural gas companies also present finding and development costs as a metric to judge the company's ability to find oil and natural gas reserves at a reasonable cost. These finding and development costs are presented as a unit of reserves found. Here is the calculation that EXCO Resources (NYSE:XCO) used for its finding and development costs in 2009:

Development and Exploration Expenses	$299,837
Proved Reserves Added	$242,056
Per Mcfe	$1.24

EXCO Resources spent approximately $299 million to add 242 Bcfe of proves reserves, resulting in a drill bit finding and developing cost of $1.24 per Mcfe. Pay close attention to how this metric is calculated, as it will typically exclude revisions to reserves during the year and reserves acquired through acquisitions.

CostsA natural gas company reports certain costs and expenses that are specific to the business that it is in, along with expenses typical of any business enterprise. These costs are usually expressed on a unit of production basis, or per thousand cubic feet equivalent (Mcfe). Here is an example from EOG Resources (NYSE:EOG) for 2009. 

Type	Per Mcfe
Lease and Well	75 cents
Transportation Costs	37 cents
DDA - Properties	$1.89
DDA - Other	12 cents
Selling and Admin	32 cents
Interest	13 cents
Total	$3.58
* DDA – Depreciation, Depletion and Amortization

This is not a comprehensive measure of all costs associated with the company, and can exclude things like gathering and processing costs, exploration costs or costs associated with dry holes.

Standardized Measure of Discounted Future Net Cash FlowsAnother measure related to proved reserves is the Standardized Measure of Discounted Future Net Cash Flows from those proved reserves. A natural gas company calculates the revenues expected to be realized from the sale of those reserves when produced, and then subtracts the costs related to producing and developing the proved reserves. Taxes are then deducted from the total, and then the remaining cash flows are typically discounted using a 10% discount rate. 

Here is an example of the calculation from Ultra Petroleum (NYSE:UPL) for 2009:

--	2009
Future Cash Inflows	$12,870,816
Future Production Costs	$(3,916,222)
Future Development Costs	$(2,249,993)
Future Income Taxes	$(1,998,114)
Future Net Cash Flows	$4,706,487
Discounted At 10%	$(2,679,787)
Standardized Measure of	$2,026,700
Discounted Future Net Cash Flows

Net Asset ValueMany investors determine a net asset value for a natural gas company and use the Standardized Measure of Discounted Future Net Cash Flows as a starting point for this calculation. The simplest method of calculating the net asset value is to take the Standardized Measure of Discounted Future Net Cash Flows and divide this by the amount of shares outstanding. 

An analyst will typically make many adjustments to this calculation to make the result more realistic. These adjustments include using a different price for natural gas to determine future cash inflows, or adding in probable or possible reserves if they feel that these less certain reserves are likely to be realized. Another adjustment made is to deduct debt or working capital deficits from the numerator. The denominator is frequently adjusted to account for stock options and other dilutive securities.

Glossary of Natural Gas Terms

• Development Well – A well drilled in a known producing area to an existing productive formation.
• Exploratory Well – A well drilled to find a new natural gas or oil field or reservoir.
• Gross Acres – The amount of lease acreage that a company has a working interest in.
• Net Acres – Gross acreage multiplied by the percent working interest the company has in the lease.
• Royalty Interest – An interest in a natural gas or oil well by an owner without having responsibility for the cost of production.
• Working Interest – An interest in a natural gas or oil well that conveys the right to conduct operating activities on the well.

by Eric Fox

investopedia.com

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