The Case for Natural Gas Investing

By: The_Energy_Report

Many analysts say that there still isn't enough demand for natural gas to make it a smart investment opportunity. John Licata, chief investment strategist at Blue Phoenix Inc., disagrees. In this exclusive interview with The Energy Report, John explains why he thinks that by year-end natural gas could be the place for investors to be.

The Energy Report: Recent housing data caused an uptick in the oil and commodities sectors. You mentioned on CNBC, though, that you didn't think that was an optimistic sign the economy is rebounding. Why do you feel that way?

John Licata: I think it's unrealistic to put so much credence in that data only because we had consecutive months of obscene weather here in the Northeast and across much of the United States that would probably cause a lot of that data to be skewed. So, I really don't think looking at one month's worth of data is a reason to get too enthusiastic, considering that the next couple of months will probably be a much better barometer of the pulse of the housing market.

If you look at the unemployment number, I think if that doesn't start to improve over the next couple of months, I can't see many people allocating more money toward gasoline and the like if they can be saving their money to put food on the table.

TER: What would you see as an optimistic level as far as unemployment goes?

JL: Where we are right now is a place nobody wants to be, but I think if we could somehow get back down to below 9%, that would start to give people much more confidence that this recovery is taking hold. That's potentially something we could see later on in Q3 or perhaps in Q4. I still think we're not out of the woods completely with this recession, even though some economic data has suggested that we are. Unless we get jobs back into the fold I really don't think that this turnaround can be considered complete.

TER: In our interview with you a year ago, oil was around $40 a barrel. You predicted at that time that oil would trade above $65 by the end of 2009. That turned out, of course, to be true. Oil is now trading in the $80-a-barrel range. Do you think we're going to see crude continuing to trade in that range or maybe go higher through the summer?

JL: I think short term, we're pretty much range-bound from $78 to $82. I think the inability to take out the January highs was definitely a short-term bearish trend, but as you can see in recent sessions, we've been trying to rally. Most traders are starting to look back at the foreign exchange, and where the U.S. dollar is trading. Today the euro is actually stronger versus the U.S. dollar and that's causing some short covering. But to get it to break out of the next range I really think that eighty-three-and-a-half needs to be taken out and held. I have an $87-per-barrel target on it for this year. I think that's pretty realistic, considering I'm anticipating, as I mentioned earlier related to unemployment, a Q3 and Q4 rally in the economy.

TER: What about weather factors? Last year was relatively mild in terms of hurricanes. Do you see the upcoming hurricane season having any impact?

JL: If you look at various weather sources, like Colorado State University or even AccuWeather, they're starting to release early forecasts for more than four named hurricanes to hit on shore. We only saw one in 2009, thankfully, but I think the fear factor is something that can come back and drive prices up. It's definitely something that's in the back of traders' minds. It only takes one threat of a storm to cause short coverings. So if we do get a storm of magnitude coming close to the Gulf of Mexico, that could be a cause of concern.

TER: Typically we start seeing prices at the pump go up as we get closer to Memorial Day. Can we expect the summer driving season to have an impact again this year?

JL: I think you're starting to see that already. There hasn't been a refinery built in the United States since 1976 and there has been much refined capacity taken offline in recent months because it has been uneconomical for the refiners to produce gasoline.

Right now you can see that the price of gasoline is trading around $2.25 wholesale. It just stands the reason that retail prices typically trade about a dollar higher on average than wholesale. I think that we could perhaps see $4 a gallon being challenged again this summer.

TER: Speaking of refineries, what's your take on the refining sector?

JL: I think that this is a sector that has been beaten down so badly because most people thought that the economies of scale were far greater than the outlook for demand. Many of the companies, whether it's Valero Energy Corp. (NYSE:VLO) or ConocoPhillips (NYSE:COP), Sunoco Inc (NYSE:SUN) or Tesoro Corporation (NYSE:TSO), are taking output offline because of margin weakness. I think that this is actually happening at a time when demand is about to go higher, in my opinion.

You cannot bring refining capacity back online like you flip a light switch. It takes weeks for these refineries to come back into full production.

My view is that crack spreads, which are the margins that these refiners live by, are going to continue to rally as we head into the summer months. We've actually already seen from the gasoline-side; crack spreads have nearly doubled in the past month, which makes the space as a whole much more attractive.

I think that the U.S. government would do an injustice to the American consumer if they decide after the November elections to increase the CO2 emission standards at a time when many of these refiners have been cutting back their capital expenditures just to meet their daily flow of cash. If they are told now that they have to increase cleaner fuels and that they have to pay more to do so, I think even more production is going to have to come offline.

Ultimately that can also be a catalyst for crude oil prices to rally and I think that gasoline prices will be much higher than where they are right now. I think that heating oil prices heading into the back months of the year can be drastically higher from where they are right now. So I think that these emissions rules that so far have temporarily been on hold are perhaps going to be in the forefront again after the November congressional election. If that becomes front page news, I think that these refining companies know full well that they actually hold the ball because they could just keep shutting off the taps and produce less and less while the consumer pays more and more.

TER: What's the investor opportunity here?

JL: I think the refining companies themselves are very attractive. Many of these companies are being valued at such low prices in terms of refining capacity. There's been consolidation in the industry over the last couple of years with companies like Holly Corporation (NYSE:HOC) acquiring assets from Sunoco at what I thought were fire sale prices.

I think that companies that are going to emerge from this as the real winners are the ones that see a brighter future and those that can actually adapt to cleaner standards such as diesel. Holly Corp. is one of those companies I believe is positioned very well to do so.

Only 5% of the automobiles in the United States can run on diesel fuel whereas 55% of cars in Europe run on diesel fuel. So in my opinion, if the American government mandates these refineries to produce that cleaner fuel you have to be positioned as an investor to look at companies that are already making moves ahead of time. Holly Corp. is that company in my opinion.

TER: Are there any others?

JL: Alon U.S.A. Energy (NYSE:ALJ) is interesting. They produce asphalt, which has higher margins than many fuels, and they are preparing for what could be the dieselization of America. They are also making moves just like Holly is in improving their refineries. They've actually just made moves to acquire a refinery in California from Flying J in a bankruptcy deal. Companies like Tesoro, which actually benefits from higher margins on the West Coast, could be another one to watch.

TER: If gas prices do approach $4 a gallon, how much of an impact would that have on a possible economic recovery?

JL: Obviously, that can strain the economy recovering. In 2008, $4 a gallon was pretty much the limit of consumer demand. That's the point when substitutes come into play. That's when you saw the emergence of more hybrid cars or people taking more public transportation or walking or biking to work. So $4 seems to be the level where consumers say, "Hey, you know what, let's go take a different mode of transportation."

TER: There's been a lot of action in the natural gas market lately. Some analysts, though, are saying that there's not much money to be made in natural gas right now because of an oversupply. You've been a fan of natural gas in the past. Do you agree with those analysts or do you see this as a good place for investors to be as we go forward?

JL: I'm still very enthusiastic about natural gas prices. While short term, we can still perhaps go down a little bit further, I think if you're looking at the year in general, we possibly could see north of $5.50 by the end of the year.

I think what some people aren't looking at is the fact that natural gas is actually trading at or below some prices of coal. I think there could be some switchovers and natural gas can actually challenge coal as the top source for electricity. With that being said, if that does happen, I think that can take away some of that excess supply that we've seen in the past year that has been straining the price of natural gas.

We mentioned earlier about hurricane season and 14% of natural gas is actually in the Gulf of Mexico. Warmer weather is another factor that can be supportive of natural gas prices.

I think that the rig count offered out by Baker Hughes (NYSE:BHI) is very telling in the fact that a year ago at this time we had about 800 rigs in the marketplace. Today we have around 940 rigs. I think what that was about was many E&P companies were looking for the United States economy to recover a lot quicker than it did. I think they were anticipating a recovery that has been slow to develop. With that said, I think that companies are going to start to maybe cut back on the number of rigs because they see where prices are right now. For many of them it's very uneconomical to keep these rigs functional. Chesapeake Energy (NYSE:CHK) just said in a March presentation that they could perhaps take 20 rigs off the marketplace if natural gas prices were below $5 and here we are right now below $4. So I think if more rigs come out of the marketplace that could be very supportive.

I think some people believe that the United States gets a lot of natural gas from Canada. While this is true, that number has actually been dwindling over the last couple of months. I do believe that the total number of rigs in Canada just last month was about 500. I think today it's actually less than 250. So to have such a substantial cut from a primary source is something I think most people should start to pay attention to.

I think another argument was that liquefied natural gas was something that we could use as an alternative and we can get plenty of it from overseas. Well, that number has actually been falling as well, and I think it's important to remember that in Russia they've had a lot of price issues with Eastern Europe and I think that those problems still exist. I think that if liquefied natural gas had to go anywhere—if there was any continued unrest in Russia and Eastern Europe—I think that those cargos would go to Europe. They would not come to American shores. So collectively, I think this is all constructive for natural gas prices. Like I mentioned earlier, I think that overhang of supplies is something that can quickly change.

In 2003, we actually had massive supplies of natural gas, yet prices doubled within a year. Historically, natural gas prices trade about 12 times lower than the price of crude oil. Today we're at 21 times lower. I think that traders have in the back of their minds that natural gas prices— although they could go down a little bit further from current levels— for year-end, natural gas might be the place to be.

TER: Are you bullish on natural gas in North America or internationally?

JL: I'm bullish on North American natural gas.

TER: When you're looking at companies in the natural gas market, what are the things that make them an attractive investment?

JL: What I look at when I look at the companies is the locations of their acreage. Are they producers? Do they have the technology needed to get the gas out of the ground? What are some of the marginal costs related to their projects? Do they have the necessary rigs to put into the ground? What are their probable proven reserves?

Economies of scale are better in certain areas of this country than others. I'm a firm believer that the Granite Wash area in the Texas Panhandle is a very attractive area to be involved in. Just because it's cheaper than say, the Haynesville area, to put technology to work to get gas out of the ground.

I'm for companies that are drilling in areas that have known seismic data that they can rely on and they don't have to have such high expenses as some other companies do in various regions.

TER: Are you focusing primarily on exploration companies or are there any plays with producing companies?

JL: The natural gas area is very interesting because there are thousands of smaller players out there. These players don't have the capital behind them like some of the large players do. Because of prices trading where they are right now, many companies that maybe six months ago, even 12 months ago, would not consider themselves an acquisition target will perhaps put a "for sale" sign on their front lawn and entertain being acquired.

I think the ExxonMobil (NYSE:XOM) acquisition of XTO Energy (NYSE:XTO) was a big shock to the industry. I think there's going to be much more consolidation in the space and some of these smaller "mom and pop" plays could be ripe for takeover just for that reason.

TER: So when you're looking at the opportunities in the junior sector, are you looking mostly for acquisition or are you looking for potential producing/producible acreage?

JL: In today's marketplace I don't think you can look at just one of those aspects without thinking about the other. When you look at companies you obviously want to see what they have in the ground and is it economical for them to take it out of the ground. Some of these companies might be fantastic plays in their own right, but it can take them years upon years to get that gas out of the ground. Obviously, if they considered a joint venture that might be the way to go as well. We heard Anadarko Petroleum (NYSE:APC) and Chesapeake both made comments recently that they are more hip to look at more joint ventures to accelerate projects. So I think if the "big boys" are considering that, then I think that these smaller companies will consider that as well.

TER: Do you have any specific companies that excite you?

JL: Forest Oil Corporation (NYSE:FST) is a company that does excite me. I like the fact that management is keen on operating in the Granite Wash area in the Texas Panhandle. I believe the economics behind that area are very intriguing. It's a name that seems to be consistently in the media in a positive way. It just seems like a name that, in my opinion, could be an acquisition target because of the attractiveness of where they're located. I do think that where you're located has a lot to do with acquisition takeover strategy these days.

TER: Are there any other natural gas companies that you're excited about?

JL: I like Devon Energy (NYSE:DVN). I think the fact that they were able to sell off the offshore assets to BP as quickly as they did is very appealing. So now they can concentrate on onshore assets. I think they did get a fair price for their assets as well. I think that some of the domestic rig players are going to be very interesting ways to play a natural gas rally, whether we're talking about neighbors or even a smaller company like a Parker Drilling (NYSE:PKD). I think they're going to be companies to watch.

I'm not very enthusiastic about Chesapeake, to be honest. I think that the debt they have is a concern to me. I'm afraid they're going to give away too much of their projects to joint ventures. Those were areas of strength for them, whereas now I think it's an area of defense for them.

Just looking at some other names, I still like EOG Resources (NYSE:EOG). EOG is a name that has been solid for many years. It's interesting that it's a company that primarily has focused on natural gas, but it seems they're looking for a more balanced portfolio. A few years back around 75% of their assets were natural gas. They're actually looking at more of a 50/50 breakdown of gas to liquids by 2010.

So I think this goes back to what we said earlier about how Exxon kind of shook up the game a little bit by acquiring XTO. I think that what that might actually foster is for companies that are predominantly in one area such as natural gas to look at a more balanced portfolio and add more oil-related assets to their portfolios. I think to just be in the natural gas game is not the right thing to do anymore. I think that balance is something that investors will look for in the future and that strategic management is going to be rewarded by shareholders.

TER: Thank you for your time.

To receive a complimentary report on natural gas from John Licata/Blue Phoenix, visit www.bluephoenixinc.com.

John J. Licata is chief commodity strategist at Blue Phoenix, Inc., an energy/metals independent research and consulting firm based in New York City. He has appeared regularly in the media (CNBC, Bloomberg TV/Radio, Business News Network, Barron's, etc.) over the years for his insights/forecasts in the commodity spectrum.

After studying economics and graduating from Saint Peter's College (where he received the Wall Street Journal Award for economic excellence), Licata set his sights on Wall Street. During his more than 14-year career, John has held both trading and research positions on the NYMEX, Dow Jones, Smith Barney and Brokerage America. Early in 2005, he founded Blue Phoenix, based in New York City. John is presently in the EMBA program at New York University's Stern School of Business. You can follow John on Twitter and LinkedIn.

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