July 28, 2020

Why Natural Gas Is the Energy Investment of the Future

Renewable sources like wind and solar may not be enough. Pension plan investors weigh the odds.

Reported by Larry Light

Art by Yogee Chandrasekaran

Natural gas is lighter than air, although its price lately is descending faster than a lead weight. Yet natural gas’s situation today—with producers going bankrupt and oversupply straining storage tanks, amid a crusade against fossil fuels—masks good prospects. Eventually.

Reasoning: Due to the push for greener investments, natural gas may end up as the last fossil fuel standing in a world of renewables, which will need it as a supplement. After all, the sun doesn’t always shine, nor the wind always blow. Should solar and wind need a backup, and if batteries haven’t advanced enough to store their power output, then natural gas would be the likeliest candidate.

Why? It has the lowest carbon emissions of its kindred fuels, namely oil and coal. “Natural gas, which is the cleanest fossil fuel we’ve got, will be an important transition,” said David Grumhaus, co-CIO of Duff & Phelps Investment Management.

Such an outcome bodes well for long-term investors in natural gas, who haven’t had much of a break. The SPDR S&P Oil & Gas Exploration & Production exchange-traded fund (ETF) is down 44% this year. The only way to make money on natural gas has been to bet against the commodity. The bear-minded ProShares Ultra Short Bloomberg Natural Gas ETF has risen 73% in 2020. In fact, aside from a brief blip up in 2016, natural gas shares haven’t fared well for a long time. Over the past 10 years, the SPDR ETF has averaged a minus 9.8% return.

Right now, few are drawing a distinction between natural gas and other energy sources. And that’s despite natural gas’ relatively better carbon emissions record: It releases 117 pounds of CO2 per million British thermal units (Btu) of energy, which is one-quarter less than oil’s carbon pollution and half of coal’s. All traditional energy stocks, among their other troubles, are in ill repute among certain parts of the institutional investor realm, specifically college endowments.

Pressured by students and, for public universities, politicians, 35 schools have booted energy stocks from portfolios (or are in the process of doing so), a study found, with more divesting on the way. The University of California recently announced that it has completed unloading them. Keeping these stocks “poses an unacceptable financial risk to UC’s portfolios,” commented Jagdeep Singh Bachher, the university system’s CIO, in a statement.

The Greening of America

One saving grace for natural gas stocks, and their peers, is that a number of large investors don’t agree with the divestment philosophy. A case in point is the giant California State Teachers’ Retirement System (CalSTRS), which has assets of $246 billion.

Its CIO, Chris Ailman, has refused calls by environmentalists to divest its $6 billion in fossil fuel stock holdings. He characterizes this stance as a better way to promote environmental, social, and governance (ESG) goals, because the pension fund retains a seat at the table and can push for sustainability goals. “You don’t change the behavior of companies” by ditching their stock, he said at a CIO webinar on ESG last week.

While much of CalSTRS’ engagement efforts are done behind the scenes, the pension plan last month cited its work as the lead investor working with Duke Energy. CalSTRS said its efforts have led the company to commit to a 50% reduction of greenhouse gas emissions by 2030 and net-zero emissions by 2050.

More broadly, there’s the hope that natural gas will emerge as the one fossil fuel that will be allowed a role in a greener tomorrow. Thus far, the trend seems to be its friend. Seeking to diminish greenhouse emissions, government mandates and other forces have prompted electric utilities, which are the largest energy users, to move away from coal and, for the most part, into natural gas.

In 2018, natural gas was 31% of power generation, up from 24% in 2000, according to the Pew Research Center. Over the same span, coal’s portion fell to 13% from 23%. Projections are that, by 2050, natural gas will make up 38%, while coal will shrink to 8%.

The big question mark is how fast renewables will grow. The cost of installing these new technologies is coming down. But a vexing complication is that vast arrays of windmills and solar panels need open spaces, which are scarce near population centers, where the energy need exists.

Transmitting their electricity long distance over power lines loses two-thirds of the energy. “Putting them in rural areas means they are less scalable,” said Ryan Kelley, a portfolio manager at Hennessy Funds.

Another wild card for natural gas, as well as oil, is the upcoming presidential election. Presumptive Democratic nominee Joe Biden pledges to eradicate carbon pollution from power plants by 2035 and spend $2 trillion to accelerate adoption of renewables. “What really will happen if Biden gets in?” wondered Jim Schaeffer, head of leveraged finance at Aegon Asset Management.

Will a President Biden actually be able to enact this ambitious transformation of the US energy industry? Recall that, in 2016, Donald Trump promised to reverse coal’s declining fortunes. Economic reality sabotaged that notion.

Gas Pains

Meanwhile, the decline of the natural gas price has been spectacular. Back in 2005, it hit a record $19.25 per million Btus. Then came the shale revolution, which allowed drillers to get at previously inaccessible deposits of natural gas (and oil). US supply expanded enormously.

This made the US the predominant oil and gas producer on the planet, a far cry from the 1970s when the Arab oil embargo led to American gasoline shortages and a recession. Large new natural gas fields opened up this century, such as the sprawling Marcellus formation (219 trillion cubic feet of the stuff) in Pennsylvania, Ohio, and West Virginia.

Unfortunately, too much of a good thing led to enormous overproduction, and the country is running out of space to keep all the natural gas. Add a series of warm winters and now the COVID-19 scourge that has depressed industrial and commercial usage, and you have pricing in free fall. A promising export market in liquified natural gas (LNG), which is poured into huge tanks and transported mainly by ships, has ebbed owing to the global economic downturn.

That $19.25 gas price of 15 years ago is a distant memory, like the legendary feats of an aging sports star. The breakeven point for profitability is $2.50 or so. By year-end 2018, the price still was OK, albeit diminished, at $4.75. Last summer, it slipped below the $2.50 breakeven level and now sits at $1.80, figures from the US Energy Information Administration show.

If and when the price recovers, other obstacles loom for natural gas. While much of the nation is crisscrossed with a gas pipeline network, certain regions are poorly served. “We need more pipelines,” said Brian Kessens, senior portfolio manager at Tortoise.

The shortage is most acute in the Northeast, where environmentalists’ opposition has thwarted efforts to lay more lines. The latest casualty in the conflict was Dominion Energy and Duke Energy’s planned pipeline that would stretch across West Virginia, Virginia, and North Carolina. Although the two companies won a Supreme Court fight over the proposal, they scrapped the endeavor out of concern about more costly litigation ahead.

Creative Destruction

A shakeout of the natural gas sector is in store. Producers are slashing their capital spending, lowering their rig count, and pulling less gas out of the ground. Still, many took on too much debt in better times and now face a reckoning.

Bankruptcy court is the likely destination for many natural gas producers. Chesapeake Energy filed in June, unable to service its onerous $9.5 billion debt load while running torrents of red ink amid the gas price collapse. Heavily indebted Whiting Petroleum, a major shale driller in North Dakota and Montana, also filed for Chapter 11 in April. Despite the name, it also is a big natural gas producer. Only a fourth of wells are gas-only; most pump out both oil and gas.

The next step will be buyouts from stronger players. For $5 billion, behemoth Chevron is purchasing money-losing Noble Energy, which discovered the immense Leviathan gas field in Israel. “More mergers are ahead,” said Ed Egilinsky, head of alternative investments at Direxion.

And if you assume Warren Buffett’s involvement in a business is a good sign, note his Berkshire Hathaway conglomerate’s recent $10 billion (including assumed debt) acquisition of the natural gas transmission and storage assets of Dominion Energy.

For an even cheerier omen about natural gas, look at the futures market. The contract for January 2021 is $2.81, which is 31 cents above the breakeven point. The stock market also is finding hope even in some of the profit-challenged natural gas companies. EQT is an example. The stock is up 30% this year. “They’re reducing their production, and they will bring it back,” Tortoise’s Kessens said.

EQT’s losses have been a chronic condition for several years, and its second quarter performance, reported Monday—it lost $263 million—is no exception. Still, the company remains in decent financial shape, with a debt ratio (long-term debt divided by assets) of 0.48. Anything below 0.50 is considered acceptable. Plus, it is selling off some of its lesser wells and other assets for $125 million.

In a report, KCI Research saw “a generational opportunity” in EQT and others like it, which have significant gas reserves and proven production abilities. And who knows? Maybe soon the stock market will end up agreeing.