Search This Blog

Sunday, October 23, 2011

An Investment Plan for the Energy Future

Contrary to the ads, America does not run on Dunkin Donuts coffee; it runs on energy. Most of that energy is generated from fossil fuels, oil, natural gas or coal. Close to a quarter of our electrical power comes from nuclear plants and a small amount comes from hydroelectric generation. An almost insignificant portion of the energy on which America runs comes from solar, wind or other "green" source. In the last few years, the amount of talk about new energy sources, green energy, "drill baby drill", hydrofracking and the like has been deafening. After all of this palaver, however, there are certain truths that cannot be denied.

1) America is going to continue to need energy to function.
2) No matter how the government tries to subsidize or tax energy sources, the relative cost of the energy source will still determine usage in the long run.
3) America is sitting on a treasure trove of low cost energy which is available to satisfy the needs of the country.

Let me expand a bit on these truths. The first item is self-evident. We simply cannot replace the need for energy to run our economy. The second item should also be clear to anyone who thinks about it. If the government decides to subsidize an energy source (like the Obama efforts with solar energy), those subsidies will let the energy source be successful until such time as the subsidies end. Just look at the Solyndra debacle. Putting aside the political favoritism shown to a big campaign donor for Obama, there remains the basic question about the validity of the government subsidy. Solyndra's solar panels were simply too costly to compete with other solar panel manufacturers, and the cost of all solar energy is substantially higher than that of other energy sources. No one in a free market would invest in solar energy or, in particular, panels manufactured by Solyndra. The day the subsidies ran out is the day Solyndra failed.

The third item is a reference to the enormous reserves of natural gas and petroleum locked into shale formations across North America. With the current improved technology for extracting these fuel sources, there is enough energy under the United States to fuel all of our needs for at least the next century.

Given these basic truths, one needs to design a long term investment plan that will allow one to profit as these truths come to the fore. Right now, that plan is, in my opinion, to invest in the low cost producers of the least expensive energy source. That means making a long term investment in the low cost producers of natural gas. Three companies in this category are Range Resources (RRC), Chesapeake Energy (CHK) and Rexx Energy (REXX).

Let's start by explaining the investment rationale. Right now, natural gas is extremely inexpensive by historical standards. The ratio of the cost of energy from oil to the cost of energy from natural gas used to stay in a relatively narrow range; when these costs moved out of the range, it was time to sell one side and buy the other. In recent years, however, oil has gotten more expensive and the price of natural gas has fallen dramatically. The effect of this change has been seen most clearly in the field of electricity generation. Right now, only about 1% of all electric power in the USA comes from oil; about a quarter of the total comes from natural gas. The big utilities have moved their generating plants towards the use of natural gas since it is inherently less expensive than oil. This move is also starting to take hold in the biggest area of oil usage in the country: cars, trucks and other vehicles. Here too, it is the largest users of fuel who are leading the way. Local bus companies in many places have made the switch. Trucking companies are also moving towards natural gas vehicles. In fact, the biggest barrier to the switch to natural gas vehicles is now the lack of adequate infrastructure for filling up where needed. That infrastructure, however, is being developed by companies like Clean Energy (CLNE) which is building a network of natural gas filling stations up and down certain interstate highways and elsewhere. The most important point is that switching from oil based fuel to natural gas based fuel reduces the cost of filling up by somewhere between 60 and 80 percent. Natural gas is also much cleaner and produced domestically, but it is the cost differential that is driving the switch.

It seems extremely likely that the cost differential between oil and natural gas will remain in place in the near term. New gas fields like the Marcellus Shale have expanded the available reserves of natural gas by a huge amount. Natural gas has gone from a resource that seemed to be quickly diminishing to one that now appears to have at least a century or more of easily retrieved supply adequate for America's needs. Of course, the necessary effect of the large increase in supply has been the decline in price of natural gas. At the moment, natural gas is selling at about $3.65 which is down from about $4.40 three months ago. While the out month futures indicate that prices will rise, the likely range of prices for this fuel is in the $3.50 to $5.00 range. At such prices, the advantage in using natural gas over oil is enormous.

Of course, the low price of natural gas means that certain producers, particularly those who are pumping natural gas from older formations, are having problems making a profit on their sale of gas. Over the next few years, unless the price of natural gas rises significantly (which is not likely), this will drive the higher cost producers out of the market. The companies that will increase their market shares are the ones who can profit at the current price levels. A good example is Range Resources (RRC), a company that is focused almost completely on the Marcellus Shale formation. According to the company, its all-in finding and operating costs for the current year are $1.60 which still leaves a profit of $2.05 at the current price of natural gas of $3.65. Chesapeake (CHK) and Rexx (REXX) similarly have low production costs as well as large fields in the Marcellus, Utica and other shale formations.

This selection of stocks is based upon the reasoning that basic economics will ultimately triumph. We may see ups and downs in the next two years. The government may step in to impede the end result or (although this is unlikely with Obama) to expedite the switch to higher natural gas usage. Ultimately, however, we will arrive at the point where there is a major switch to natural gas. This will raise natural gas prices a bit and absorb the increased volumes that will be produced. These three low cost producers should be enormously profitable by that time.

So, you may be asking, what could go wrong with this hypothesis. The most likely answer here is that there could be new discoveries of oil both in the USA and around the world that are so extensive that the price of oil drops to $40 a barrel or less for a sustained period. This would take away the economic advantage that natural gas needs for the switch to that fuel to continue. I truly cannot see that happening. Remember, as China and India continue to grow, the number of cars in these countries will soar and the resulting demand for oil will also soar. That means that the amount of oil that would have to be found to cut prices dramatically is extremely large.

Natural gas remains the American fuel of the future due to its cost advantage. Buying the low cost producers is a smart long term play. By the time that full usage of natural gas kicks in, these companies should be selling at much higher prices.

DISCLOSURE: I am long RRC, REXX, CHK. I have no plans to change those positions in the next week.

Please remember that prior to buying any of the stocks mentioned in this article, you should do your own investigation to determine whether or not to trade in them.

No comments: