August 27, 2003 Opportunity in Natural Gas: How to Capitalize Throughout the multi-year downturn in global stock markets, the Perspectives model portfolio has consistently made money. One central reason is that we’ve often resorted to specialty holdings, such as gold, emerging markets and energy. The gains from these holdings were considerable and kept us firmly in the black, even during the darkest days of the bear market. One such specialty pocket is that of stocks that are sensitive to natural gas prices. Our core holdings in Devon Energy and EOG Resources have already posted handsome gains, but the best for the sector is yet to come. Let me explain why and give you my recommendations of how best to position yourself. Sporadic Shortages Here’s the problem: US natural gas demand is steadily outstripping available supplies, all while demand itself is rising. By 2010 or so, when significant new sources may finally come along, the country’s demand for natural gas will have risen a whopping 33%. So acute was the shortage of natural gas last winter that the price for the commodity more than doubled. That, in turn, curtailed activity in several key sectors of industry. Analysts expect similar price spikes in the future, whenever inclement weather takes hold or industrial activity strengthens. Federal Reserve Chairman Alan Greenspan seems to agree. So concerned is the central bank chief that he went to Congress twice in the past six months to warn of the economic consequences of not addressing the natural gas shortage! Why does the shortage exist to begin with? There are two major reasons. The first is that various “oil shocks” made it relatively easy for government to urge consumers and industry to look for alternatives. Natural gas caught on faster and to a greater extent than was anticipated by almost everyone. The second reason for the shortage is that the US has not had the political will to either spur domestic natural gas production, or to make a serious effort to create facilities to transport natural gas in its liquefied form (LNG) to US shores. Unlike Europe, where dozens of LNG terminals can accommodate inbound tankers, the US has only three such facilities. Construction of at least 12 additional terminals will be required to mitigate the situation, a process which will take years, enormous capital expenditures and which will be vigorously opposed by many who live near contemplated sites. Natural gas tankers will pose an easy target for terrorists and, for this and other reasons, are seen as a potential environmental hazard. Also on the radar screen of environmentalists are pipelines. As the grid of available pipeline capacity is expanded, protests mount. Part of the problem is that operators can often only bring natural gas to the contiguous United States by running part of their lines under the ocean, which heightens environmental risks. Two years ago, the Bush government introduced a plan to move on several fronts at once. By bringing massive reserves of natural gas into production and making a $20 billion investment in new pipeline capacity, the administration would have liked to solve the natural gas impasse once and for all. But both sides of Congress have signaled that the plan is doomed. Natural Gas Statistics World’s largest reserves (trillion cubic meters) Russia Iran Qatar Saudi Arabia United Arab Emirates United States Algeria Venezuela Iraq 1,680 812 509 224 212 183 160 148 110 World’s largest producers (billion cubic meters) Russia United States Canada 555 548 183 World’s largest consumers (billion cubic meters) United States Russia United Kingdom Germany Canada Japan 667 388 94 83 81 77 All statistics: BP Statistical Review of Energy Why? The key problem is that the Bush administration wanted to tap the huge natural gas beds in Alaska, including inside the Arctic National Wildlife Refuge. Opponents of the plan have ridiculed the energy proposal as extremely shortsighted and, from an environmental perspective, they’re probably right. What is rarely said, however, is that the massive reserves of US natural gas (the world’s largest outside of the Middle East and Russia!) are almost exclusively situated in areas which are as environmentally sensitive as the Arctic Wildlife Refuge. In short, the message the US government created--namely to use clean-burning natural gas over oil--has been wildly successful, but efforts to increase supplies have stalled on every front. In a way, then, the natural gas imbalance is a microcosm of the US energy situation as a whole. When all forms of energy are considered, the United States lacks a coherent vision. On the one hand, Americans from coast to coast completely lack the will to cut back on even the most wasteful usages of energy; on the other, they oppose creating incentives for added production. Natural Gas the Preferred Energy Source Natural Gas Statistics The US Supply Deficit (billion cubic meters) 2002 shortfall 119 Pipeline imports from Canada LNG imports from Trinidad LNG imports from others 109 5 5 Total imports 119 The trouble with natural gas, in particular, is that reducing demand voluntarily is not easily done. Just as individual consumers using natural gas are unlikely to replace their heating systems in order to switch back to oil, industry is equally inflexible. More and more of America’s utilities use natural gas-fired generators to create electrical power. Whole sectors of industry, also, are woefully dependent on natural gas: the chemical industry, in particular, uses natural gas in the production of fertilizers, plastics and synthetics. Pulp and paper mills, as well as the steel, glass, automobile and food processing industry use natural gas as their primary energy source. Moreover, as new regulations curtail environmentally unfriendly energy (coal) or energy that’s considered unsafe (nuclear), natural gas usage is boosted even further. The bottom line: a sizeable supply deficit for natural gas will remain for years, which will lead to sporadic price spikes. Timing these spikes will prove difficult, as fluctuations in weather patterns and industrial activity are notoriously difficult to predict. For you as an investor, that means that the best time to position yourself in this volatile arena is at times of weakness in natural gas prices. The certainty that a balancing of demand and supply will take years to accomplish will most likely lead to a protracted uptrend at least in the near and intermediate terms. The reason I’m writing to you today is because natural gas prices have retreated sufficiently since last winter to make investment compelling. From a seasonal viewpoint, as well, the timing appears favorable. Winter is not far away and the odds are good that the US will once again enter the cold season with insufficient natural gas inventories. And finally there is the economic cycle. The US, Canada and Japan, three key natural gas users, are all in the recovery phase. What to do now One way to play natural gas is to buy commodity futures or options on futures. Both belong to the realm of seasoned traders, which is not the constituency of Perspectives. The preferred vehicle for investors is that of energy stocks with a strong natural gas exposure. We already hold core positions in two such companies: Devon Energy and EOG Resources. Today, I’d like to add two other firms with good leverage to natural gas: Encana Corporation and Burlington Resources. At the same time, I’d like to significantly boost our exposure to the natural gas sector. But more about that later; let me first tell you why I believe in this quartet of natural gas sensitive stocks. Devon Energy (NYSE:DVN). Devon represents the largest energy holding in my model portfolio. I view it as the premier investment for those seeking a company with extraordinary growth and strong leverage to natural gas price movements. An independent energy company engaged primarily in oil and gas exploration, development and production, Devon holds a strong portfolio of producing properties in the United States, Canada and abroad. Management has done a superb job in growing through a string of well-timed and superbly executed acquisitions (in the past three years Mitchell Energy, Anderson Exploration and Ocean Energy) and it has also been very successful in growing reserves and converting them into producing assets. Devon is vulnerable to a decline in natural gas prices, but will handsomely benefit in an environment of price strength. Current Share Price: 2004 Cash flow per share: US$50.90 US$12.47 Yield: 0.4% Price/2004 Cash Flow: 4.1X EOG Resources (NYSE:EOG). EOG explores, develops, produces and markets natural gas and crude oil. The company operates mainly in the United States (67% of production), Canada (16%) and Trinidad & Tobago (17%). EOG’s growth profile is compelling, and the company’s most recent acquisition of Canadian assets from Marathon may boost it further. What attracts me to the stock: EOG trades at a reasonable valuation, has a very strong balance sheet, and a whopping 87% of operations is weighted towards natural gas! Current Share Price: 2004 Cash flow per share: US$40.90 US$8.25 Yield: 0.5% Price/2004 Cash Flow: 5.0X EnCana Corporation (NYSE: ECA, TSX: ECA). EnCana was formed through the merger of Alberta Energy and PanCanadian Energy Corporation. It is an independent natural gas producer and gas storage operator. Approximately 90 of the Company's assets are in four key North American growth platforms: Western Canada, offshore Canada's East Coast, the United States Rocky Mountains and the Gulf of Mexico. EnCana also operates in Ecuador and the North Sea. I like the company because it has extraordinary exposure to natural gas. Current Share Price: 2004 Cash flow per share: US$36.80 US$7.80 Yield: 0.8% Price/2004 Cash Flow: 4.6X Burlington Resources (NYSE:BR). Through its principal subsidiaries, Burlington Resources Oil & Gas, Louisiana Land and Exploration, Burlington Resources Canada and Canadian Hunter Exploration Ltd., BR is engaged in the oil and natural gas exploration, development, production and marketing. The Company conducts business in North America, Canada and elsewhere. Burlington Resources is not capable of the type of growth I foresee for the other three companies, but it has superb leverage to natural gas. Each 10-cent shift in the commodity price translates into a gain of roughly 4% in next year’s cash flow! Current Share Price: 2004 Cash flow per share: US$47.75 US$8.85 Yield: 1.2% Price/2004 Cash Flow: 5.4X How much to buy? Our model portfolio currently holds a healthy exposure to natural resources stocks, which keeps appreciating. At market prices, natural resources now make up 21.5% of total equities. Natural gas oriented stocks make up only a modest part of that: about 1.75% has been held in Devon Energy and 1.75% in EOG Resources. I’m now positioning the portfolio to take advantage of what I believe will be a protracted uptrend in natural gas prices. At this time, I’ll double the exposure we hold in Devon and EOG, while adding 2% positions in each of Burlington Resources and EnCana Corporation. I may recommend further additions as the story develops. £ Publisher: Cavelti & Associates Ltd., Toronto, Canada. All rights reserved.