The Easy Money Has Been Made
By Rich Rosen
March 10, 2012
As investment professionals, we chafe whenever we hear that expression. Why? Because in this business, there is no such thing as easy money. All our investment decisions are the end result of a great deal of research. Rarely are our greatest expectations realized, but neither are our greatest fears. In either case, it is never ‘easy.’ Having said that, we feel confident in forecasting that an investment in natural gas (once it bottoms this spring/early summer) will perform substantially better going forward than it has for the last several years and with less risk.
Thanks to the application of fracking technology to shale formations, the supply of gas in the U.S. has been significantly increased in recent years. The market has grown ever more imbalanced however, due to an inability to export this bounty or stimulate enough additional demand through the displacement of other fossil fuels. Compounding this problem was a ‘use it or lose it’ stipulation in many drilling leases which fostered a growth of supply regardless of price or profitability. The spot price of gas, now roughly $2 per million cubic feet (mcf) , is not only close to 90% below the all-time high, set in 2008 (the price has declined more than Greek bonds, for crying out loud, and at least gas can keep you warm!), but is also roughly 60% below where it was just last June. In the near term, forces are in place to make it possible for prices to collapse even further, possibly below $1.
So why be bullish, other than to cite the same contrarian logic espoused by others over the past several years? In one word, change (it is an election year!). Exploration and Production companies have shifted their investment dollars to oil-rich opportunities, where they can earn a return above their cost of capital, something they just can’t do with gas at these prices. We expect this trend to continue at least until the economics change substantially for gas-related investments. We see this change in behavior by looking at the gas rig count, which has fallen sharply and by production rates in the most prolific shale formations which have recently rolled over. If true, then why are gas prices still going down, not up? Because seasonal demand is weak, thus compounding the effects of the huge inventories already built during one of the warmest winters on record. So, the turn is happening. It just can’t be seen at the surface. Looking forward, even a normal winter will boost demand in the face of what will be reduced supply growth. Importantly, we don’t need to dream about natural gas powered autos or exporting Liquid Natural Gas (LNG) to build a bullish case, only a return to a clearing price that delivers an economic return for the marginal producer. That is roughly $5 per mcf. So, do we need to load up on gas-related assets today? Not necessarily. But from the perspective of a long term investor, it certainly appears to us that after numerous false starts that we are in position to go shopping if these opportunities present themselves soon. What is the risk? With supply correcting, the biggest risk would be a demand-crushing decline in the economy that would postpone the recovery we foresee, though another warm winter wouldn’t help either. Finally, though the price of gas is $2, some stock valuations anticipate higher prices.
We think that there are unsustainable factors weighing down the price of gas; at some point companies will require a return at or above their cost of capital. In the meantime, in spite of politicians and commentators lauding the bounty of cheap and plentiful gas, exploration companies are turning to oil-based opportunities for the same reason: The price is too low! For the long term investor, an opportunity is beginning to present itself to invest in a heretofore hard to invest industry as gas prices get set to rise from below $2 to $5, over time. Our advice is to keep your powder dry until gas prices spike down in the next little while, an event that, if it happens, will create havoc and opportunity within the market.
Though never easy and certainly not without risk, opportunities like these are often looked back upon with regret by those who missed out because “the easy money has been made.”
The views expressed are as of 5/7/12, may change as market or other conditions change, and may differ from views expressed by other Columbia Management Investment Advisers, LLC (CMIA) associates or affiliates. Actual investments or investment decisions made by CMIA and its affiliates, whether for its own account or on behalf of clients, will not necessarily reflect the views expressed. This information is not intended to provide investment advice and does not account for individual investor circumstances. Investment decisions should always be made based on an investor's specific financial needs, objectives, goals, time horizon, and risk tolerance. Asset classes described may not be suitable for all investors. Past performance does not guarantee future results and no forecast should be considered a guarantee either. Since economic and market conditions change frequently, there can be no assurance that the trends described here will continue or that the forecasts are accurate.
Investment products are not federally or FDIC-insured, are not deposits or obligations of, or guaranteed by any financial institution, and involve investment risks including possible loss of principal and fluctuation in value.
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