Cooking With Gas
Natural gas prices are soaring amid growing demand from U.S. power generators, and the market isn't likely to wane any time soon, ANDREW BELL writes. Investors, many of whom will pay vastly higher heating bills this winter, may want to ease the sting by buying shares of major Canadian natural gas producers.
ANDREW BELL Saturday, November 18, 2000 Globe and Mail
Feel that nasty draft? It's coming from south of the border, where power-mad America is terrified that this winter may be a frozen ordeal as energy shortages worsen. Oil prices crested above $34 (U.S.) a barrel on the New York Mercantile Exchange (Nymex) this week -- up from less than $12 last year and only just short of the 10-year highs of more than $36 they set in October. But the real heat is building in the market for natural gas, the relatively clean-burning and flexible fuel that has become the energy source of choice for a digital economy with an insatiable demand for electricity. For investors, many of whom will be paying vastly higher heating bills this winter, the bull market in natural gas is an opportunity to earn a fat profit on the shares of major gas producers, analysts say. Natural gas-fired electricity plants in the United States will burn 38 per cent more gas in 2000 than last year, energy consulting firm Resource Data International says. For the natural gas market, "there's a new sheriff in town," says Martin Molyneaux, veteran oil and gas analyst with First Energy Capital in Calgary. "And that is the electricity players." Natural gas for delivery in December blasted through $6 per million British thermal units on Nymex this week, setting record highs. Gas prices have soared from less than $3 in 1999 and less than $2 in 1998. To be sure, some of these stocks have already had a major runup and they're vulnerable to any correction in energy prices. Few professional observers expect gas to maintain its current lofty valuation of about $6 -- CIBC World Markets analysts, for example, assume a Nymex price of only $3.85 for this year and $3.75 for 2001. But astute observers argue that the power industry's insatiable demand for gas will support prices for years to come. Electricity producers love the flexibility, low emissions and easy construction of gas-fired power plants. Gas bulls include Michael Economides, a chemical engineering professor at the University of Houston, who's celebrated for making a canny prediction last year that oil would soon top $30 a barrel. Prof. Economides and colleague Ron Oligney co-wrote this year's The Color of Oil,a popular history of the industry. They reckon natural gas is set for a long-term boom and it'll supply one-half of the world's energy by 2020, compared with about one-fifth now. What about natural gas prices in the near term? Prof. Economides says prices will hit $7 early in the winter. "It's impossible to avoid shortages next winter, irrespective of weather," he predicted in a speech this summer. As for the longer term, "we're in for a three- to five-year bull market that will make this market pale by comparison," he told Dow Jones Energy Service. Some analysts are even talking about the potential for $13 natural gas this winter. And that's "predicated on normal weather for a month, not a normal winter," Credit Suisse First Boston analysts said on Nov. 3. "We will be surprised if the strain on the natural gas system, which is already at record levels, does not become more acute as winter develops." Why is this happening now? In short, because electricity producers, unlike traditional heavy users of the fuel, such as chemical companies, can't stop buying gas as prices rise. "Electricity companies don't care about price, they care about reliability of supply," First Energy's Mr. Molyneaux says. Electricity prices have been spiralling upward in some parts of the United States as demand outstrips supply, leading to service interruptions but also allowing power companies to pay higher prices for gas. So how do investors make money off expensive natural gas? The first and most obvious way is to buy shares of big Canadian energy producers that get a large portion of their revenue from gas. But get ready for a jerky ride: For example, shares in giant gas producer Alberta Energy Co. Ltd. topped $65 (Canadian) in October as energy prices soared, but by this week they had sunk below $59. The shares of most big gas producers have jumped more than 20 per cent this year but they still trade at only three or four times their projected cash flow per share for next year. That's low for energy producers, which historically have fetched a multiple of between 4.5 and 8.5 times their cash flow. Gas stocks won't move up decisively until prices have stabilized in a range that investors think will hold, says Mr. Theal of CIBC World Markets. "Until we move to sustainable gas prices, they're largely just going to go sideways." Our chart below shows a mixture of 10 "gassy" producers, ranging from giant Shell Canada Ltd. with a market capitalization of $10-billion to volatile up-and-comer Berkley Petroleum Corp., which investors were valuing this week at just over $700-million. The most stable choice is probably Shell, one of Canada's four giant "integrated" energy companies that pump oil and gas out of the ground, process it and sell the fuel. Shell's earnings soared 56 per cent to a record $226-million or 82 cents a share in the third quarter as gas gushed faster than expected from its 31 per cent owned Sable Island project off Nova Scotia. And for the nervous, there's a bonus: A dividend yield of 2.2 per cent, which is rich for the oil patch. Having said that, Shell shares, which traded at just over $36 this week, up 26 per cent this year, aren't cheap. In a September report, Nesbitt Burns Inc. analyst Philippe Hervieu calculated that the stock was trading at just over seven times next year's cash flow per share, compared with a 5.7 average for its peers. He rated the stock a cautious "market perform." Investors looking for income and a potential capital gain from the surge in natural gas have also been turning to Shiningbank Energy Income Fund, a royalty trust that has concentrated on gas since its launch in 1996. As of this week, its units had surged 40 per cent during 2000, to trade at about $15. In a report this fall, Nesbitt analyst Gordon Tait estimated the trust will pay $2.60 a unit in distributions during 2001, calling it a "top pick." In the past 12 months, Shiningbank has paid $2.21 a unit. Further out along the risk spectrum are "senior" producers that have concentrated on gas production -- Alberta Energy, Anderson Exploration Ltd., Canadian Hunter Exploration Ltd., Penn West Petroleum Ltd. and Rio Alto Exploration Ltd. As of this week all of the companies' shares had gained more than 29 per cent in 2000 except for Penn West, which had climbed 17 per cent to trade at just over $32. The stock is trading at a low multiple of about 3.2 times forecast cash flow for next year. Penn West shares, which have soared five-fold since 1995, have been hampered lately by investor fears that the company is running short of promising properties, Nesbitt analyst Kurt Molnar said in a September report. However, he argued that Penn West, renowned for keeping a tight lid on expenses, has simply been restraining its expenditures because industry costs are rising. "This approach generates superior returns for shareholders in the longer term." He called the stock a "top pick," predicting it will hit $49 in a year. For institutional investors, the premier plays among gas-heavy producers are Alberta Energy and Anderson, with their gigantic market values of $8.5-billion and $4-billion, respectively. But according to First Energy's Mr. Molyneaux, Rio Alto, Canadian Hunter, Alberta Energy and Anderson all offer investors the three essential qualities for a successful gas company. Those are big tracts of undeveloped land, geological and engineering expertise and a "really sharp" marketing department, "because you've got to be on your toes in terms of what's going on electricity-wise." Then there are the intermediate producers such as Berkley, Bonavista Petroleum, Encal Energy and Paramount Resources The potential rewards may be greater with these smaller companies, but so are the risks: Shares in former high-flier Berkley, an aggressive explorer that specializes in higher-risk projects, have slumped 40 per cent this year after the company disappointed investors. Nesbitt's Mr. Molnar said in September that he reckons the stock will be an underperformer until the company "can demonstrate that it can achieve targets and grow at a reasonable cost." Finally, and potentially most leveraged of all to gas prices and exploration, is Enerflex Systems Ltd., a major supplier of gas compression systems. The stock traded this week at just over $28, down from more than $38 this summer. Investors were disappointed with the company's second-quarter earnings, which dropped 11 per cent to $2.3-million or 16 cents a share as gas producers tried to keep their capital expenditures under control. Don't expect to double your money in any of these stocks quickly -- betting on commodities is almost always a losing proposition. And soaring gas will eventually self-correct when it becomes too expensive to use. Just as producers across North America step up supply, many natural gas users are cutting back on their consumption. "With supply increasing, I think there's going to be demand-side management at these prices," Mr. Theal of CIBC World Markets says. "That's going to temper the gas market." And this week's spike was caused by a cold snap across the United States, meaning prices will almost certainly drop in the short term if the weather turns mild. But don't underestimate the energy chaos and potential for electricity shortages in the United States, either. Long term, demand for gas is almost certain to climb as hungry new power-generation companies build their gas-fired plants. In fact, many American consumers got off easy this past summer, because cool weather reduced the need for air conditioning, according to Steve Bergstrom, president and CEO of aggressive energy generator Dynegy Inc., which operates a string of "merchant" power plants selling juice in several states. "You haven't had any weather this year in the Midwest," Mr. Bergstrom told a conference this summer. "If you'd had normal weather, you would have seen an enormous amount of brownouts and curtailments." His plea to gas producers: "Go drill; we need the resources." Deciphering Gas Measurements Just to make everything even more complicated, the gas industry likes to use a multitude of different measurements and prices. But here's the lowdown. The benchmark for much of the industry is the price paid for gas for delivery next month, a futures contract traded on the New York Mercantile Exchange. That's quoted in U.S. dollars per British thermal unit (or BTU). BTu is a measure of energy, but it's simple to do a rough conversion into the more familiar cubic feet. As a widely used rule of thumb, one million BTU is the same as one thousand cubic feet. A British thermal unit, as if you needed to know, is the quantity of heat needed to raise the temperature of one pound of water by one degree Fahrenheit at or near 39.2 degrees Fahrenheit. A gigajoule is another unit of energy used for gas. One million BTUs is equivalent to 0.95 gigajoules. The benchmark Nymex futures price is based on gas at the great Henry Hub storage facility in Louisiana, while the prices many Canadian producers get are based on those paid at Alberta Energy Co. Ltd.'s AECO-C storage hub in southwestern Alberta. Back in 1998, Canadian gas that's transportable to the United States fetched about $1.80 (U.S.) less per thousand cubic feet than U.S. gas, reflecting high costs for pipeline transportation. But new pipelines -- including the Alliance Pipeline from Western Canada to Chicago, which is already shipping massive quantities southward despite teething troubles -- mean the differential has narrowed to between 35 and 70 cents lately, according to a Nov. 8 report from CIBC World Markets. The North American gas market will "become a fully integrated competitive gas market," the brokerage predicts.
Some have already soared
Nat. gas as Share % chg 2001 cash Stock a % of 2001 price this in price flow per price/cash production week, $ this year.share, $* flow
Alberta Energy. 59% $61.45 37% $16.08 3.8 Anderson Exp. 71 28.20 64 7.60 3.7 Berkley Pet. 67 7.50 -41 2.09 3.6 Bonavista Pet. 90 27.00 66 5.65 4.8 Cdn. Hunter Exp. 89 35.90 51 8.62 4.2 Encal Energy 64 9.50 44 3.07 3.1 Paramount Res. 97 16.15 -5 3.85 4.2 Penn West Pet. 62 33.00 17 10.12 3.3 Rio Alto Exp. 83 26.35 29 8.09 3.3 Shell Canada 63 37.00 26 4.79 7.7 TSE oil & gas prod. index 30 Enerflex Systems 28 -25 Shiningbank Energy Inc. Fund 14.85 39
-* First Energy estimate, based on gas price of $4.75 (Can.) per thousand cubic feet Source: First Energy Capital; Bloomberg Financial Services