The shale gas revolution

New technology has opened up vast natural gas reserves. It’s a game changer – and an opportunity for investors, say James McKeigue and David Stevenson. Here they tip three energy stocks to buy now.

The idea of cheap energy might seem a laughable pipe dream to British consumers, particularly after recent price hikes by utility companies. Yet for anyone living in America, one form of energy has seen its price do little but fall in recent years.

Natural gas traded in the US (there is no global market as yet, as we'll see below) has plunged from more than $13 per thousand British thermal units (MBtu) to around $3.60 MBtu today.

Why? On the demand side, last winter was the warmest the States (bar Alaska) has seen since 2000, according to the National Climatic Data Centre. So American consumers didn't switch on their heating as often. On the supply side, gas drillers ramped up output. Rising supply plus falling demand can only lead to one thing: lower prices.

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But don't expect gas prices to stay this low forever. The planet is in dire need of a reliable, accessible energy source. Natural gas fits the bill. Colourless, odourless and non-toxic, it's the cleanest-burning fossil fuel. It may not be perfect, but with coal too messy, nuclear too risky and solar and wind still too pricey, it's the best long-term alternative we have for now.

What's more, one of the reasons for its price weakness over recent years is also its greatest strength. The fact is, the potential supply of natural gas is huge. For North America, the discovery of technology that can access vast reserves of shale gas has been a game changer. Some experts believe it now has as much as 100 years' worth of supply. It's almost all due to what's known as the shale gas revolution'.

What is shale gas?

Regular MoneyWeek readers will have heard all about this by now, but in short, shale gas is natural gas trapped within shale rock formations. Over the past decade, new drilling methods and a process called hydraulic fracturing (fracking'), which involves pumping a mix of pressurised water, sand and chemicals underground to crack underground rocks and free the gas, have enabled American producers to access gas that was once uneconomic to extract.

Fracking has its critics, who raise concerns over the risk of chemicals escaping into water sources. But the US Environmental Protection Agency and many state regulators believe fracking can be carried out safely. The American Lung Association says it can also help to reduce air pollution.

Moreover, using natural gas has many economic benefits. In 2011 America produced 94% of the natural gas it consumed, says the US Energy Information Administration (EIA). That near self-sufficiency has made the fuel more appealing than crude oil, where the States still depends on foreign producers.

On top of that, cheap natural gas has created many jobs. The drilling industry is one obvious growth area, but falling energy costs have also helped make US manufacturing globally competitive again.

But with such huge supply, won't prices fall even further? Perhaps not. Because prices are so low, US gas drillers are cutting their output. The natural gas rig count a widely watched measure of future production stands at 422, reports oil and gas producer Baker Hughes. That's the lowest level in 13 years, and suggests the current surplus gas supply may not last much longer. This has helped gas futures prices to rally to the current $3.60 MBtu level from late-August's $2.80.

Meanwhile, American average household spending on natural gas could soar by 15% this winter compared with last year, says the EIA, reflecting "a return to roughly normal winter temperatures east of the Rocky Mountains". In fact, the Northeast, Midwest, and South may even be a lot colder than last winter, says the National Oceanic and Atmospheric Administration.

Mike Watford, boss of American natural gas producer Ultra Petroleum, also believes US rig operators will be reluctant to raise output until they're convinced the rally is for real. So there could be more upward pressure on prices next year.

Is shale here to stay?

What about the longer term? The EIA forecasts that, by 2035, 80% of all America's new electricity generation capacity will come from natural-gas-fired power plants. This alone is a good reason for being bullish on natural gas, and the prospects for those who produce and sell it.

But the real story may lie outside America. So far, not everyone has benefited from cheap US gas prices. That's because, unlike crude oil, gas doesn't trade in a global market. So while prices in America are below $4 MBtu, elsewhere they are much higher: $10.17 MBtu in Spain, $10.75 MBtu in India, $12.75 in China and $13.15 MBtu in Japan, for example.

One reason is that unless there is a handy pipeline available gas is much more tricky to transport than oil. It needs to be cooled into a liquid, known as liquefied natural gas (LNG), and stored in specialised containers. Then, when it reaches the other end, it needs to be turned back into gas, which requires special port facilities.

In the past, this was an expensive process, so both exporters and importers demand long-term contracts. Because gas and oil prices normally moved in tandem, these contracts were indexed to the oil price.

As a result Asian buyers, who have access to few pipelines, still pay a lot for natural gas. In Europe, the situation is slightly better because it can pipe gas from Russia or receive LNG. But now all that is gradually changing. America's glut of gas has freed up more gas for the spot' market.

For example, in the early 2000s, Qatar invested billions of pounds in building huge LNG facilities to export gas to America (which shows just how recent and rapid the shale gas revolution has been). When it became clear that America wouldn't need the gas, the Qataris had to find new buyers. While this hasn't necessarily resulted in lower prices as yet, the availability of extra supply has encouraged more and more energy importers to turn to gas.

Shale goes global

This rise in international customers for gas has coincided with, and encouraged the development of, cheaper LNG facilities. In turn, the falling cost of LNG plants means more importers and exporters have been building them. Thanks to this virtuous circle, the volume of LNG traded around the world doubled between 2006 and 2010. Now more than 40 countries import and export the stuff.

That's increased the size of the LNG spot market which currently accounts for a fifth of all gas traded creating more flexibility for buyers. Rather than lock in to costly long-term contracts, they can take the risk of buying on the spot' market. Bernstein Research estimates that LNG use will double over the next decade to 408 million tonnes a year.

The biggest demand growth will come from China, says Leslie Hook in the Financial Times. China wants gas use to more than double from 2011 levels by 2015. "Beijing sees natural gas as a cornerstone of its energy policy over the next decade because it burns cleaner than coal." It currently sources most of its gas domestically, but as demand grows it will need to increase its imports. Meanwhile, Japan and Germany are both relying on gas to help to replace nuclear power in the wake of the Fukushima disaster.

So who will benefit from a world where gas is king? On the production side, extracting unconventional gas is all about technology, whether that's used to look further offshore, or dig deeper into shale. There's lots of room for improvement.

Often "fracturing remains an expensive, brute-force exercise that wastes resources while causing unnecessary disruption to affected communities", energy analyst John Kemp notes on Reuters. "The horizontal sections of wells are often being fracked at regular intervals along the entire length, even though significant parts... have limited or no production potential because the geology is not favourable." So lots of water, energy and money is being wasted on dud wells.

A recent US Geological Survey report found that "production from the most productive wells in an area is commonly more than 100 times larger than from the poorest". The best way to improve efficiency is to be more picky about where fracking is carried out. That's why oil and gas services firms, such as Schlumberger, have developed advanced seismic equipment that gives producers a better picture of what lies beneath the ground.

Opportunities in storage, transport and consumption

Another key area is storage there needs to be somewhere to put all this extra gas. Canada, Russia, Australia and Qatar are busy building or upgrading LNG export facilities, while, Japan, Korea and China have all developed new LNG import facilities. China has also boosted its pipeline network: a pipeline from Burma should be completed this year, an existing pipeline from Turkmenistan is being expanded, and China is negotiating with Russia for a new pipeline between the two countries.

It's also upgrading its internal distribution network. It recently began work on a third East-West' line to bring gas from the interior to the energy-hungry coast. In total, the International Energy Agency (IEA) reckons $35trn will have to be spent between now and 2035 on building the production, storage and transport infrastructure to meet demand.

But perhaps the most exciting opportunities are in consumption. As gas becomes more popular, it will be used in more and more areas. For example, in America the petrochemicals industry has cut costs by using gas instead of oil. "Switching feedstock from naphtha, derived from oil, to ethane, derived from gas, has kept petrochemicals cheap even as oil prices have peaked," says The Economist. That means American firms can now "compete with the world's lowest-cost producers, the state-owned petrochemicals firms in the Middle East".

As a result, petrochemical firms are dismantling plants elsewhere in the world and returning to America. In turn, a cheap local supply of petrochemicals is helping other industries. Accountancy firm PricewaterhouseCoopers estimates lower feedstock and energy costs could create a million more US factory jobs by 2025.

Another beneficiary could be the transport sector. Gas can directly power vehicles either as compressed natural gas (CNG) or LNG. Compressed gas is stored at high pressure, which means these cars have a smaller range than their petrol equivalents. Retro-fitting cars to run on gas is also pricey. Yet more manufacturers are starting to mass-produce natural gas vehicles (NGVs).

Moreover, for large-scale commercial users that run predictable routes and have their own filling networks, such as trucking firms and bus companies, a gas-powered fleet often works out cheaper in the long run.

For NGVs to compete in the wider market, there needs to be a network of filling stations for drivers to use. In some countries, normally those with historically high gas use, that's already in place. For example, Iran, Pakistan, Argentina and Brazil have almost ten million NGVs between them and tens of thousands of gas fuelling stations. Thanks to strong growth in these countries, the global number of NGVs has increased more than tenfold over the last 15 years.

In America, where petrol has long been cheap, there are only 110,000 NGVs and around 1,000 CNG/LNG public filling stations. That's not much less than 1% of America's total number of vehicles and filling stations respectively but in the last ten years, as petrol prices have risen and natural gas prices have fallen, NGV numbers have doubled.

New filling stations are also being built and analysts expect another 1,000 to be completed by 2019. This should help sales of NGVs, particularly if petrol prices remain high. Pike Research reckons that sales of gas-powered trucks in America will double over the next seven years.

What to buy now

One firm already benefiting from the growing use of gas is gas compressor manufacturer Dresser-Rand (NYSE: DRC). Its two main product lines, turbocompressors and reciprocating compressors, make up 70% of sales. They are sold to liquefied natural gas (LNG) plants, petrochemical firms, power stations, refineries, oil and gas producers, and anyone else who needs to compress gas.

As gas production increases and the fuel is used in more industrial processes, demand for these products should only increase. "The growing complexity of developments [call] for significant compression capacities, in demanding environments," says Julien Laurent, an analyst at Natixis Securities.

Another major Dresser-Rand division around 10% of sales builds engines that run on gas or diesel, while the final 20% of sales come from steam turbines. These improve the efficiency of a factory, chemical plant or refinery, by harvesting steam created as a by-product and turning it into mechanical rotation energy. In effect, this part of the business is a play on energy efficiency.

Dresser-Rand's exposure to gas goes beyond the States North America is its biggest market, accounting for about 31% of sales, while the rest is fairly evenly spread across the world. Yet on a forward price/earnings (p/e) ratio of 15, Dresser-Rand is cheaper than many of its peers. The share price is hovering around $55, but Natixis Securities has a target of $66.

A more risky play is Clean Energy Fuels (Nasdaq: CLNE). Founded by US oil man T Boone Pickens in 2009, the firm is building a network of CNG (compressed natural gas) and LNG refilling stations in North America. The plan is to service trucking firms, with Pickens betting that natural gas vehicle (NGV) numbers will grow as firms cotton on to the savings to be had.

Gas-powered trucks are $30,000 more expensive than conventional ones, but at current fuel prices that extra outlay is repaid after 18 months. Another boost should come from improving gas engine designs, as more manufacturers enter the market.

Clean Energy Fuels currently fuels 25,000 NGVs a day at 273 locations in America and Canada. It has already raised enough money to build a further 150 stations. Friendly gas producers, who are keen to create a new market for their fuel, have even lent the firm $150m to help it expand.

Of course, being a pioneer in something like this is risky. The firm hasn't made a profit and isn't expected to for another two years. Politics is also a risk factor. After the failure of a recent bill to subsidise NGVs, the firm's shares have dropped by almost 50%. But if trucking companies do make the switch to natural gas, no other firm is better placed to benefit. It's rated a buy by Crowell, Weedon & Co, which has a $25 price target.

As for natural gas production, we like French oil and gas giant Total (Paris: FP). It's the fourth-largest global listed producer of natural gas and also one of the world's top three LNG suppliers. Total is also continuing to grow its natural gas interests. It recently agreed to buy 0.7 million metric tonnes of LNG per year from the US operation of South Korea's national producer Kogas for the next 20 years.

Further, the group has just made its first venture into Papua New Guinea, taking stakes of between 35% and 50% in five exploration blocks. And the stock is very cheap. The market capitalisation is just half its overall sales, the 2012 p/e ratio is just seven, while the prospective dividend yield is a tasty 6%.

James McKeigue

James graduated from Keele University with a BA (Hons) in English literature and history, and has a certificate in journalism from the NCTJ. James has worked as a freelance journalist in various Latin American countries.He also had a spell at ITV, as welll as wring for Television Business International and covering the European equity markets for the London bureau. James has travelled extensively in emerging markets, reporting for international energy magazines such as Oil and Gas Investor, and institutional publications such as the Commonwealth Business Environment Report. He is currently the managing editor of LatAm INVESTOR, the UK's only Latin American finance magazine.