How to buy into the 21st century's most vital energy source

The world has woken up to the importance of natural gas in recent week, says Martin Spring of the On Target newsletter, as Russia's dispute with Ukraine over gas prices gave Europeans a nasty shock. Here he uncovers the stocks best-placed to benefit from 'the fuel of the century'.

If the 19th was the century of coal and the 20th the century of oil, the 21st seems set to be the century of natural gas.

In recent weeks we have seen this resource, once widely regarded as an oilfield nuisance to be burned off into the atmosphere, emerge as a key element in the intensifying competition for control over world energy supplies, and give special meaning to the phrase "power politics":

- Europe has been shocked into realizing how dependent it is on Russian gas to fuel its factories and power stations and heat its homes, when an ugly dispute between Russia and Ukraine over gas prices threatened to cut pipelined supplies from the East, which meet almost half the European Union's needs. This will give new impetus to diversification to North African sources, as Western Europe's own gas reserves are being used up.

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- Moscow has scrapped restrictions on foreign ownership of Gazprom, the state-controlled giant which owns an amazing one-third of global natural gas reserves, as a step towards developing it into the world's biggest energy company. Russia is increasingly using its gas and oil supplies as a political weapon to expand its influence.

- Evo Morales, president-elect of Bolivia, threatens to revoke foreign companies' rights to exploit his nation's gas deposits, South America's second biggest the latest example of resource-rich countries' focus on grabbing a larger share of the wealth generated by foreign investors.

Natural gas is the world's fastest-growing major energy resource. Demand for it has been expanding nearly twice as fast as for oil over the past five years. It now supplies almost a quarter of the world's energy needs, and is expected to overtake oil to become the most important energy source in about 20 years' time.

Natural gas is found in greater abundance than oil, and in similar locations. It's the most convenient fuel for industrial and domestic heating. And it's environmentally-friendly when burnt, it produces much less carbon dioxide than other fossil fuels. Not surprisingly, almost all new power plants built in the US in recent years are gas-fuelled.

Traditionally, most natural gas has been transported from where it's found to where it's needed by pipelines. And lots more of those are being built, especially by Russia, which has the world's largest reserves.

However, investor attention these days is focused on the alternative way of moving the stuff turning it into a liquid by freezing to 163 degrees below zero, carrying it across the seas in refrigerated tankers, and then heating up the liquid to turn it back into gas.

It's this technique known as LNG, for Liquefied Natural Gas that is going to transform the industry.

With pipelines, you can only deliver gas to the places the lines go to. With LNG, you can unload on any coast where there's a "re-gas" terminal.

Until a few years ago, LNG was too expensive a business to be able to generally compete. It has only been used where pipelining was impossible for example, to bring gas to Japan and Korea from Indonesia.

It's still a massively expensive business. A single LNG "train" liquefaction plants, tankers and regasification terminals typically costs $5 billion for an annual capacity of 5 million tons. But engineering advances and economies of scale have cut costs by two-thirds since the late 1980s.

And natural gas has also become a more profitable business as the prices of all energy resources are higher. Because of strong demand they're expected to stay well above the break-even point for LNG, generally considered to be about $3.50 per unit, or about 40 per cent of the level at which futures markets suggest gas will trade over the next six years.

Shipping frozen energy to market

LNG is going to be one of the big new trends in global energy, with annual tonnage shipped in this form forecast to rise from 120 million in 2003 to 315 million by 2020. The energy industry expects to invest some $100 billion in LNG facilities over the next ten years.

Its "green" advantage alone would be enough to ensure a bright future for natural gas, but other favourable factors have also come into play:

- Nations that are major producers as well as consumers are running out of domestic resources, forcing them to seek supplies from abroad to meet current and future needs.

The US already imports a fifth of the gas it needs, mainly by pipeline from Canada. Now it's on the verge of a massive move into importation of LNG, with more than 30 terminals planned in addition to the existing four.

The UK, the world's fourth biggest gas producer, is starting to run out of resources. It's planning to import gas by pipeline from the Continent, to which it has been an exporter, and to bring in LNG from Africa.

China has a huge programme under way to import LNG from Australia and Southeast Asia. It plans to invest $26 billion in 50,000 kms of pipelines and LNG terminals.

- Natural gas is increasingly viewed as a strategic alternative to oil, because it can be sourced from countries that are friendly and politically stable such as Australia, Norway, Qatar, or at least located far from the Mideast (Russia, Nigeria).

It will even be an alternative source of liquid fuels. The South African company Sasol, a world leader in gas-to-liquid (GTL) technology, is involved in projects in China, Qatar and Nigeria to convert gas into exceptionally "clean" diesel fuel. Several oil giants have followed Sasol with GTL projects in Qatar.

The Gulf state expects to produce as much as 750,000 barrels of GTL diesel a day by 2010. If, as independent analysts claim, this can be done at a cost of about $14 a barrel, it's going to be a highly profitable business.

As natural gas competes directly with oil in major uses such as power generation, prices of the two tend to move together. However, gas prices have lagged in recent years. One reason is that gas supply is largely restricted to the pipeline networks that carry it, whereas oil can be moved easily to wherever it's in demand. This limitation will erode in time as a higher proportion of gas is moved in the form of LNG.

Some natural investment opportunities

How can you invest in this buoyant industry?

Unfortunately there are no collective funds specializing in gas stocks. The few funds devoted to the global energy sector focus on companies that mainly produce oil.

There are many companies listed in the US which mainly produce or distribute gas rather than oil, but their businesses are overwhelmingly geared to American resources and markets.

Some examples are: San Juan Basin Royalty Trust (100% gas), which has recently been trading on a price/projectd earnings multiple of 9x; XTO Energy (83% gas, 9x); Encana Corp. (83% gas, 9x); and Cimarex Energy (71%, 6x).

All the international oil companies have substantial interests in natural gas, but it usually only accounts for about a quarter of their value, the rest coming from oil production or downstream (refining and distribution) activities.

The world's biggest natural gas company by far is Russia's Gazprom, and you can invest in it, for example through its London listing. But would you want to, given its awful management and role as a tool of the Russian state?

The only large company that is a pure gas play is Britain's BG Group, which is diversifying away from its core business producing and selling North Sea gas, and has worldwide interests, including output in Trinidad and Egypt. It has been a first mover in the field of LNG and controls of one of the four terminals in the US. Management is excellent, but the stock has recently been trading on an expensive historic PE of 24x.

Another option is to buy Australia's largest oil and gas independent, Woodside Petroleum, which is focusing increasingly on gas as it wholly or partially owns offshore deposits - Northwest Shelf, Pluto, Sunrise, Browse - will be exploited to produce LNG for Asian consumers. It plans to double its output within five years. Shell owns 34% of the company, whose shares currently trade on an historic PE of 24x.

Another approach to investing in natural gas is to invest in supply industries, such as those building terminals and LNG tankers (which cost about $160 million apiece).

Companies to consider include Spain's Repsol, Toronto-listed TransCanada and Sempra Energy in the US. Shipyards in Korea Samsung Heavy Industries, Hyundai Heavy Industries and Daewoo Shipbuilding have got the lion's share of recent orders to build 100 LNG tankers. Bergesen, a specialist gas shipping company, was recently listed on the Oslo stock exchange.

Canadian analyst Kurt Wulff expects the ratio of oil to gas prices in US dollars to move in favour of gas from seven times now to an average of five times over the next decade.

"This appears to be a good time to buy global natural gas," he says. To invest on the assumption that the disparity between gas and oil prices, relative to their energy value, will close "looks like a good long-term bet."

By Martin Spring in On Target, a private newsletter on global strategy