Cheap Natural Gas is Creating its own Demand

Last week the Environmental Protection Agency  (EPA) issued emission standards tightening the rules surrounding the output of mercury and other harmful pollutants. These standards will have the practical effect of making natural gas relatively more attractive than coal for electricity generation since coal-burning plants require the installation of expensive “scrubbers” to clean the emissions they generate. Converting older plants to operate more cleanly often fails to make economic sense and as a result new power plants are increasingly burning natural gas. The Wall Street Journal noted this in an article on Friday.

Of course the shale revolution in natural gas has produced a glut of the stuff, and at $3.13 per MCF it’s barely possible to drill for it profitably. That the price has fallen so low at the onset of Winter when demand typically picks up is testament to the success of the drillers. But it does emphasize the importance of being invested in companies with low costs of production since there’s little near term prospect of higher prices.

But the longer term outlook is increasingly positive. U.S. based natural gas is now cheaper than anywhere in the world outside the Middle East, and that is drawing interest from other industries that rely on cheap sources of energy. States that sit atop the Marcellus Shale (such as Pennsylvania and West Virginia) are competing with one another to attract ethylene production facilities. And a Brazilian textile company recently chose Texas over Mexico to build a new denim factory because of a 30% cost advantage in electricity. Over time cheap natural gas will lead to cheap electricity, drawing in additional industries and creating manufacturing jobs. And this increased demand will no doubt help support prices.

It’s not a sector to own for a trade, but companies with low operating costs and minimal debt are best positioned to benefit from what’s happening. We recently added Southwestern Energy (SWN) to our Deep Value Equity strategy since it meets these criteria. We continue to own Devon Energy (DVN) whose liquids business provides a usefully profitable offset to today’s soft natural gas prices. The natural gas story continues to have many chapters.

Author is Long SWN, DVN