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A Reasonable Speculation
By Chris Mayer December 7, 2006

Anytime the price of anything drops two-thirds in a matter of months, it is worth checking out the story. Financial train wrecks like these can make interesting reading over boiled eggs and coffee — as long as your dollars weren't riding on the train. For investors, though, it's more than something to digest over breakfast. It's the sign of possible new investment ideas on sale.

And so we take a look at the price of natural gas. As the "Natural Gas — Where to Next?" chart shows, it's taken a beating. And natural gas companies sit well off their highs, but more on that later:

The chart title poses a question, which I will take a guess at answering. First, you should know that natural gas prices are highly seasonal and dependent on the weather. We had a balmy winter last year. That meant a lot of leftovers in natural gas storage in the spring. It's like buying a lot of beer and wine for a dinner party, only to have the usual heavy drinkers not show up. On top of that, hurricane season was practically a nonevent. Someone forgot to tell the hurricanes it was time to do their thing. (More on that too later in this letter.)

These effects seem temporary. A cold snap could burn through that excess supply in a hurry. Besides, there are structural reasons for natural gas to stay at pretty high levels ($5-plus) compared with what it was in the late 1990s (under $3), at least for the next few years.

"Structural reasons" is high-minded Wall Street chatter for "things that look pretty obvious long term."

For instance, natural gas powers 95% of the electricity capacity built in the U.S. from 1998–2005. Awash in cheap gas for most of the 1980s and 1990s, we did a lot of switching from coal to gas. Not only was gas cheaper, it was much easier on the environment.

Further grist for the mill: Each fall, the North American Electricity Reliability Council (NERC) puts out its forecast on the reliability of the America's power grid. This year's report showed demand growing 3 times as fast as capacity additions. Capacity margin, a measure of the ability of a system to meet with unexpected extreme weather and other contingencies, will fall below the minimum target of 15% in most of the U.S. There is little slack in the system, and gas figures prominently in America's power supply.

Natural gas trails only coal as the fastest-growing energy source in America (see nearby chart). The EIA Annual Energy Outlook 2006 forecasts demand to rise 22% from now until 2030. This includes a 62% increase in gas used for electric power generation. As is, gas meets 23% of the nation's energy needs.

So the short story here is that demand for natural gas looks pretty steady:

What about supply? As the Red Queen (of Lewis Carroll's Through the Looking Glass ) says, "It takes all the running you can do, to keep in the same place." Once natural gas is gone, it is gone for good and new supply must replace it. Most of the natural gas we use comes from North America. Only 3% of natural gas supply comes from imports of liquefied natural gas (LNG).

Therefore, North American consumers rely most heavily on North American producers. While there is plenty of natural gas, companies must drill deeper and work harder to get at it. And we've picked over North America pretty well. Relying on larger imports of LNG is not feasible because it requires significant infrastructure — infrastructure that currently meets with all sorts of political pressures opposing it. Perhaps someday LNG will be the answer, but that appears years and years away.

All of these reasons, combined with the steep slide in gas prices, lead to me to think warm bullish thoughts about natural gas — the creator of that familiar blue flame. Still, my crystal ball is as fogged over as ever on predicting future prices. But I do like the odds of higher gas prices in the near future.