2012 is barely two weeks old, but investment markets have apparently already claimed a casualty: natural gas.
The generic gas contract traded on the New York Mercantile Exchange (NYMEX) has fallen to its lowest mid-winter price since the 1990s–$2.67 per million British thermal units (MMBtu) as of this morning. And with temperatures in the US South and East Coast expected above normal the next two weeks, the price could well fall further.
Some 51 percent of US households use natural gas for heating, and gas’ share of power generation has surged to nearly 30 percent in recent weeks. Use of gas for transportation continues to rise. And several companies in both the US and Canada have filed for permission from federal regulators to revamp liquefied natural gas (LNG) import facilities for exporting.
The latter holds particular promise, as gas prices are far higher overseas than in North America. This week, for example, the equivalent to per MMBtu prices in the UK was averaging around $8.47, more than three times the NYMEX price.
All of that, however, has to date been dwarfed by the flood of new supply, which has pushed inventories in storage to new heights. Last week domestic dry gas production hit 64.1 billion cubic feet per day, a level 10.3 percent above last year’s level. Gas in storage at last count was 17 percent above its five-year average and 13.3 percent above last year.
Gas production has surged primarily because of vast discoveries of shale reserves across North America. At least some producers have begun pulling back on output due to the fuel’s steep drop in price over the past year. Also, a handful of states and the US Environmental Protection Agency (EPA) are investigating the impact of hydraulic fracturing on surrounding areas. “Fracking”–essentially using a water/sand-based mixture to blast fissures in rock–is the primary method for exploiting shale reserves of oil and gas.
It’s likely new regulations will push up the cost of fracking in coming years, even as domestic gas use and exports become possible. Producers’ hedge positions, however, have locked in well above market selling prices for many companies for 2012, and well beyond for some, such as master limited partnership (MLP) Linn Energy LLC (NSDQ: LINE).
Meanwhile, a boom in demand for liquids like ethane, which occur with gas in many areas, has made it economic to continue producing even at very low prices. Ethane–a low-cost substitute for petroleum in manufacturing plastics–is separated from the dry gas at a processing facility. And as it’s priced relative to oil, it can be sold at a hefty margin, allowing companies to use dry gas as a loss leader.
The upshot is demand for gas is likely to keep rising. With coal high priced globally and renewable energy mandates kicking in, its use in generating electricity is likely to accelerate. But, at least for the next few months, that’s going to be more than offset by massive over-supply. And though prices have fallen so far now they’re likely to stabilize, there’s little reason to expect a real recovery in price any time soon, even back to the $4 per MMBtu range that prevailed last summer.
Odds are not many income investors own shares in the various natural gas exchange-traded funds (ETF), which attempt to mirror the price of the fuel. There are, however, many dividend-paying stocks backed by companies that are affected one way or other by the steep drop in gas prices:
- Producers of natural gas that pay a high percentage of cash flow to investors in distributions, such as US MLPs, unit trusts, the former Canadian royalty trusts and other corporations such as Encana (TSX: ECA, NYSE: ECA). Their profits are directly impacted by changes in natural gas prices, which has an immediate impact on their ability to pay dividends.
- Owners and operators of energy midstream assets such as pipelines, processing facilities and storage, organized as MLPs, the former Canadian income trusts and pipeline-focused corporations like Williams Companies (NYSE: WMB). These companies are considerably more insulated from changes in energy prices, as revenue is secured by long-term contracts with producers. In addition, many of these are structured as “take-or-pay,” meaning the facility owner gets paid even if the producer doesn’t ship or process anything.
- Power generators, from independent power producers to regulated electric utilities. Falling natural gas prices have dramatically cut costs for generators relying on the fuel like Calpine Corp (NYSE: CPN). Wholesale power prices, however, are directly set to gas prices in states like Texas. Rising gas prices raise margins, while falling gas slashes them.
Where Risk Lies
How worried should income investors be? In this age of playing the averages, much of the money governing daily market fluctuations simply treats all companies in an industry the same way. Even a negative blog post can trigger sector-wide selling, as evidenced by the one-day slide in most pipeline owners this week.
That’s certainly nothing income investors haven’t seen the past few years. And as we’ve seen time and again, the impact is always temporary, so long as companies’ underlying businesses remain on solid ground and dividends are secure.
Consequently, the only real worry income investors have is if their individual companies’ profits are at risk to the natural gas plunge. And the answer varies widely from company to company, depending hugely on management decisions the past several years.
We don’t have to go further than the 2008 crash to see how vulnerable these sectors can be to crashing energy prices, particularly producers. Linn Energy was able to hold its distribution steady throughout the crisis, thanks to locking in selling prices for essentially all of its natural gas several years into the future. In fact, Linn was able to take advantage of others’ weakness, using its locked in cash flow to increase output and reserves.
So did a handful of Canadian companies, such as Vermilion Energy Inc (TSX: VET, OTC: VEMTF), which had the advantage of selling the majority of its oil and gas in Europe and Australia/Asia. Super Oils avoided dividend cuts despite a steep plunge in profits, thanks to very little debt and extremely conservative payout policies to begin with.
Many producers, however, were forced to slash their payouts at least once during the 12 months following the mid-2008 price peak in oil and gas. Some were forced to eliminate dividends altogether to avoid bankruptcy.
The good news is, this time around producers have several advantages they didn’t have in late 2008. First, though gas prices have plunged selling prices for oil and by extension natural gas liquids (NGLs) have remained robust. Companies that have been able to beef up their “liquids” output have been able to keep overall returns strong, even as the bottom has fallen out for natural gas profit margins.
Second, since mid-2009 corporate borrowing rates have been at generation lows. That’s provided capital for many producers to make a move into liquids, even as hydraulic fracturing has unlocked light oil reserves in shale as well as NGLs-rich natural gas. It’s also allowed even smaller, financially weaker firms to restructure banking agreements to allow more flexibility to deal with the uncertain price environment.
That argues for less dramatic dividend reductions than in 2008, even for the most vulnerable companies. Investors, however, will need to keep a sharp eye on fourth-quarter results at any producer stocks they own to ensure dividends are still well covered by the relevant measure of profits, be it distributable cash flow or earnings per share. And it’s absolutely critical to know just how much any producer you own relies on oil and NGLs as opposed to natural gas.
Vulnerability in the pipeline and energy infrastructure sector is primarily related to expectations. At some point in the fourth quarter many pipeline stocks started acting like momentum stocks, as investors poured into them for safety as well as for takeover possibilities.
High expectations are easily deflated. And for some time many pipeline stocks have been better candidates for partial profit-taking than purchases.
But it’s hard to see the case for a sector apocalypse, either. There’s still a shortage of infrastructure in shale-rich areas, particularly those rich in NGLs. Companies are able to lock in long-term contracts for new facilities before committing funds. And when they do equity or debt capital, it’s at the lowest rates ever. That means not only is every new project accretive to cash flow and dividends, but it further bullet-proofs the company against setbacks, in part by boosting scale and asset diversification.
Crashing gas prices will have an impact on certain industry assets. Low-cost, abundant supplies of gas from the Marcellus Shale, for example, could potentially reduce demand for long-haul pipeline capacity. Companies like Kinder Morgan Energy Partners LP (NYSE: KMP), however, are protected from any revenue shortfall by long-term contracts as well as the fact they own myriad other assets that have nothing to do with gas prices. What they lose in one place can be more than made up in another, such as NGLs or ethanol transport.
Most important, management teams–even in this industry–haven’t forgotten 2008. And it’s clear to anyone who’s listened to a sector company conference call lately that no one is betting on a boom, and everyone is protecting themselves against a bust.
Those just aren’t conditions that bring on collapse. But again, investors need to realize this is a sector with elevated expectations and take care in what they buy and hold. Not everything is a gem.
Finally, the drop in natural gas prices is a godsend for regulated power utilities. Most enjoy an automatic pass-through of fuel costs to customers, so there’s no direct impact on earnings. Falling gas prices, however, do bring down customers’ bills. That makes it a lot more palatable to pass on other capital costs into rate-base, lifting earnings and, eventually, dividends.
Low and falling gas prices have also made it much more economic for companies to phase out old coal-fired power plants, bringing themselves into compliance with clean air regulations. Burning gas also emits less than half the carbon dioxide of burning coal, which inoculates companies against future regulation, including so far unreleased EPA rules.
The link between gas and wholesale electricity prices, however, has very negative consequences for unregulated generation. Producers not attached to utilities haven’t been income investments for a while, so it’s not likely to hurt any but speculators if Dynegy Inc (NYSE: DYN) or GenOn Energy (NYSE: GEN) eventually go belly-up. Both are heavy on coal-fired power, the cost of which has actually risen due to high global prices for the black mineral.
Several utilities with unregulated generation, however, face an “earnings cliff” starting in 2013, when long-held power price hedges expire. That cliff could be made a good deal worse by falling gas prices. That’s a very good reason to watch fourth-quarter results of companies like American Electric Power (NYSE: AEP) and Exelon Corp (NYSE: EXC) in coming weeks, though both appear protected by conservative financial policies, stable utility assets and diversified operations.
If gas prices remain this weak or fall even further, we can expect to see more scary headlines in the coming days and weeks. We can also count on reading more predictions of sector apocalypses from the bears.
The key is to remember that when it comes to dividend safety, there is no sector. Rather, everything begins and ends with the strength of the businesses behind the individual stocks you own. That means knowing what you own and betting according to your tolerance for risk.
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