Natural Gas: The Race to $1

For the first time since 2002 the price of natural gas is less than $2 per million British thermal units. That’s almost a one-third decline from the beginning of the year, a halving in less than six months and a more than 85 percent plunge from the mid-2008 high.

Such dramatic action in the price of such an essential commodity always has repercussions. It’s obviously bad news for producers of the stuff, particularly those who’ve failed to switch at least some of their focus to oil and natural gas liquids (NGL) in recent years.

In retrospect, the worst move was made by Canadian giant EnCana (TSX: ECA, NYSE: ECA), which in 2009 went all gas by spinning off its oil production arm into an entirely separate company. That company–Cenovus (TSX: CVE, NYSE: CVE)–shared its rising fortunes with investors last month via a 10 percent dividend increase.

Meanwhile, EnCana has maintained its dividend, largely thanks to not paying much in the first place, but is increasingly challenged to stick with what previously were extremely robust development plans. The stock currently sells for less than half its 52-week high from May 2011.

Generators of electricity for wholesale power markets have also been challenged, particularly non-utility producers using large amounts of coal. This week Dynegy (NYSE: DYN) shares sank as low as 35 cents following the failure of an attempt by major shareholders–including Carl Icahn–to avoid bankruptcy by moving assets around.

A court decision ended that plan. Now creditors will be the primary owners, with current shareholders all but wiped out. Even without all that debt, however, Dynegy will still face a depressed market for its energy, even as the cost of running its primarily coal-fired plants continues to rise.

Low gas prices have also radically worsened the economics of building any power plant not running on natural gas. Wind power, of course, still enjoys tax credits through the end of 2012, and developers are universally able to lock in long-term contracts with utilities. But things are a lot less certain past 2012.

As for new nuclear, SCANA (NYSE: SCG) and Southern Company (NYSE: SO) have won all needed approvals from the Nuclear Regulatory Commission (NRC) to build two new AP1000 reactors each, in South Carolina and Georgia, respectively. Both have locked in the lowest-cost financing in decades to do the job, as well as raw materials and engineering costs. And both companies are recovering expenses on the plants as incurred, rather than having to wait until completion.

These are key differences with the nuclear construction cycle of the 1970s. And the process largely insulates these companies from the troubles of that era, including regulator reversals and spiking interest rates. Utilities’ attempts to gain similar automatic cost recovery are, however, being challenged in Florida and Missouri. Even the Obama administration–stalwart in its support of new nuclear the past three years–now has a dissenting vote on the NRC in Chairman Gregory Jaczko. The upshot is advantage natural gas over nuclear as well.

Producers of coal have also faced tougher times with the cost of natural gas so low. In fact, many investors appear to have decided it’s time to sell anything connected to the black mineral, including stocks of companies such as Peabody Energy (NYSE: BTU), whose US sales are locked in with contracts and which has directed its growth toward still fast-rising Asian demand.

Finally, many investors have begun to worry about natural gas transportation and storage companies, as inventories have risen to record levels and well beyond due to the mild winter. So the bear argument goes, if temperatures remain mild the rest of the year and production from shale continues to grow, there will be no ability to store gas. Pipelines will have to stop shipping and producers will have no choice but to burn it off until storage becomes available. That will zap earnings at pipelines companies, much as gas storage firms are being hurt by a lack of turnover.

According to information released today by Baker Hughes (NYSE: BHI), the number of operating drilling rigs in the US has fallen to the lowest level since early August, as producers have cut back on gas. This number would have been a lot worse, were it not for a shift to oil drilling. And fear of more of the same has pushed down energy services stocks.

So much for the negative. Falling gas prices do, of course, have numerous favorable effects. Even as they’ve faced high gasoline prices, households across the country have gotten a huge break on home heating bills this winter. Better, as gas distributors lock in low prices for future years, heating prices are set up to be low next year as well.

Low gas prices have also reduced the cost of generating electricity for many companies. Regulated utilities automatically recover changes in the cost of fuel to run power plants, so these savings are passed on to customers. That makes it easier for them to pass through capital costs in rates. It also makes it lot cheaper to run an energy-intensive business, with the result that many major industrial companies are considering locating new facilities in the US for the first time in decades.

As I pointed out in the February 2012 Utility Forecaster feature article, Profits and Perils from the Gas Plunge, power companies–particularly regulated utilities–have been able to use plunging gas prices to accelerate the phase out of older and increasingly uneconomic coal power plants. That not only cuts costs.  It also sharply reduces exposure to tougher environmental enforcement of existing air and water pollution laws, even as earnings rise from the addition to rate base.

The UF Portfolio’s guiding philosophy is to hold a balanced mix of the best companies from a wide range of essential-service sectors. As a result I hold power generation companies that rely on a range of fuels, including coal, wind and nuclear as well as natural gas. I own energy pipelines, almost all of which own infrastructure devoted to oil and natural gas liquids as well as natural gas. I even have a handful of companies that produce energy, including gas.

Of course, these companies also have strong balance sheets, low payout ratios and in almost all cases the lion’s share of income is not directly affected by changes in commodity prices. That means they’re not really leveraged in a meaningful way to energy prices, falling gas prices in particular. Even if natural gas stays at these levels and some of the more apocalyptic views of storage pan out, they’re not likely to give up much in cash flows this year.

Kinder Morgan Energy Partners LP (NYSE: KMP) and my other pipeline stocks, for example, do operate pipelines that transport natural gas. It’s all under contract to financially strong shippers, however, and there’s no evidence to date that traffic is falling off. Moreover, all of these companies also have operations across the energy spectrum, including a lot of exposure to infrastructure serving oil and natural gas liquids producers.

At $6 gas almost every producer makes money. Most do at $4 to $5 per million British thermal units. Far fewer do at $2 or less, however, and the result could be bad for pure producers with high costs, too much debt and inadequate hedging.

Happily, that doesn’t apply to even the most exposed of the UF stocks. In fact, most have a great deal more to gain than lose from low gas prices.

The most important thing for income investors, however, is to know just what your companies’ dividend exposure is to low gas prices. So long as they can write those checks–and preferably increase them–it’s a safe bet they’re not as endangered as some might have you believe.