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The MRI 3D Report

Crude Oil or Natural Gas?

Commodities / Natural Gas Dec 02, 2011 - 11:04 AM GMT

By: Zeal_LLC

Commodities

Best Financial Markets Analysis ArticleHydrocarbons have become the lifeblood of this modern era.  And with a huge economic incentive for finding and extracting them, drillers have scoured the world in search of this finite resource.  When they do find it, there is nothing more thrilling than bringing this raw form of energy to the surface.

The most famous extracted hydrocarbon is in liquid form, known as petroleum, or crude oil.  With the next most common form being gaseous, known as natural gas.  Crude oil has of course long been the superior hydrocarbon.  In fact, until the last half century or so oil was really the only hydrocarbon with any commercial worth.


Interestingly throughout most of history natural gas’s utility, and occurrence, had been totally misunderstood.  In the days of yore gas was more of a mystical element.  On occasion lightning would strike a surface seep, causing an explosion and/or igniting a large flame.  Amusingly ancients would regard an event like this as spiritual, and built temples or shrines at the sites of these occurrences.  As time wore on some cultures were able to harness gas’s energy to varying degrees, but never on a grand scale.

One of the biggest historical challenges with natural gas was transportation.  In the 1800s a handful of big cities in the US figured out how to pipe in local sources to fuel their street lamps.  But up until about World War II, there was no way to transport it effectively.  With no network of pipelines, storage facilities, or processing plants, natural gas was for the most part a useless byproduct of oil drilling.

In the past drillers that came across primary gas fields usually left them alone.  And even when they did find primary oil fields, they still had to deal with the accompanying gaseous hydrocarbon.  The drillers were ultimately forced to discard the natural gas, by venting it into the atmosphere or flaring it.

Natural gas’s fortunes finally started to change in the late 1940s.  And by the 1960s the US had developed the world’s first large-scale natural-gas infrastructure.  Advances in technology allowed the US to innovate in pipeline design and storage, and by the time the 1970s rolled around this network consisted of thousands of miles of pipe.

With the transportation of natural gas becoming viable on a commercial scale, a huge wave of innovation permeated the consumption side of this hydrocarbon.  And as a result it had quickly become a popular and indispensable form of energy.  Natural gas is now piped directly into residential homes for central heating and as fuel to run appliances, manufacturers are using it to power their plants, and utilities use it to generate electricity.

The natural-gas revolution obviously greatly increased demand, and thus created a market for this commodity.  And as time wore on it was no longer a mere afterthought to oil.  Primary oil drillers gained an economic incentive to capture their gas, and many other drillers went on to make gas their primary business.

The many excellent natural-gas companies that had risen up saw demand for their primary product greatly increase over the years.  Per the U.S. Energy Information Administration (EIA), US natural-gas consumption saw a four-fold increase from 1950 to 1970.  And after a lull in consumption into the early 1980s, it has been slowly on the rise ever since.  In 2010 US consumption came in at a record 24 trillion cubic feet.

In the last 50+ years the natural-gas industry has gained incredible strength and stability.  And with a recent push towards cleaner-burning fuel, consumption is expected to continue to rise in the years to come.

This gas love fest has naturally led to rising prices over time.  Once the government started easing regulation in the 1970s, thus creating a more fluid market, prices went from relatively fixed at about $0.16 in the 1960s to average $0.50 in the 1970s, $2.08 in the 1980s, $1.92 in the 1990s, and $5.07 so far in the great commodities bull of the 2000s.  Natural gas’s explorers, producers, and servicers had found a cozy niche in the energy markets.

But alas, the natural-gas industry would be in for a huge wake-up call just as things were starting to really heat up in this secular commodities bull.  As you can see in the chart below, natural-gas prices have been diverging from big-brother oil and the rest of the energy complex.  And this divergence is in a direction that has caused wailing and gnashing of teeth for many drillers.

Oil, the king of all commodities, has had an incredibly-strong run off its $10 lows in 1999.  Global demand for this hydrocarbon is up nearly 50% in the last 25 years.  And when you consider the unprecedented rise of Asia, demand will stay strong ad infinitum.  With demand so strong, supply has struggled to keep pace as the drillers just haven’t been making enough large discoveries to comfortably secure pipeline for the future.  The 10-year chart above clearly shows how this imbalance has had an effect on prices.

Nearly the entirety of the energy complex has been flying in the upwash of oil’s momentum.  And as you can see, natural gas was no exception.  From the beginning of 2002 to their apexes in mid-2008, oil and gas had respective gains of 593% and 418%.  But though the going was good for both of these energy powerhouses, they had become severely overbought in their spectacular parabolic ascents.

At $145 oil and $13 gas, a healthy correction was imminent.  And in the summer of 2008 oil and gas, along with nearly all commodities, entered into major corrections.  Unfortunately commodities ended up getting sucked into the fear maelstrom brought on by the global financial crisis.  And what was supposed to be a simple healthy correction to rebalance sentiment ended up being a full-blown bloodbath.

As measured by the venerable Continuous Commodity Index (CCI), most of the panic selling in commodities had been exhausted by the time 2009 rolled around.  And oil’s bottoming in February capped off a mind-blowing 76% decline to sub-$40 prices that hadn’t been seen since 2004.

So with the CCI hitting its panic low in December, oil hitting its low in February, and most of the rest of the commodities group hitting their lows around this same time, you’d think natural gas’s low would also fall in somewhere around then.  But provocatively, gas decided to buck the commodities trend.

Natural gas kept on falling, and fell hard until it finally reached bottom in September 2009.  By the time all was said and done, gas had fallen a staggering 86% from its 2008 high.  And its precarious price behavior throughout most of 2009 signaled that there was much more to this panic plunge.

Upon reaching its lowest point since 2001, virtually wiping its entire bull-to-date gains, natural gas finally caught a bid.  And it tripled in just a few short months.  But while this fast rise was quite spectacular, it was merely a smoke screen.  And judging by what has played out since the beginning of 2010, there is no doubt that this commodity is in the midst of a structural reckoning.

To put gas’s price action in context, first consider oil’s post-panic fortunes.  From its 2009 low, oil has mounted a powerful recovery.  And even with today’s shaky stock-market action, it is still holding strong near $100 in a nice tight uptrend.  Natural gas’s trend on the other hand tells a completely different story.  After its quick pop to $6, it has nestled into an alarming two-year downtrend.  Amazingly gas prices are currently where they were back in 2002, and are down 8% over the exact-same period where oil is up 113%.

So what’s going on with natural gas?  Well in looking at the chart, it’s clear that gas is no longer in oil’s upwash.  It has diverged to the downside and is now trading on its own merits.  And these merits represent a major shift in fundamentals that anybody attuned to the energy scene is plainly aware of.

Simply put, this shift is a byproduct of radical innovations in the geosciences, horizontal drilling, hydraulic fracturing, and more.  And the result of this shift was the unearthing of massive natural-gas resources that have easily taken off the strain of whatever economic imbalance there was thought to be.

The biggest game changer is those resources found within deep-underground shale.  Massive discoveries in the Barnett, Marcellus, Haynesville, and Eagle Ford shale fields among the many have really given a boost to US gas resources.  According to the latest EIA report, there is now well over 800t cf of technically recoverable shale-gas resources in the US.  And many experts believe this to be quite a conservative number.  With these recent shale-gas discoveries, it is now believed that the US has 100+ years of natural-gas supply.

And this US success of course has global implications.  Since the US uses about one-quarter of the total global supply and gas is priced in US dollars, domestic happenings greatly color the world markets.  And since the US produces about 90% of its own consumption needs (with most of the rest coming from friendly-neighbor Canada), it doesn’t rely on foreign supply.  Unlike in oil, foreign gas producers have little pricing power.  And in this current situation, gas prices are naturally going to fall.

Ultimately from a strategic perspective larger inventories and lower prices are a big boon for the clean-energy initiative.  But these fortunes haven’t been great for drillers’ margins.  While there are still plenty of companies that can thrive at these lower prices, there’s no denying the fact that natural-gas exploration and production has lost some of its appeal in recent years.

For this reason many of the drillers that saw the writing on the wall have made their way back to “old reliable”.  All the while that natural gas had been gaining popularity in recent decades, oil’s attractiveness remained steady and unwavering.  And unlike gas, oil’s fundamentals are still wildly bullish.

And provocatively the formula for success in natural gas’s boom has opened up vast opportunities for oil drillers, especially in the US.  In September I wrote an essay on the renewed US oil boom, in which I discussed the emergence of shale-oil drilling.  Utilizing horizontal-drilling and hydraulic-fracturing techniques pioneered in the shale-gas push, drillers are now able to profitably tap shale oil.

And with the large shale-oil reservoirs in the US, shale-oil drilling now represents one of the biggest production growth areas in the entire oil industry.  Even better is shale oil won’t really make a material dent in global supply.  Drillers can therefore go after the margins and not worry about their success altering oil’s fundamentals (and thus prices) too much.  In the US especially, given the choice drillers have been ditching gas and targeting oil.  And these shale-oil drillers are in line to make fortunes, which has naturally served stock investors quite well.

Speaking of stocks, the impetus for this essay was some findings that came out of a major in-house research project looking at the universe of mid-cap oil stocks trading in the US and Canada.  We wanted to focus on oil due to its superior fundamentals to gas, with our goal to pick out the dozen most-promising stocks in which at least 50% of their reserves, production, and revenues were from oil.  And we found an amazing group, with each stock profiled in detail in our latest research report.

As part of this research we discovered that mid-cap exploration and production companies really are the sweet spot of the oil-and-gas industry.  These companies throw down some serious capex relative to their size, exhibit incredible growth rates, and yet are still small enough to where a discovery, acquisition, or asset sale could completely transform the look of their portfolios.  And interestingly in the process of this research we found that many of the stocks in this mid-cap group, including some of our favorites, are gas-to-oil converts.

In looking at their histories we found that some of these companies were actually gas-centric not too long ago.  However when faced with lower margins on their gas projects, along with the dangling carrot of higher margins in newly-illuminated oil plays, they were quick to transform their business models.

Some of these companies are now among the elite mid-cap oil producers.  They’ve accumulated sizeable leaseholds in some of the hottest up-and-coming fields in the US, and are positioned to greatly leverage oil’s bull.  And at Zeal we’ve been recommending that our newsletter subscribers go long in several of the stocks profiled in our popular report.

One company we recently recommended has already been acquired for a quick 44% realized gain in just over two months.  And the rest of our positions ought to perform quite well over their trade durations.  To get the fascinating fundamental profiles of each of our favorite mid-cap oil stocks, buy your Zeal report today.  And to find out which of these stocks we are recommending along with cutting-edge market analysis, subscribe to our acclaimed weekly or monthly newsletters today.

The bottom line is oil has long been the hydrocarbon of choice for the drillers.  But with natural gas stepping into its own about a half-century ago, and quickly becoming an indispensable energy source, the drillers found themselves with options.  And gas drillers have found amazing success.  Unfortunately, this success has recently gotten ahead of itself.

Unlike oil, natural gas is now abundant relative to demand thanks to what’s been found in large shale reservoirs underlying the surface.  And gas’s radically-changing fundamentals have put downside pressure on its price.  These lower prices have made drillers think twice about which hydrocarbon they go after.  And with the prospects of lower margins in gas and higher margins in oil, many have refocused on oil.  In today’s environment oil-centric drillers ought to greatly outperform in the energy-stock sector.

Scott Wright

So how can you profit from this information? We publish an acclaimed monthly newsletter, Zeal Intelligence , that details exactly what we are doing in terms of actual stock and options trading based on all the lessons we have learned in our market research. Please consider joining us each month for tactical trading details and more in our premium Zeal Intelligence service at … www.zealllc.com/subscribe.htm

Questions for Adam? I would be more than happy to address them through my private consulting business. Please visit www.zealllc.com/adam.htm for more information.

Thoughts, comments, or flames? Fire away at zelotes@zealllc.com . Due to my staggering and perpetually increasing e-mail load, I regret that I am not able to respond to comments personally. I will read all messages though and really appreciate your feedback!

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