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Peak Performer

by Justice Litle
September 27, 2006

The Daily Reckoning PRESENTS: Demand for natural gas has been on the rise for a lot longer than you would think - and in the next few decades consumption of natural gas is expected to rise more than 20%. Justice Litle takes a look at this market for opportunities to profit. Read on...

"You're seeing the earliest phase of natural gas history for the next 30-50 years... energy use goes in 50-year swings. You had wood, then coal, then oil and now natural gas." - Fred Barrett, natural gas executive (quoted in The Wall Street Journal)

Energy pop quiz: In what century was the natural gas pipeline invented? A ballpark estimate will do. Take a moment to think about your answer.

Clearly, it wasn't the 20th - that would be too easy. If you guessed the 19th century, you're still out of luck. Eighteenth? Nope. Seventeenth? Still nowhere close.

As with many other inventions far ahead of their time, credit for the first gas pipeline goes to China. The Chinese built the original natural gas transport system out of bamboo poles. Chinese merchants used the gas to evaporate seawater and harvest the salt left behind. (Salt was a booming business back then, as it still is in some parts of the world today.) Confucius documented the existence of natural gas aquifers and bamboo pipelines circa 600 B.C. The Greeks actually discovered the "burning springs" as far back as 1,000 B.C. - but unlike the Chinese, they didn't come up with a commercial use for the stuff. Around A.D.100, the king of Persia hit on the novel idea of using natural gas in his kitchen. Rather than bring the gas to the stove, though, the king did it the other way around. He had his royal kitchen built in close proximity to a gas spring, where the seepage fueled a continuous hot flame.

By the late 18th century, Britain was using manufactured gas (produced from coal) to light houses and streetlights. Baltimore was one of the first American cities to be lit this way, in 1816. Five years later, gunsmith William Hart dug the first designated natural gas well in Fredonia, N.Y. Hart, regarded by many as the Father of American natural gas, later founded the Fredonia Gas Light Co. - the first company of its kind. One of the key commercial developments for natural gas was the Bunsen burner, conceived by German scientist Robert Bunsen in 1885. Bunsen's regulated mix of gas and air offered a convenient way to tame the flame, and thus greatly increase the safety and precision of its use.

Demand for natural gas continues to rise. The U.S. Energy Information Administration (EIA) expects natural gas consumption to increase more than 20% over the next few decades. Natural gas for electric power generation is expected to rise by more than 60%. This is largely due to its favorable profile as a low-particulate, clean-burning fossil fuel. Yet for all the steady rise in demand, production has been nearly flat for quite some time now. Domestic production growth over the last 10 years has come in at well under 1% annualized.

This snail's pace is not due to sloth on the part of natural gas companies. The problem is that we are largely running to stand still. Existing wells are being depleted faster than new wells can be developed. Christopher Edmonds of Pritchard Capital Partners reports:

The average natural gas well in North America is experiencing accelerated decline rates. This year, the average well will post 30%-plus decline rates. That means we have to come up with that 30% decline in new production just to keep production flat. Simply, the production treadmill is moving faster every year... Even an increase in wells hasn't helped. We have seen a nearly 50% increase in the number of producing natural gas wells since the beginning of this decade, and production has barely moved. It takes more wells - because yield per well continues to decline - just to keep production at existing levels.

America still has some pretty impressive swathes of untapped gas reserves tucked away. The problem is that most of those reserves are politically restricted, too hard to access or otherwise off-limits for various reasons. As with crude oil refineries, natural gas is an industry in which NIMBY and BANANA politics very much apply. (NIMBY = Not in My Backyard, BANANA = Build Absolutely Nothing Anywhere Near Anybody.)

Alaska has significant quantities of gas, but building a pipeline to the lower 48 would be wickedly expensive. Liquid natural gas holds significant possibility and meets only 3% of our current needs, but getting enough LNG terminals built poses a real headache. In the event of human error or terrorist attack, a burning LNG tanker could produce a fireball intense enough to burn someone a third of a mile away. Not the most appetizing prospect for local communities. There is also the matter of aggressive bidding from multiple countries for currently available LNG supplies. Capacity is swamped by demand. LNG is another promising area in which the infrastructure bottleneck is slowing things to a crawl.

Given the bullish long-term perspective, natural gas has nonetheless been driven down by bearish sentiment in the short to intermediate term. An unseasonably mild winter this past year, plus hefty storage numbers approaching 3 trillion cubic feet as of this writing, have both pushed natural gas futures to almost two-year lows.

It won't take much for this pessimistic picture to turn on a dime. Bloomberg reports that "Natural gas has rallied in September in three of the past four years. Those gains were 21% in 2005, 34% in 2004 and 26% in 2002." A nasty winter, or even just a normal one, could affect things greatly. Industry executive Fred Barrett tells The Wall Street Journal that "It only takes five-10 days of cold weather to wipe out about 400-500 billion cubic feet of gas."

And unlike last year, The Farmer's Almanac, which has a highly respectable track record for seasonal predictions, says we can expect bitter cold and plenty of snow for the winter ahead. Nor can future hurricanes be ruled out. Climate fluctuation ranges are expected to increase in coming years, as are tropical storms. The deep waters of the Gulf, a recent source of new supply hopes, are practically hurricane central.

Regards,

Justice Litle
for TheDaily Reckoning

Justice Litle is an editor of Outstanding Investments, ranked number one by Hulbert's Financial Digest for total return performance over the past five years. He has worked with soybean farmers, cattle ranchers, energy consultants, currency hedgers, scrap metal dealers and everything in between, including multiple hedge funds. Mr. Litle also acted as head trader for a private equity partnership, and made contributions to Trend Following: How Great Traders Make Millions in Up or Down Markets, a popular trading book by Mike Covel (FT/Prentice Hall).