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Natgas Down, Opportunity Up

By Marin Katusa, Chief Energy Investment Strategist, Casey Research

The energy market is a complex beast, its many parts interconnected through a multitude of linkages. When one part fails, the entire system reacts: certain linkages are burdened with extra stress, while other components sit idle. Only by studying the entire machine can one understand the rippling effects that stem from one change.

With the energy market, the system is made up of various sectors – oil, natural gas, uranium, coal, and alternative energies – and the countries that have each of those energy resources. The components are then linked through a long line of forces, including the geographic distributions of supply and demand, international allegiances and trade deals, global markets and commodity prices, and the ever-evolving field of international relations. A change in any country, sector, or linkage resonates through the entire system.

From this perspective, North America’s shale gas revolution truly earns its accolade as a “game changer.” As many people now understand, the boom in natural gas reserves and production in the United States and Canada is changing the way North America will power itself in the future.

What a lot of people do not understand is how to profit from this shift.

Natural gas prices are depressed and expected to remain so for the short to medium term, so investing in natural gas options or a natural gas exchange-traded fund is not likely to bring home the big bucks anytime soon. Domestic natural gas equities are an even riskier idea – most producers are scaling back production and selling assets as they hunker down in preparation for a tough few years.

In this case, the way to profit is by understanding how natural gas’ changing role is impacting North America’s energy machine as a whole. Cheap natural gas is prompting utilities to switch from coal to gas where possible. The confluence of cheap natural gas and a risky global economy has droves of investors turning their backs on green energy, the sector that was such a market darling only a few years ago. Farther down the road, North Americans are debating – and in places implementing – a range of strategies to take advantage of the continent’s newfound abundance of natural gas, from natural-gas-powered transport trucks to exportation of liquefied natural gas (LNG).

Isaac Newton showed us that for every action there is an equal and opposite reaction. That is why every downside force in the energy sector creates upside opportunities elsewhere. The challenge is finding them. It takes an understanding of the entire global energy machine to figure out what areas are benefitting from the changing landscape.

For Every Down, There’s an Up

Natural gas seems to know that it is heading for several years in the doldrums and, in fighting spirit, it is trying to take a couple of other energy sectors down with it.

With coal, it is succeeding, but there are still lots of coal opportunities outside of the United States. With uranium, the global supply-demand scenario and America’s position within it is in such flux right now that cheap natural gas is doing little to reduce America’s need for U3O8. Then there’s the well-field services sector, where the successes born from horizontal drilling and fracturing created the gas supply glut that is forcing production cuts. Far from slowing down, however, well-field service companies are busier than ever as the oil industry adopts fracking to access shale oil, and the deepwater Gulf of Mexico continues to test the limits of drilling technology.

Coal

The sector feeling the worst impacts from gas’ downturn is thermal coal. Demand for the coal burned to generate power in the US is plummeting as utilities take advantage of the cheapest natural gas in ten years. Consumption of coal to produce electricity is expected to fall 2% this year to its lowest level since 1992, while gas-fired consumption rises 5.6%. Making matters worse, winter heating demand is falling in the face of mild weather: through January, this has been the warmest winter since 2006 and the fourth-warmest on record. With natural gas and warm weather conspiring against it, coal demand is decidedly down – in the second week of February, coal consumption was 4.3% lower than it was a year ago.

Exports are not going to provide any help. Last year, Europe bought 50% of America’s thermal coal exports, but demand from the EU is shrinking as the region struggles to stave off a recession. The economies of the EU shrank 0.3% in the fourth quarter of 2011 compared to the previous quarter, the first contraction since mid-2009.

In response, US thermal coal prices are deteriorating. Appalachian coal, the US thermal-coal benchmark, fell 15% in January alone to sit near US$60 per tonne and has moved little since (by comparison, Australian thermal coal is currently fetching almost US$120 per tonne). Mining costs to dig thermal coal out of the ground range from $60 to $75 per tonne for Central Appalachian producers, which means margins are already razor thin or nonexistent. Several major US thermal coal producers are reducing output and in some cases closing mines, including Arch Coal (NYSE.ACI), Patriot Coal (NYSE.PCX), and Alpha Natural Resources (NYSE.ANR).

Now for some good news. Thermal coal prices in the United States may be faltering, but that doesn’t mean that coal is in the doldrums across the globe. In fact, quite the contrary: global thermal-coal demand is expected to increase by 50% from 2008 to 2035, with the vast majority of increased demand coming from the developing world. That equates to a demand increase of 1.5% each year, and production is not quite expected to keep up to that pace. Rising demand plus not-quite-enough supply equals investment opportunities – maybe not in the US, but elsewhere.

That’s just thermal coal. There’s another component to the coal world: metallurgical coal, the higher-carbon coal used to make steel. Supplies are even tighter with metallurgical coal, which is why our subscribers have exposure to “met coal” through either equities or a fund. More recommendations are on the horizon: the upcoming edition of the Casey Energy Report will be all about coal. We will provide the background, supply and demand projections, and the best ways to profit from the global coal sector.

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