Royal Dutch Shell’s (ADR: RDS.A) decision to sell their stake in the South Texas Eagle Ford shale field this week affords me the opportunity for a wonderfully alliterative headline, but more importantly it has caused some to question whether the shale boom has peaked. Conventional wisdom would suggest that the big oil companies, who came late to the game, are at a disadvantage, but that the small independent producers still have plenty of upside.
For once, I find myself agreeing with the accepted take on the situation. Over the last few years, investing in small oil and gas producers has been far from profitable. Many of the companies have grown quickly in terms of output, but the depressed price of natural gas, which in most cases is a significant part of that output, has hurt them.
The three year chart for NYMEX natural gas above would indicate that a bottom has been found for the commodity just below the current $3.55 level. If that is the case, then the now leaner exploration and production companies are set to finally start cashing in.
The depressed price is quite natural, based on simple economics. The technology required to extract these massive reserves of energy here in the US is relatively new and expansion in production has been rapid, resulting in supply outstripping demand. There is, however, a natural progression in such occurrences. As the price drops due to the imbalance, so demand increases and equilibrium is restored. Increased restrictions in the coal industry and improved infrastructure make that tipping point seem imminent.
If you want to invest in natural gas, there are several ways to do it. The most obvious is to buy into the commodity itself. For most individual investors, the best way to do that is through an ETF that tracks the price, such as the United States Natural Gas Fund (UNG). I have, however, an aversion to commodity ETFs due to problems with contango. There are products available that take this into account, such as the E-Tracs Natural Gas Futures Contango ETN (GASZ), but my conviction is not solely based on the commodity price.
One should also consider that the companies involved have, by necessity, reduced costs and could well become profitable soon, even if natural gas prices just remain stable. From an ETF perspective, then, I would prefer one based on stocks in the sector, such as the First Trust ISE-Revere Natural Gas Index Fund (FCG).
FCG reached a 52 week high yesterday, but, as the 5 year chart above shows, there is still significant room for improvement before butting up against longer term highs.
There are of course a host of individual companies to choose from for a more direct investment. To me, those with large exposure to natural gas represent the best opportunities, even though some of them are already tracking higher.
The two at the top of these charts, Natural Gas Services (NGS) and Magnum Hunter Resources (MHR) are good examples. NGS supplies the industry, so is a more generalized play on the sector, while MHR has expanded rapidly in the field, from 1.275 Billion cubic feet of production in 2010 to an estimated production of over 20 Billion cubic feet this year.
The bottom two companies in the chart cluster above, Exco Resources (XCO) and Petro Quest Energy (PQ) are still depressed in price. These stocks may represent more risk, but potentially more opportunity too.
It must be pointed out that commodity markets are volatile, and any investment that is subject to their influences is therefore inherently risky. It does seem, though, that the fundamental dynamics of basic supply and demand may finally be moving in the direction of shale producers, particularly those with a bias towards natural gas, and that investors would do well to look more closely at companies in the sector.
Shell’s decision to sell their interest in the Eagle Ford shale field made sense for them, but it would be wrong to take it as a commentary on this kind of energy production in general.