US Equities: It’s a gas

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The hydraulic fracturing revolution could re-shape the US economy – and US equity portfolios with it, writes Joseph Mariathasan

The creation of the 150-strong pressure group Artists Against Fracking in August 2012 by Yoko Ono and Sean Lennon was not a great advert for hydraulic fracturing (‘fracking’) but it certainly showed the headline appeal of a technology that many see as an American game changer.

Despite justifiable concerns over possible pollution – and not just from artists – the huge landmass of the US makes it likely that compromises will be reached that allow the industry to thrive in regions that do not cause significant risks to large populations. Moreover, a chief competitor to shale gas is coal, hardly renowned for its lack of environmental impact.

And then there is the economic payoff. “Without fracking, US unemployment figures would be 1 percentage point higher,” declares Marc van Loo, head of energy & utilities equity research at ING Investment Management.

“By 2018, imports of oil to the US from the Middle East will have come down from three million barrels per day to half a million – essentially a drop to zero – with the US being a net exporter of petroleum products,” says Christopher Wheaton, manager of the Allianz Energy fund.

American gas prices reached a low in the first half of 2012 of below $2 (€1.5) per million British thermal units (MMbtu) – few wells were profitable at this price. By the beginning of 2013, prices had recovered to around $3.00-3.50/MMbtu, still a fraction of prices in Europe.

Gas is traded internationally in the form of liquefied natural gas (LNG). US shale gas could be sold internationally in the form of LNG, with costs of around $3.50/MMbtu for liquefaction and $2-3/MMbtu for transportation, giving an end price approaching $10/MMbtu. With current spot prices around $19/MMbtu, the potential for US exports of LNG is vast.

The question facing Americans is whether they are better off exporting their endowment in the form of LNG or restricting exports to keep domestic energy prices low and facilitate a renaissance of energy-intensive US manufacturing industries. Needless to say, this is an issue that is both controversial and subject to much-disputed analysis.

A recent report commissioned by the US Department of Energy, ‘Macroeconomic Impacts of LNG Exports from the United States’, came to the conclusion that the benefits of export expansion would more than outweigh the losses from reduced capital and wage income to US consumers from higher domestic gas prices. As the authors state, this is exactly the outcome that economic theory describes when barriers to trade are removed.

Wheaton argues that even an increase in domestic prices would not be significant. “In the worst-case scenario of all export proposals being approved, the report suggests that domestic gas prices would still be half of what Europe has to pay,” he says.

Moreover, Van Loo points out that while there are 17 proposals to export LNG from the US, it is unlikely that more than a handful will actually go ahead due to lack of required permits and financing.

US equity strategies: all change?
In the immediate term, the sectors benefiting are those dependent on cheap power, those providing the infrastructure to take advantage of fracking (such as such as Kinder Morgan, Plains All American and Enterprise Products), and those utilising hydrocarbons as raw material.

Roughly speaking, there has been a 5% move to gas in power generation by utility companies. Wheaton sees a much bigger increase happening in 2016 when coal plants commissioned in the 1970s with a 40-year life start to be decommissioned. Wheaton expects industries such as cement manufacturing to benefit from cheaper power. More profoundly, the US is becoming the global centre for chemicals again.

“There are plans to build seven new ethylene crackers in the US, which will take natural gas feedstock and produce plastics,” says Wheaton. “Five years ago, they would have been built in the Middle East.”

While the US will benefit immensely from a general lowering of energy prices relative to Europe and Japan, the real revolution could be the use of natural gas as a transportation fuel, according to Sandy Pomeroy, managing director of Neuberger Berman’s MLG Group. The reason is clear – two thirds of marginal oil production is used for transportation and the US is the largest market in the world.

“Almost all conventional vehicles can be easily changed to utilise natural gas,” says Pomeroy. “The trick is in developing the whole eco-systems of fuel stations, servicing, mechanics, and so on. The value proposition is overwhelming as natural gas at $4/MMbtu is 20 times cheaper, in energy terms, than conventional gasoline.”

But as Charles Whall and Tom Nelson, co-portfolio managers of Investec’s Global Energy portfolios, state in a recent note: “There is neither government policy incentive, nor infrastructure, nor consumer appetite to transition a meaningful proportion of the US vehicle fleet to natural gas vehicles in the foreseeable future.”

Wheaton at Allianz, however, shares Pomeroy’s optimism. He points out that oil companies are trying to create a critical mass in small regions – Shell, for example, is creating a natural gas ‘green corridor’ with filling stations along a stretch of highway heavily used by trucks. “If gas can get penetration into transportation fuel, it will be a game changer for global oil prices,” declares Wheaton.

Neuberger Berman sees that compressed natural gas (CNG) will only work if introduced as a hybrid solution to be used with gasoline, enabling drivers to continue using America’s existing gasoline infrastructure. Their analysis suggests that adding a gas tank to a standard 2012 Toyota Camry vehicle would reduce boot space by 10% – a small price to pay for considerable fuel-cost savings. They also suggest that with around 60% of US homes connected to the gas mains, home refuelling could also be a possibility.

A revolution is under way whose speed makes it hard to fathom the long-term consequences. But a revolution it is, and far-reaching, too – which makes it imperative that investors think about its ramifications for portfolios.

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