How To Profit From The Shale Gas Boom

How Low Natural Gas Price Can Affect U.S. industries

Executive Summary:

The shale gas boom presents various U.S industries with chances to benefit. The boom has caused natural gas prices to reach record decade-low levels. Fertilizer companies can benefit by reducing their production costs, while transport companies can make significant cost savings by switching to gas. Engine and CNG truck manufacturers, as a result, will enjoy higher than usual demands and profits. Energy engineering and construction companies will experience massive cash inflows, as the economy will require them to set up the basic infrastructural facilities that can help bring in the supply of gas, which will help to smooth the switching process. On the other hand, this boom has adversely affected coal companies, which have seen a decline in demand as natural gas has become a cheaper substitute for coal. Railroad companies have suffered as well due to reduced carloads of coal required by utility companies. The following thesis will look into each of these industries in detail, while also providing a detailed analysis on other industries and companies, and how they benefit or suffer from the shale gas boom.

Introduction:

Shale gas is natural gas formed after being trapped within shale (a fine grained rock composed of minerals) formations. With an increase in usage of horizontal drilling and hydraulic fracturing over the past decade, large volumes of shale gas can be accessed that were previously uneconomical to produce. Shale gas has become an increasingly important source of natural gas in the United States, and it has reduced U.S. dependence on costlier foreign producers. This increase in the supply of natural gas in the U.S. has led to a reduction in natural gas prices.

Natural gas prices:

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Coal

Most of the major coal companies in the market are serving utilities and industrial customers. Both of these segments have seen a decline in demand. Over the past 12 months, the best performing coal company is down by 28%, while the two least impressive [Patriot Coal (PCX) and Puda Coal (PUDA)] have lost more than 95% of their value. Low natural gas prices will hurt coal stocks but the market opinion remains that coal stocks have reached or nearly reached a bottom.

The companies can play the shale gas boom by concentrating on exporting coal to Asia, Europe and Japan, where demand is higher. Alliance Resource Partner (ARLP) currently exports roughly 3.5% of total sales tons of coal. The following graph from ARLP’s analysis shows that over the past three years, only the export consumption of coal has continuously increased.

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Similarly, Walter Energy (WLT), a metallurgical coal company, shows that most of its sales in 2011 have come from Europe and Asia.

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As far as the substitution of gas for coal in utilities is concerned, it is determined by a variety of complex factors like gas prices, weather, coal inventories and the decision of the plant operator concerned.

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Some analysts say natural gas will eventually be the preferred choice of utilities over coal in the long run in response to pressure from stricter environmental regulations. A gas-fired power plant produces 50% less emissions than that of coal.

We are favoring coal companies because some utilities are bound by supply contracts that force them to buy coal. Coal stockpiles held by power generators were almost 18% above the level in March 2011, and above the five-year range. Coal stockpiles are up as a result of reduced coal consumption by electric power plants.

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In this situation, Cloud Peak (CLD) may be a good choice because it is currently focusing on growth through maximizing exports. Virtually all of its reserves are in the Powder River Basin, and the company has access to West Coast terminals to ship its production to Asia and Japan, where nuclear power generation is being replaced with coal, at least temporarily, is a big buyer, as is China who needs metallurgical coal.

Railroad

The primary problem facing the Railroad Industry, at the moment, is the reduced coal carload traffic due to the lowest natural gas prices in a decade. According to the CEO of CSX Corp. (CSX), gas prices need to be the $4-to-$4.50 range per million BTU to encourage utilities to use more coal and in turn drive up the coal revenues for railroads. Coal represents the largest volume of traffic on the U.S. railroads i.e. 25% of total yearly revenue. U.S. railroads have hauled nearly 200,000 fewer carloads of coal this year than they did the last year. In the week ending June 2, 2012, the Association of American Railroads (AAR) said, “Carloads are down by 3.1% compared with the same week last year. Coal carloads fell by 16.6% in April 2012 versus April 2011.”

Norfolk Southern (NSC), Union Pacific (UNP) and CSX Corp. are primary players in the industry. Of these three companies, CSX is the one that is most exposed to coal (31% of its revenue), followed by NSC. UNP is the industry leader and is a less risky investment as compared to CSX because it is not as highly exposed to coal. At present only 22% of its revenues come from coal and petroleum. NSC has already started to exploit the shale gas boom by transporting sand that is used in fracturing rocks (hydraulic fracturing) to get the gas.

We recommend not to short CSX because the stock has exhibited a better 1Q performance than wall street expectations, it offers a high dividend yield, exports of coal to Europe and China are expected to increase, merchandise and intermodal business segments show increasing revenues, and the company is diverting resources away from the declining utility coal segment to other profitable segments.

We think that railroads can profit from the shale gas boom if a shift, from using diesel to natural gas as fuel, is possible. This would lead to significant fuel cost savings. In case of CSX, fuel (diesel) expenses have recently seen a 10% increase (largest cost component) as compared to the previous year. During the past five years, Norfolk Southern Railway’s fuel expenses have almost doubled, and at Kansas City Southern (KSU), locomotive fuel costs have risen 77 percent during the past two years. Chesapeake Energy (CHK) and some other Canadian companies are working to demonstrate the feasibility of using natural gas to fuel railroad locomotives. The company is working with Caterpillar (CAT) and General Electric (GE) “to roll out natural gas-powered locomotives” sometime in the summer of 2012. The company also believes that any diesel engine in the U.S. can be retrofitted to run on a blend of natural gas and diesel. Railway companies say that there is no support for the claim that gas-fueled locomotives will be less expensive, and that such locomotives will require significant investments.

Railroads, like coal companies can also concentrate on coal exports to China and India to drive up coal revenues. They could also benefit from the shale gas boom by transporting Frac sand, pipe, chemicals and barite like NSC.

Chemical:

Low natural gas prices have energized the Chemical Industry. Companies, who were moving away from the U.S. due to high petrochemical costs, are now finding the U.S. very attractive for reopening closed plants and to build new ones. Dow chemical (DOW) made a significant announcement in April 2012 that it will build an ethylene cracker and a new propylene production facility. Some other chemical companies are following suit. This would have been unthinkable five years ago when natural gas prices were high.

Energy accounts for more than 50% of the costs for chemical companies. European chemical companies will be at a competitive disadvantage as the energy costs for US companies fall due to low natural gas prices. Companies such as Dow Chemical Company and DuPont (DD) saw first quarter 2012 profits exceed the expectations of Wall Street analysts. Both companies use natural gas as a feedstock. As the capacity of U.S. chemical companies increases, along with decline in energy costs, they can take over market share from their European and Asian counterparts too. This cost advantage makes chemical companies an attractive investment. This can be seen in the case of Lyondell Basell Industries (LYB) which has stated that U.S. ethane is advantaged by 15-25 cents per pound as compared to that produced in north-east Asia. Western European operations of LYB are also suffering from higher cost of production for ethylene than those in America.

DOW is a relatively expensive stock, trading at a forward P/E of 16. Its competitors DuPont and Eastman Chemical (EMN) are performing better at the moment in terms of profit margins and are cheaper (P/E of 13 and 11 respectively). According to a JP Morgan analyst, DOW does not thrive in a weak economy, while Eastman benefits from advantaged raw materials and earnings increase from the purchase of Solutia.

Fertilizers

Natural gas is a major raw material for the production of ammonia, via the Haber process, for use in fertilizer production. Some 90 percent of the cost of manufacturing nitrogen fertilizer depends upon the price of natural gas. Depressed U.S. natural gas prices means that the fertilizer companies make more money. Profit margins have greatly improved. The graph below shows the change in operating profit margins with changes in the spot price of natural gas.

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Of all the fertilizer stocks in the market, CF Industries is good for buying as it is cheap (P/E of 9.15as opposed to Potash Corp. of Saskatchewan, Inc. (POT)’s P/E of 11.15), it is growing (Quarterly Earnings growth YoY is 30.60%) and has plenty of free cash flow.

Transporters/Truck (Engine) Manufacturers/Waste Management

The increasing divergence between oil and gas prices that once crossed the unbelievable 50.0x (i.e. 50 times multiple) mark in April is currently floating around 40.0x, which is way higher than the general rule of the thumb figure of 10.0x suggested by economists, or sometimes 6.0x, which is commonly called the Burner Tip Parity.

This provides all those industries, which use diesel or oil in their operations, with an opportunity to switch to the cheaper option of using natural gas for fuel purposes. In a simple calculation, one can estimate that gas costs hardly $2 per gallon as compared to the spot rates $3.5 for gasoline or $3.7 for diesel. This means a straightaway 50% cut in fuel costs, which can mean massive cost-savings for companies who have fuel cost as a dominant portion of their overall cost of operations.

However, one should have a close estimate of the cost associated with this switch before one blindly jumps into it. The first and foremost cost is that of buying a CNG model truck/van that is needed to transport the orders. According to a recent study, the incremental cost is $70,000 for a heavy duty truck and $11,000 for a pickup truck. The following table shows the story: