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Natural gas good for patient player

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I got bad news yesterday. A company I have invested in reduced its dividend to 3.5 cents from 4.5, and the stock price fell almost 20 per cent. It wasn't management's fault; it's just that the company produces oil and natural gas, and gas prices are at historical lows.

So this is going to sound strange, but I believe natural gas represents a tremendous investment opportunity. The only caveat is I don't know when it will start to pay off.

North American gas prices are not only at extraordinary lows, they're way lower than prices everywhere in the world.

In Japan, a million British thermal units of gas costs US$16. In Australia, it's US$14.50. In Europe, it's US$11.

And in the United States, where much of our gas goes? Try $2.30.

Let me cast the value of gas in another way: Most companies that produce gas and oil convert their gas to barrel-of-oil equivalents at 6:1, based on energy content (that means 6,000 cubic feet of gas is equivalent to a barrel of oil in energy content).

The AECO price for natural gas Friday was $1.66 per 1,000 cubic feet. A barrel of oil, with six times the energy, sells for about $100. The natural gas barrel-of-oil equivalent is worth about $20.

This can't go on forever. Oil is a more global commodity, whereas natural gas is regional. But energy is energy, and such wide price differences should not stand for long.

And yet gas prices here have deviated from oil prices for several years. Why? Because of new technologies that have made new discoveries available, which has glutted the market with cheap gas. Mild winter weather hasn't helped matters.

But the laws of economics will inevitably correct this. In fact, they already are. Very warm weather has devastated natural gas demand for heating. It was about 8 billion cubic feet per day lower this winter, about a third less than last year. Yet demand for gas for power generation was at the very high end of the historical range. Low prices are making natural gas more and more competitive against coal, the traditional fuel used to make electricity, and utilities are running more gas-fired plants.

If we'd had a normal winter, gas prices would not be this low.

So that's the demand side. There's still this problem of oversupply. But again, economics is doing its thing. The cure for low gas prices is low gas prices. The balance is clearly leaning heavily toward consumers in the gas equation; producers aren't making much money. There comes a point where they say "enough is enough" and move on to other pursuits, notably chasing oil. If you have a drill rig, you can use it to look for natural gas and give power companies a big break, or you can use it to find oil, which is fetching 50 times more. What would you do?

That said, inventories are still very high. They are, despite more demand from power utilities, 800 billion cubic feet higher than normal, according to economist Peter Tertzakian, who adds that a couple hundred extra bcf above usual is normally enough to wipe out prices for the year. That means prices aren't going up any time soon.

But with less exploration (drills reallocated to the oilfields), supply should flatten or perhaps start to fall. And as we move into summer, when demand from utilities increases in the United States (air conditioning has an enormous effect on electrical demand), the glut should begin to disappear. That's the short term.

The longer-term argument is that markets are rational, ultimately, and it's not rational that there is such a price difference between natural gas and oil, or between gas in various regions. That can go on for a while, but not forever.

So beware of gas today, but keep an eye on it, because I suspect within the next 12 months, the gas price will hit bottom and gas-related investments will follow. I don't think the rebound will be rapid, but there will be money to be made.

Fabrice Taylor is an award-winning financial journalist and analyst and author of the President's Club Investment Letter. Email him at:

fabrice.taylor@gmail.com

Republished from the Winnipeg Free Press print edition March 31, 2012 B8

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