Peak Performer

The Daily Reckoning PRESENTS: Demand for natural gas has been on the rise for a lot longer than you would think – and in the next few decades consumption of natural gas is expected to rise more than 20%. Justice Litle takes a look at this market for opportunities to profit. Read on…

PEAK PERFORMER

“You’re seeing the earliest phase of natural gas history for the next 30-50 years… energy use goes in 50-year swings. You had wood, then coal, then oil and now natural gas.” – Fred Barrett, natural gas executive (quoted in The Wall Street Journal)

Energy pop quiz: In what century was the natural gas pipeline invented? A ballpark estimate will do. Take a moment to think about your answer.

Clearly, it wasn’t the 20th – that would be too easy. If you guessed the 19th century, you’re still out of luck. Eighteenth? Nope. Seventeenth? Still nowhere close.

As with many other inventions far ahead of their time, credit for the first gas pipeline goes to China. The Chinese built the original natural gas transport system out of bamboo poles. Chinese merchants used the gas to evaporate seawater and harvest the salt left behind. (Salt was a booming business back then, as it still is in some parts of the world today.) Confucius documented the existence of natural gas aquifers and bamboo pipelines circa 600 B.C. The Greeks actually discovered the “burning springs” as far back as 1,000 B.C. – but unlike the Chinese, they didn’t come up with a commercial use for the stuff. Around A.D.100, the king of Persia hit on the novel idea of using natural gas in his kitchen. Rather than bring the gas to the stove, though, the king did it the other way around. He had his royal kitchen built in close proximity to a gas spring, where the seepage fueled a continuous hot flame.

By the late 18th century, Britain was using manufactured gas (produced from coal) to light houses and streetlights. Baltimore was one of the first American cities to be lit this way, in 1816. Five years later, gunsmith William Hart dug the first designated natural gas well in Fredonia, N.Y. Hart, regarded by many as the Father of American natural gas, later founded the Fredonia Gas Light Co. – the first company of its kind. One of the key commercial developments for natural gas was the Bunsen burner, conceived by German scientist Robert Bunsen in 1885. Bunsen’s regulated mix of gas and air offered a convenient way to tame the flame, and thus greatly increase the safety and precision of its use.

Demand for natural gas continues to rise. The U.S. Energy Information Administration (EIA) expects natural gas consumption to increase more than 20% over the next few decades. Natural gas for electric power generation is expected to rise by more than 60%. This is largely due to its favorable profile as a low-particulate, clean-burning fossil fuel. Yet for all the steady rise in demand, production has been nearly flat for quite some time now. Domestic production growth over the last 10 years has come in at well under 1% annualized.

This snail’s pace is not due to sloth on the part of natural gas companies. The problem is that we are largely running to stand still. Existing wells are being depleted faster than new wells can be developed. Christopher Edmonds of Pritchard Capital Partners reports:

The average natural gas well in North America is experiencing accelerated decline rates. This year, the average well will post 30%-plus decline rates. That means we have to come up with that 30% decline in new production just to keep production flat. Simply, the production treadmill is moving faster every year… Even an increase in wells hasn’t helped. We have seen a nearly 50% increase in the number of producing natural gas wells since the beginning of this decade, and production has barely moved. It takes more wells – because yield per well continues to decline – just to keep production at existing levels.

America still has some pretty impressive swathes of untapped gas reserves tucked away. The problem is that most of those reserves are politically restricted, too hard to access or otherwise off-limits for various reasons. As with crude oil refineries, natural gas is an industry in which NIMBY and BANANA politics very much apply. (NIMBY = Not in My Backyard, BANANA = Build Absolutely Nothing Anywhere Near Anybody.)

Alaska has significant quantities of gas, but building a pipeline to the lower 48 would be wickedly expensive. Liquid natural gas holds significant possibility and meets only 3% of our current needs, but getting enough LNG terminals built poses a real headache. In the event of human error or terrorist attack, a burning LNG tanker could produce a fireball intense enough to burn someone a third of a mile away. Not the most appetizing prospect for local communities. There is also the matter of aggressive bidding from multiple countries for currently available LNG supplies. Capacity is swamped by demand. LNG is another promising area in which the infrastructure bottleneck is slowing things to a crawl.

Given the bullish long-term perspective, natural gas has nonetheless been driven down by bearish sentiment in the short to intermediate term. An unseasonably mild winter this past year, plus hefty storage numbers approaching 3 trillion cubic feet as of this writing, have both pushed natural gas futures to almost two-year lows.

It won’t take much for this pessimistic picture to turn on a dime. Bloomberg reports that “Natural gas has rallied in September in three of the past four years. Those gains were 21% in 2005, 34% in 2004 and 26% in 2002.” A nasty winter, or even just a normal one, could affect things greatly. Industry executive Fred Barrett tells The Wall Street Journal that “It only takes five-10 days of cold weather to wipe out about 400-500 billion cubic feet of gas.”

And unlike last year, The Farmer’s Almanac, which has a highly respectable track record for seasonal predictions, says we can expect bitter cold and plenty of snow for the winter ahead. Nor can future hurricanes be ruled out. Climate fluctuation ranges are expected to increase in coming years, as are tropical storms. The deep waters of the Gulf, a recent source of new supply hopes, are practically hurricane central.

Regards,

Justice Litle
for The Daily Reckoning
September 21, 2006

P.S. I’ve recently recommended to my Outstanding Investment’s readers a high-quality company with significant exposure to natural gas. It has significant hedges in place for future production, but with the crazy volatility swings natural gas can throw out, this is probably wise (and this company is experienced enough to profit on balance from natgas volatility, rather than be hurt by it). There is more than enough exposure for them to shine once the bullish case for natural gas reasserts itself, and then there’s the lingering possibility of an oil major takeover to boot.

Editor’s Note: Justice Litle is an editor of Outstanding Investments, ranked number one by Hulbert’s Financial Digest for total return performance over the past five years. He has worked with soybean farmers, cattle ranchers, energy consultants, currency hedgers, scrap metal dealers and everything in between, including multiple hedge funds. Mr. Litle also acted as head trader for a private equity partnership, and made contributions to Trend Following: How Great Traders Make Millions in Up or Down Markets, a popular trading book by Mike Covel (FT/Prentice Hall).

This is either the first day of autumn or the last day of summer; we don’t know. But in France, the mornings are now very gray, with fog settling in the valleys. Along the Champs Elysées, the chestnut trees are still green, but the light has an autumnal look about it. The days are mild; the nights are cool.

Everything passes away…like it or not. You can sink into a gloomy funk about the end of summer – but what’s the point? It is like being saddened because you are getting old. Better to enjoy the sweetness of decay…

Yesterday, the Fed decided to sit tight again. Inflation is under control, said the feds; there is no need to raise rates.

What may not be under control is deflation…or at least the very early stage of it. Oil has dropped to $61. Gold is down to $586. The yield on the 10-year note is only 4.73%.

And the housing market continues to soften. In LA, home sales are down 25% from the year before. Friends report ‘For Sale’ signs in abundance.

“I’ll probably take a loss of $100,000 on that house I bought near Miami,” said a friend this morning.

He just bought the place two years ago for $500,000. Now, he is trying to get rid of it. Statistically, there is no proof of a $20% drop in housing prices. But out on the speculative frontier – eager sellers seem to be taking some significant losses.

Meanwhile, one market that is not deflating is the stock market. Falling bond yields give stocks a boost. Investors compare the returns they are likely to get from stocks to the returns offered by the bond market. As yields from bonds go down, stocks look like a better bet.

We spent time yesterday talking with a friend who is a full-time investor of his own money.

“I’ve looked at this business [investing] from practically every possible vantage point,” he explained. “It’s really very simple. You take the returns offered by bonds…or you take more risk and get higher returns. Not always…but over the long run. The risk premium from stocks is very well researched and well known. It is maybe only a couple of percentage points, but over the long run that is a lot of money. Now, everyone in America knows about it, so it is not as great as it used to be. But it is still there…and still worth getting.

“So the question is, how do you get it? That too is simple. You just buy an index fund. Or buy the S&P Index itself. Or, if you want to do a little better, you can follow a mechanical system for selecting the stocks that are likely to do better than the index itself, such as the Dogs of the Dow approach. I’ve done that for many, many years. There is no question that it works.

“Better yet, find someone who does a lot of homework to figure out which companies are likely to do better than a purely mechanical system. This is tricky. Because you have to be careful to get the right person. Warren Buffett, for example, picks stocks by doing intensive research over a long period of time, and sticking to a value investing approach. Value investing works too. It can work very well; it certainly has for me. Value investing is essentially what the Dogs of the Dow system gives you…but it is very crude without any room for individual judgment or deep research. If you can do the research yourself…or find someone you trust to do it…you’ll probably get a better return. I follow many of your advisors, for example…and many of them are very good. They’re getting some good results. Especially lately. [Our own Justice Litle, who writes the Outstanding Investments letter, is rated #1 by the Hulbert Financial Digest].

“The only thing you have to remember is that the risk premium isn’t free. You have to be prepared to stick with stocks throughout the entire cycle – which is about 30 years. If we’re at a high point now…and the market itself turns down…you can still do okay in stocks, but you may have to wait until, what, 2036 to realize it.”

Ah, there’s the rub, isn’t it, dear reader? Here at The Daily Reckoning, we think stocks are near an epic peak. The market reached its zenith in January 2000 and has gone mostly nowhere since, all except the NASDAQ…but even that is considerably down.

Stocks have enjoyed a long season in the sun…and an extended Indian summer. But nothing lasts forever. Summers end. Autumn…winter…still lie ahead. Many of our smartest friends and associates are still making money in the stock market. But we will wait for the market to die…and be reborn…before we get into it broadly. This stock market still has a lot of leaves left to drop.

More news, from our friends at The Rude Awakening:

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Kevin Kerr, reporting from Connecticut…

“The closest most people get to trading grains is buying a box of Shredded Wheat. It’s too bad really, because the grain futures markets often provide excellent trading opportunities.”

For the rest of this story, and for more market insights, see today’s issue of The Rude Awakening.

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And more views:

*** Everything passes away…even our time this week at the Chateau de Malesherbes, near Fontainbleau.

In 1787, Monsieur de Malesherbes – Chancellor Lamoignon – must have been on top of the world. The chateau that bore his name is a beautiful place even now, but then it was twice as big. Today, it still has 25 bedrooms…all of them grand…with spectacular views out over the park. Our bedroom had oak paneling, with huge windows directly in front, so we could look down a broad allee lined with linden trees.

Before the French Revolution, the house was frequented by the richest, most famous, most powerful people in the world. Even the famous writer, Chateaubriand, came for a visit…for his brother was married to Malesherbes’ daughter. There, in the salon, the writer left his mark. He was fascinated by the movement of the sun and the heavenly bodies around it. So he drew out a long pattern on the floor…subsequently cut into the ceramic tiles…and attached a metal disk to the outside wall, with just a small hole in the center, so that on the 21st of June at precisely 12 noon – that is to say, at the very moment of the mid-summer solstice – the sun shone directly through the hole and lit up the long triangle inscribed on the floor. We can imagine the delight of Malesherbes and his guests. It must have appeared to them all that the Malesherbes family not only commanded the respect of Louis 16th – great, great grandson of the Sun King, Louis 14th – but actually seemed to command the sun itself. For hadn’t the great sol come to the very point where it was supposed to come…where Chateaubriand’s metal disk was waiting for it?

Adding to Malesherbes’ status and wealth was the fact that the man was a lawyer…but not just any lawyer. He must have been the Johnny Cochran of his time…a man of the law so distinguished that the king himself turned to him for legal help. Lawyers, more than any other professional class, are able to insinuate themselves into the ranks of power and money. They are the most accomplished parasites; and, as a social/political system matures, they gradually take it over. That is why so many of the members of Congress are lawyers…and why when you have a traffic accident in the nation’s capital, the odds are one in ten that you have run into a lawyer…and they are significantly higher if the person was driving a Mercedes (of course, we simply recall the statistic…we do not guarantee it).

Alas, Malesherbes’ success in court and courtroom was the cause of his ultimate failure. He defended Louis 16th against charges of treason brought by the new revolutionary tribunal after the mobs had stormed the Bastille and a new government was installed. He argued his case well, but not well enough. Louis was beheaded…and his lawyer’ s head followed! The revolutionaries were nothing if not thorough. Just to make sure that the Malesherbes seed was extinguished, they also beheaded his wife, his children, and his grandchildren – including the children of Mr. Chateaubriand.