A Surprising Winner From the Natural Gas Boom

Before you go, we thought you'd like these...
Before you go close icon

Low natural gas prices have proved to be a major burden for energy companies that derive a substantial portion of their revenue from the out-of-favor commodity. Over the past year or so, most exploration and production companies have curtailed gas drilling and shifted their focus toward oil and natural gas liquids, which are more profitable.

But one subsector within the energy industry has actually benefited handsomely from the depressed state of the natural gas market - the refiners.

America's natural gas boom
Recent advances in drilling technology applied to unconventional shale reservoirs have helped ignite what many have termed a "shale gas revolution." Domestic production has risen steadily, from 19.3 trillion cubic feet (tcf) in 2007, to 20.6 tcf in 2009, to a whopping 22.9 tcf in 2011 - an all-time record. According to recently released data from the U.S. Energy Information Administration, production last year likely surpassed the 2011 record, with some sources estimating year-end production coming in at 24 trillion cubic feet.


Booming production from sources like Pennsylvania's Marcellus Shale and Texas' Barnett Shale has led to a massive oversupply of natural gas, contributing to severely depressed prices over the past couple of years. Last year, for instance, natural gas spent the entire first half of the year under $3 per thousand cubic feet (mcf), though it rose above that level in the latter half of the year.

Since most gas wells are uneconomical at under $3 per mcf gas, energy companies exited gas drilling in droves last year. For instance, EXCO Resources cut its rig count in the Haynesville and Marcellus Shales - both prominent natural gas plays - from 18 and four, respectively, as of year-end 2011 to just five and one as of the third quarter 2012.

Chesapeake Energy , the second-largest natural gas producer in the country, also drastically reduced its gas-directed rig count, which stood at less than 10 as of the third quarter, down from nearly 90 in early 2011.

And LINN Energy pretty much went whole hog on a highly prolific oily play, known as the Hogshooter, where it maintained eight rigs as of the third quarter, with wells posting staggering average initial production rates of around 2,100 barrels per day of oil.

With these and other energy producers turning to liquids drilling, it should come as no surprise that the total number of rigs drilling for natural gas in the U.S. fell precipitously over the course of last year, plunging by almost half. While low prices proved to be a major burden for gas producers, cheap natural gas turned out to be a major boon to refining companies.

Refiners' changing fortunes
Geographically advantaged refining companies were big winners last year, profiting from the wide difference between the price of domestic oil and the price of global oil. Essentially, they were able to purchase cheaper domestic crude oil while selling the refined product at much higher, globally determined prices.

Fourth-quarter earnings among some of the top dogs in the sector were nothing short of spectacular. Valero Energy posted earnings of $1.01 billion, the highest in seven years, and up significantly from just $45 million in the year-ago period. Marathon Petroleum reported earnings of $755 million, a drastic reversal from its $75 million loss in the same quarter last year.

Besides illustrating the highly cyclical nature of the refining business, these results also reinforce some very positive developments for the sector as a whole. First and foremost is the aforementioned wide gap between domestic and global crude oil prices. Another major positive development for U.S.-based refiners has been high demand for refined product, especially from Latin America, which has provided a big boost to exports.

And last, but not least, has been the beneficial effect of low natural gas prices. Now let's take a closer look at this factor.

How low natural gas prices help refining companies
While there are a host of factors impacting refiners' margins, the biggest component of a refiner's variable operating costs is the fuel it uses to produce hydrogen and power its refining facilities. Over recent years, demand for processing ultra-low-sulfur fuels has risen rapidly, which has boosted the demand for fuel and hydrogen.

Obviously, refiners that are more energy-intensive have benefited more than others. For instance, cracking and coking refineries, which convert heavy crude into light petroleum products such as gasoline, jet fuel, and diesel, tend to spend more on energy costs.

And between these two types of refining facilities, coking refineries tend to be the most energy intensive, demanding more than two and a half times the energy to refine a barrel of crude compared to the average cracking refinery. Hence, they have been the biggest beneficiaries of low natural gas prices among refiners.

The massive drop in natural gas prices, from roughly $9 per mcf in 2008 to as low as $2 per mcf in 2011, translated into massive cost savings for both these types of refineries. Over this time period, the average cracking refinery realized savings of $0.55 per barrel in processing costs, while the typical coking refinery realized cost savings of almost $1.50 per barrel.

For San Antonio-based Valero, falling gas prices since 2008 have amounted to savings of $1 billion per year. And as a New York Timesarticle documented, access to cheaper inland oil and lower energy costs have provided Valero's Three Rivers refinery, located near San Antonio, with about $665,000 a day in savings, which has boosted profit by more than 400% since 2008. That's no pocket change.

Final thoughts
Natural gas prices almost certainly will rise over the next few years, which would suggest a gradual erosion of refiners' cost savings. However, even if prices were to rise above $4 per mcf this year and the next, that price level is still significantly below the historical norm. In addition, $4 per mcf natural gas is still substantially cheaper than European and Asian prices and should continue to provide U.S.-based refineries with a major competitive advantage over their foreign peers.

All in all, I think that several American refining companies are still attractive, though I would prefer to wait for a pullback in their share prices, many of which skyrocketed last year. While last year's phenomenal returns are unlikely to be repeated, the sector should continue to prosper due to a host of positive developments that appear structural in nature.

In addition to cheap natural gas and a Brent-WTI spread that is likely to remain above historical norms, refined product exports should continue to boost refiners' profits. While U.S. gasoline demand peaked in 2005 and will probably continue to fall, the demand for refined product should continue to grow in the developed world, particularly in Latin America.

There are many different ways to play the energy sector, and our analysts have uncovered an under-the-radar company that's dominating its industry. This company is a leading provider of equipment and components used in drilling and production operations, and poised to profit in a big way from it. To get the name and detailed analysis of this company that will prosper for years to come, check out our special free report: "The Only Energy Stock You'll Ever Need." Don't miss out on this limited-time offer and your opportunity to discover this under-the-radar company before the market does. Click here to access your report -- it's totally free.

The article A Surprising Winner From the Natural Gas Boom originally appeared on Fool.com.

Fool contributor Arjun Sreekumar has no position in any stocks mentioned. The Motley Fool has the following options: Long Jan 2014 $20 Calls on Chesapeake Energy, Long Jan 2014 $30 Calls on Chesapeake Energy, and Short Jan 2014 $15 Puts on Chesapeake Energy. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

Copyright © 1995 - 2013 The Motley Fool, LLC. All rights reserved. The Motley Fool has a disclosure policy.

Read Full Story

Want more news like this?

Sign up for Finance Report by AOL and get everything from business news to personal finance tips delivered directly to your inbox daily!

Subscribe to our other newsletters

Emails may offer personalized content or ads. Learn more. You may unsubscribe any time.

From Our Partners