Energy arbitrage offers opportunities

MAY 27, 2012
In the past seven years, the spread between oil and gas prices has widened dramatically in what looks to be a persistent shift in a critical market relationship. The effects are potentially far-reaching across a value chain that touches industries such as energy, utilities, chemicals and transportation, not to mention geopolitics. In 2005, a barrel of oil cost about six and half times a thousand cubic feet of natural gas, with oil priced at $61 and gas at $9.50. Currently, that ratio stands at an incredible 50-to-1, with oil at $105 and gas just above $2. Several factors have supported the increase in the oil-gas differential. Crude oil has moved higher as demand growth from emerging markets has eroded excess capacity, tightening the global market balance. More recently, the Iranian nuclear issue has introduced a geopolitical risk premium into crude oil pricing by elevating concerns about market access to critical supplies in Saudi Arabia via the Strait of Hormuz. The most important factor, though, has been the emergence of shale as a significant source of natural gas, enabled by the use of new production technologies. In recent years, shale has transformed the domestic natural gas industry from a state of decline to accelerating growth in both production and reserves. Without the link to global markets that has supported crude oil, domestic gas prices are depressed by this excess supply. Each of these factors — the tight global oil market, Middle East tensions and U.S. shale gas supply — is likely to persist for many years. In turn, it is reasonable to expect the spread between oil and gas to remain elevated for a sustained period. Industries that source energy from natural gas and deploy it in markets where pricing is based on crude oil will successfully capture the energy arbitrage. Therefore, to identify the beneficiaries, we must consider the entire value chain — following the gas from the shale (upstream), through processing and pipelines (midstream) to its end use (downstream). In the upstream, energy services companies that deal with the waste stream of shale gas production are well-positioned to benefit from this trend. Environmental regulation of this process is expected to become more onerous, and providers who can stay abreast of changing requirements will have an advantage. In the midstream, natural gas may be fractionated, or stripped of its liquid content, stored and ultimately transmitted via pipeline to its end-use markets. Existing midstream infrastructure was built primarily for conventional gas basins, rather than the newer shale plays. This creates an opportunity for new investment at relatively high returns with a significant degree of safety, because well operators are willing to provide long-term guarantees, in advance of construction, in order to secure the capacity to handle anticipated production growth. Downstream, energy arbitrage is transforming the petrochemical industry. In the past decade, Middle Eastern producers gained market share in the supply of plastics, leveraging their access to low-cost energy and feedstock. However, North American plants are equipped to use natural gas as energy, and natural gas liquids as feedstock. Thus, the widening oil-gas spread has given an advantage to North American producers, who are reasserting themselves in this market. A similar dynamic is playing out in the nitrogen fertilizer market, where North American gas-based producers are gaining market share at the expense of international oil-based competitors. In addition, fertilizer producers have the added tail winds of robust prices and low to moderate inventory levels across most fertilizer-intensive crops.

EXPORTING LNG

There also is potential for the United States to develop a liquefied-natural-gas export market. The major beneficiaries of the various market dynamics detailed above are likely to include environmental services companies with exposure to energy production, major owners and operators of midstream processing and pipeline assets, chemical manufacturers that can leverage domestic natural gas to compete globally, nitrogen fertilizer producers that can capture this same dynamic and LNG terminal operators positioned to ride a potential wave of exports. In summary, the widening of the spread between oil and gas prices is creating enormous new markets across a variety of industries. With a thematic investment approach, it is possible to identify undervalued securities in companies set to capitalize on the energy arbitrage opportunity. Jason Benowitz is a portfolio manager at Roosevelt Investment Group Inc.

Latest News

SEC bars ex-broker who sold clients phony private equity fund
SEC bars ex-broker who sold clients phony private equity fund

Rajesh Markan earlier this year pleaded guilty to one count of criminal fraud related to his sale of fake investments to 10 clients totaling $2.9 million.

The key to attracting and retaining the next generation of advisors? Client-focused training
The key to attracting and retaining the next generation of advisors? Client-focused training

From building trust to steering through emotions and responding to client challenges, new advisors need human skills to shape the future of the advice industry.

Chuck Roberts, ex-star at Stifel, barred from the securities industry
Chuck Roberts, ex-star at Stifel, barred from the securities industry

"The outcome is correct, but it's disappointing that FINRA had ample opportunity to investigate the merits of clients' allegations in these claims, including the testimony in the three investor arbitrations with hearings," Jeff Erez, a plaintiff's attorney representing a large portion of the Stifel clients, said.

SEC to weigh ‘innovation exception’ tied to crypto, Atkins says
SEC to weigh ‘innovation exception’ tied to crypto, Atkins says

Chair also praised the passage of stablecoin legislation this week.

Brooklyn-based Maridea snaps up former LPL affiliate to expand in the Midwest
Brooklyn-based Maridea snaps up former LPL affiliate to expand in the Midwest

Maridea Wealth Management's deal in Chicago, Illinois is its first after securing a strategic investment in April.

SPONSORED How advisors can build for high-net-worth complexity

Orion's Tom Wilson on delivering coordinated, high-touch service in a world where returns alone no longer set you apart.

SPONSORED RILAs bring stability, growth during volatile markets

Barely a decade old, registered index-linked annuities have quickly surged in popularity, thanks to their unique blend of protection and growth potential—an appealing option for investors looking to chart a steadier course through today's choppy market waters, says Myles Lambert, Brighthouse Financial.