The Energy Report: Ron, welcome. You are making a presentation at the Money Show conference in Orlando in late January. What is the gist of your presentation?
Ron Muhlenkamp: The gist of my presentation is that
natural gas has become an energy game changer in the U.S. We are cutting
the cost of energy in half. This has already happened for homeowners
like me who heat their homes with natural gas. We think the next up to
benefit is probably the transportation sector.
TER: What is behind this game change?
"Natural gas has become an energy game changer in the U.S."
RM: The combination of horizontal drilling and
fracking has made an awful lot of gas available cheaply. There's a whole
lot of gas that's now available at $5/thousand cubic feet ($5/Mcf) or
less. I live in Western Pennsylvania, and 30 years ago, Ray Mansfield
was in the oil and gas drilling business, having retired from the
Steelers. He said, Ron, we know where all the gas is in Pennsylvania;
it's just a matter of price. If the price runs up, we will drill more.
If the price runs down, we will drill less. Any way you slice it, we are
just sitting on an awful lot of it.
Two years ago, we had a warm winter, and the price of gas actually
got down to $2/Mcf. You saw an awful lot of electric utilities switch
from coal to gas. Literally in a year, what had been 50% of electricity
produced by coal went to 35%. The difference was made up with natural
gas.
In transportation, the infrastructure to make the switch to natural
gas has not been in place. We didn't have the filling stations or the
trucks. Now, the trucks are just becoming available. You can buy pickup
trucks from Ford Motor Co. (F:NYSE) and General Motors Co. (GM:NYSE)
that run on natural gas. Furthermore,
Clean Energy Fuels Corp. (CLNE:NASDAQ) has established natural gas filling stations coast to coast, every 250 miles on five different interstate highways.
Westport Innovations Inc. (WPRT:NASDAQ)
has been producing 9 liter (9L) natural gas engines. Waste Management
(WM:NYSE) uses 9L engines on garbage trucks and expects 8590% of its new
trucks to be natural gas fueled. Westport has just come out with 12L
engines, which are used for over-the-road trucks. I don't expect those
engines to get adopted as fast as the utility industry made the switch
to natural gas, but there has been a fairly rapid adoption in the waste
management industry. I think we're on the cusp of a major trend.
TER: That fuel switching in the power industry has
been going on since 2008. Is it still progressing at the same rate or is
it picking up?
"The big switch is over in utilities. But we've barely begun the transition with transportation fuel."
RM: It's pretty much leveled off. In fact, there's
probably a little bit less gas used than when gas was below $3/Mcf. The
latest numbers I've seen show that we're running about 37% coal and
about 3334% gas. Going forward, I think coal use will continue to
decline, and natural gas use will continue to rise. The big switch is
over in utilities, and it will be gradual from here. But we've barely
begun the transition with transportation fuel.
TER: So the game has changed for the power industry,
and the transportation industry is next. What other changes do you
foresee in the future?
RM: We will continue to use more natural gas and
less crude. Right now, for equal amounts of power, crude oil is priced
at about three times the natural gas price in the U.S. That is too wide a
spread to ignore, economically.
The Natural Gas - Crude Oil Spread
source: Bloomberg
Incidentally, in Europe, natural gas is still at $12/Mcf. It's on a
par with crude. Most European chemical plants use a crude oil base to
make chemicals. U.S. plants use a natural gas base. Natural gas becomes
ethane, then ethylene, then polyethylene and then plastic. So producers
of plastics or the feedstocks for plastic in the U.S. now have an
advantage they didn't have before.
"The natural gas price advantage will be with us in North America for quite a long time. It's huge."
In Japan, the natural gas price jumped from $12 to $16/Mcf just after
the tsunami wiped out the Fukushima nuclear power plant. To ship gas
from the U.S. to Japan, the cost of compression, liquefying and
decompression is about $6/Mcf. Executives at U.S.-based companies like
Dow Chemical Co.
(DOW:NYSE) are saying they don't want the U.S. to
export gas because that would drive the price up. But domestic gas
consumers already have that $6/Mcf advantage. Meanwhile, in Williston,
N.D., the natural gas price is effectively zero. Producers still flare
it because they don't have the pipelines to take it out of the area. So
this price advantage will be with us in North America for quite a long
time. It's huge. That's why we call it a game changer.
TER: So how can investors take advantage of these changes?
RM: Well, any number of ways. We hold some fracking services companies, like
Halliburton Co. (HAL:NYSE). We own a couple of drillers, including
Rex Energy Corp. (REXX:NASDAQ). And we invest in the people who build natural gas export facilities, such as Fluor Corp. (FLR:NYSE), KBR Inc. (KBR:NYSE) and Chicago Bridge Iron Co. N.V. (CBI:NYSE).
I already mentioned companies building natural gas-fired engines,
including Westport, which makes a kit to modify a common diesel engine.
And because natural gas will require new, larger fuel tanks, investing
in companies that build natural gas tanks is another way to play it. One
of the disadvantages of natural gas versus gasoline or diesel is
compressed natural gas takes about three to four times the volume to get
the same range. Liquefied natural gas (LNG) takes about two times the
volume.
Of course, compressed natural gas is stored in pressure tanks,
so it takes a pressure tank of larger size. Fuel tank conversions have
been almost as expensive as the engine conversions. 3M Co. (MMM:NYSE) has gotten in that business, as has General Electric Co. (GE:NYSE). There's another outfit called Chart Industries Inc. (GTLS:NGS; GTLS:BSX), which has already run a good bit.
"We want a foot in each of these
camps because we're not quite sure who the ultimate winners will turn
out to be, but we know what the product lines will have to be."
We want a foot in each of these camps because we're not quite sure
who the ultimate winners will turn out to be, but we know what the
product lines will have to be. Don't forget about the companies that own
the LNG export facilitiesCheniere Energy Inc.'s (LNG:NYSE.MKT) facility should be up and running in probably 2015, but, again, that stock has run up a good bit, too.
Pipelines will benefit from the switch. One of the biggest pipelines in the country is Kinder Morgan Energy Partners L.P.'s (KMP:NYSE)
Rockies Express Pipeline, which stretches from Northern Colorado to
Eastern Ohio and ships gas east. Kinder Morgan recently filed to reverse
the flow on part of the line. Right now, in Western Pennsylvania, we
have a glut of gas. A few months ago, they reversed the flow of the
pipeline from the Gulf Coast that used to come up to Western
Pennsylvania. There's a whole lot going on.
TER: After some serious oil train derailments in
recent months, pressure is building now to increase pipeline capacity,
but there is also pressure on producers to reduce flaring, which is
happening on a huge scale in the Bakken Shale. How will the economics
and the operations of Bakken producers be affected if they can't flare
and pipeline capacity is not increased?
RM: The Bakken is primarily an oilfield; the gas is a
byproduct. We hear a lot about the Keystone XL Pipeline, which is meant
to carry oil from the Bakken south. I can't speak specifically, but if
you're going to lay an oil pipeline from the Bakken, you should lay a
gas pipeline alongside it. You can ship oil by rail, but it's not
economic to ship gas by rail. One way or another, the oil will be
shipped.
TER: Bill Powers,
the independent analyst and author of "Cold, Hungry and in the Dark:
Exploding the Natural Gas Supply Myth," says gas prices are going to
rise steadily to as much as $6/million British thermal units ($6/MMBtu)
because U.S. gas production has peaked and now is now flat or declining.
Do you agree with that?
RM: Our production of gas has not peaked and is not
declining. We are using fewer rigs drilling for gas, but each well,
particularly if you drill horizontally instead of just vertically, is
producing so much more gas. Production is not declining and isn't likely
to for at least a decade. At current rates, we can drill in
Pennsylvania for another 50 years. Yes, you drill the best wells first
but also, over time, you get a little bit better at timing this stuff.
I'd be very surprised if the price in the next decade gets over $5/Mcf
for any extended period of time because there's an awful lot of gas
that's very profitable at that price. I'm willing to make that bet with
Bill Powers. But even $6/Mcf gas would equate to $55/bbl crude, which is
still a huge spread and wouldn't negate my general argument.
TER: What's your forecast for gas prices in 2014?
RM: My forecast is $4/Mcf, give or take $1. We just
had a big cold snap on the East Coast. What used to happen is any time
you had a cold winter, the price of gas jumped. For instance, in 2005,
when crude was selling about $50/barrel ($50/bbl), gas began the year at
about $7/Mcf, which was on par with crude, but in the wintertime, it
doubled and ran up to $14/Mcf. The recent cold snap took gas all the way
up to ~$4.20/Mcf. Gas is going to be in that range for a long time.
TER: Your advice to investors in natural gas is to
get exposure to exploration and production companies, service companies
and even LNG plant constructors. What about the LNG plant owners, the
pipelines and the railroads?
RM: The pipelines will do well. They've already been
bid up. The railroads will benefit from oil and gas, but they're
getting hurt because coal tonnage is way down, CSX Corp. (CSX:NYSE) just
reported. So for the railroads, it's going to be a wash. They'll haul
less coal and more oil. The railroads won't haul gas. How much oil they
haul is an open question. We're about to tighten restrictions on how
tank cars are built.
TER: What did well in the Muhlenkamp Fund last year?
RM: The fund was up 34.4%. We did very well in
biotech stocks. We did very well in financial stocks. We also did well
in some energy stocks. Airlines did well for us. Incidentally, airlines
benefit big time from cheaper energy, as you know. So it's fairly
diverse.
TER: How are you adjusting your portfolio this year?
RM: Not too much has changed. We're no longer
finding many good companies that are cheap. So we're monitoring and
adjusting a little bit around the edges. We do think banks have further
to go. We think the economy will grow somewhere between 2.53% this year.
We've owned no bonds for the past couple of years, but with the
Treasuries now, the interest rates on the longer end are high enough so
that savers can get a little bit of return.
TER: I was surprised to see a really sharp drop in November for Fuel Systems Solutions Inc. (FSYS:NYSE). Why did that happen?
RM: Fuel Systems makes conversion kits for cars to
burn compressed natural gas. In places like Pakistan, 40% of the cars
run on natural gas; this is not new technology. A number of its
customers decided to make these kits in-house. Fuel Systems is a small
position of ours, but, yes, it got hit in Q4/13 when it announced that a
number of its customers decided to produce their own kits. One of the
nice things about this is there's no new technology involved. We've been
using natural gas as a power source for generations. What has changed
is the amount that's available reliably at a cheap price.
TER: There was another sharp drop in Clean Energy Fuels in October. What happened there?
RM: Clean Energy, so far, doesn't make a profit
because it has been shelling out all the money to build all these
filling stations. It's just taking a little longer than people expected.
The stock is compelling at these levels. A number of these companies
ran. Westport doubled, and we took some profits. It's now back down, and
we should do a Buy rerating. There is volatility in this stuff, but the
economics are undeniable. We still managed a 34.4% gain this year,
which isn't bad.
"Royal Dutch Shell Plc is building natural gas fueling stations in concert with another truck stop operator."
Clean Energy has signed a joint venture with Pilot Flying J to build
natural gas fueling stations at Flying J truck stops coast to coast. Royal Dutch Shell Plc (RDS.A:NYSE; RDS.B:NYSE)
is doing a similar thing in concert with another truck stop operator.
For instance, the Port of Long Beach, Calif., passed a rule several
years ago that the trucks on the port need to burn natural gas. The Port
of Hamburg, Germany, has contracted to put a natural gas-fired power
unit on a barge so that when cruise ships come into the harbor, instead
of running their own power off their diesel engines and generators,
they'll use this barge to supply power to the cruise ship because
natural gas exhaust is cleaner than diesel exhaust.
TER: A couple of other companies had surprising
drops Rex Energy and Westport Innovations. Rex rose all year until
October or November, when it suddenly dropped. Westport also dropped
suddenly. You had a wild ride in your portfolio, didn't you?
RM: We bought Rex at $13/share, and it went to $22
or $23, and it's now $19. I can live with that. The dips give you a
chance to load up again. That volatility is why we have a diversified
portfolio. That's why you don't just bet on three stocks.
As an investor, most of the time what you're looking for is to find a
difference between perception and reality. Today, we have two
realities: One is the price of crude oil, and the other is the price of
natural gas. So it's literally an arbitrage if you can buy energy either
at the equivalent of $100/bbl or at a third of that.
Four dollar gas is
equivalent in energy content to about $35/bbl crude. So I can buy my
energy either at $100/bbl or $35/bbl. Economics says that spread is too
wide. It won't necessarily close, but it sure as heck will narrow a good
bit. For instance, I own no conventional oil companies. I think the
price of oil will be coming down.
TER: So what companies in your portfolio look most promising?
RM: If you really want to get me excited, we can
talk about natural gas, which we've been talking about. We could talk
about biotechnology, which is exciting but I don't understand it as
well. We can talk about U.S. manufacturing, but that's basically based
on cheaper energy. I just bought more Rex. At these prices, I'm buying
Westport. I just bought Chicago Bridge. I just bought KBR.
TER: What is your main motivation in buying these
companies? Is it just the stock price or is there something about the
management of the company or the technology?
"I want to buy Pontiacs and Buicks
when they go on sale. I don't want a Yugo at any price. I would like to
buy Cadillacs, but they don't go on sale very often."
RM: We're in the investment business. What we rely
on is good companies, and we look to buy them when they're selling
cheaply. Our first measure of how well a company is run is we start with
return on shareholder equity. So we like companies that are at least
above average in return on shareholder equity. I cannot yet say that
about Clean Energy, but we do think Clean Energy is at the forefront of
something that's needed for this transition. We're always looking for
good companies. Then the question is whether you can buy them at a
decent price.
My phrase is: I want to buy Pontiacs and Buicks when they go on sale.
I don't want a Yugo at any price. I would like to buy Cadillacs, but
they don't go on sale very often. But if I can get Buicks when they're
on sale, I'll make good money for my clientele. We think that the
companies we have are at least Buicks. If we can get them at Chevy
prices, that's when we buy them. I will not pay an unlimited amount for
any company.
I've never seen a company that was so good it didn't matter what you
paid for the stock. To us, value is a good company at a cheap price.
Some people bottom fish. They look to see when they can steal companies,
and there are times when you can make money that way. But at that point
it's not often a very good business, and there aren't too many well run
companies at bargain basement prices. So it's very unusual for us to
buy a weak company or a weak industry.
TER: Ron, this has been a good conversation. I appreciate your time, and good luck with your Money Show presentation.
RM: Thanks; it'll be fun.
Ron Muhlenkamp is the founder and portfolio manager of Muhlenkamp Co. Inc.,
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