The North American energy revolution shows no signs of slowing. Along with the dramatic expansion in Midwest oil production – which has fueled striking economic growth in North Dakota – there is also a game-changing boom in natural gas production in the East.
Horizontal drilling combined with hydraulic fracturing has led to a five-fold increase since 2009 in natural gas production in Pennsylvania, West Virginia, southern New York and eastern Ohio, primarily from the Marcellus Shale and Utica Shale formations. This amounts to approximately 25% of overall U.S. natural gas production. The new low-cost supply has altered market dynamics regionally and nationwide, suppressed Henry Hub gas prices (the national standard pricing point for natural gas futures, named for a Louisiana pipeline hub) and created a critical need for new infrastructure investment to connect the production in the East with market hubs and demand centers elsewhere.
The midstream energy sector (i.e., companies that transport energy product from the source and before end use) could see increases in capital spending as pipeline projects develop to answer this infrastructure need. Over the next several years, we expect the midstream energy sector will grow more quickly than the overall U.S. economy, providing support for current fundamentals. However, given the disruptive nature of technological innovation and inherent barriers to entry, there will be distinct long-term winners and losers. Differentiating among them will likely depend on understanding regional dynamics and on bottom-up analysis of individual companies.
Marcellus Shale production growth likely to keep rising
The surge in drilling activity in the Marcellus Shale formation has generated both economic benefits and environmental controversy. Prior to 2008, the Marcellus formation was believed to have negligible natural gas potential; as of September 2014, research suggests it holds the largest volume of recoverable natural gas in the country. Marcellus dry shale gas production (i.e., consumer-grade natural gas) is climbing steadily (see Figure 1) and could double by year-end 2020 (see Figure 2). The recent growth is especially impressive considering the slight decrease in the Marcellus rig count in the last 12 months as producers have reduced drilling time and increased productivity and efficiency on a per-well basis. The U.S. energy sector reaps benefits of not only bountiful natural resources, but also technological innovation.
The market responds to increased production
Prolific shale gas extraction in the East has turned the natural gas market on its head and altered the flow of natural gas throughout the country. Marcellus natural gas production grew at an astounding >50% compounded annual rate from September 2010 through September 2014 (source: U.S. EIA data). Over the same timeframe, Henry Hub natural gas spot prices decreased by 47%, the total natural gas rig count decreased by 65% and total U.S. natural gas supply increased by only 4.5% per year (as modest or stagnant growth in other regions largely balanced the Marcellus/Utica boom).
In the East, even as natural gas production has soared, demand has remained relatively constant. Marcellus natural gas production is poised to surpass the combined peak winter demand for natural gas across seven states in the region (see Figure 3). This abundant regional supply has effectively displaced the need to “import” natural gas from elsewhere in the country, a trend that has suppressed prices on a local and national basis.
Massive capital spending is on the horizon
The significant decline in natural gas spot prices brought about by the excess supply has, in effect, spurred increased demand: Industries and consumers are increasingly turning to natural gas as an abundant source of cheap energy. PIMCO estimates U.S. natural gas demand (including exports) could increase by 20Bcf/d – 25Bcf/d (billions of cubic feet per day) over the next five to seven years, driven primarily by exports, increased usage from power generation and industrial sectors, and the emergence of natural gas vehicles.
In the meantime, shifting trends in regional demand and the discounted prices in the Marcellus region – where gas typically trades at a 35%–40% discount to Henry Hub – have producers scrambling to secure long-term pipeline takeaway capacity to move gas to emerging demand centers in the U.S. Gulf Coast and Southeast. In these areas, we estimate that over $100 billion in new capital is being deployed to build new petrochemical facilities, LNG (liquefied natural gas) export terminals and natural gas power plants. For adequate and (currently) cheap Marcellus gas to connect with these assets – many slated to go into service starting in 2018 – long-haul pipeline capacity will need to roughly triple. This, in turn, means the midstream energy sector would need to invest approximately $20 billion to $25 billion in new pipeline capacity. Given it took 50 years to build the existing gas pipeline infrastructure in the Northeast, tripling capacity over the next five to seven years will be a massive undertaking. Companies are already moving forward: In the past year at least two dozen fully contracted new pipeline projects were announced. These projects are typically underpinned by guaranteed “take-or-pay” contracts for 15 to 20 years.
When these new assets become fully operational in 2018 or later, natural gas prices could rise, but until then we expect prices will remain at current levels (with occasional weather-related price spikes).
High barriers to entry equate to a select few long-term winners
Pipelines are a good example of how the midstream energy sector can have high barriers to entry, in turn helping the sector serve as a defensive allocation for investors, with potential for stable cash flow and a solid total return story in the longer run. Over the next several years, the midstream energy sector is likely to grow more quickly than the overall U.S. economy.
Long-haul transportation pipelines are critical to the entire North American infrastructure and are closely regulated by the Federal Energy Regulatory Commission (FERC). Many pipeline assets are virtually impossible to replicate given population density, new construction costs, right-of-way permitting issues and high costs to switch customers. The surge in Marcellus natural gas production has helped several master limited partnership (MLP)/pipeline firms announce projects for new, expanded or converted pipeline, and in many cases these firms’ existing long-haul natural gas transportation assets, relationships with major customers (such as local utilities) and right-of-way permitting put them at a distinct competitive advantage versus any potential new entrants.
Converting pipeline is a good example of this competitive advantage. We believe the market has historically underappreciated the value of existing “pipe in the ground” (for a detailed discussion, please see the December 2012 Viewpoint, “Energy Face-off”), but in fact it builds a high barrier to entry. Over the past year, we have seen several proposed/contemplated pipeline projects that convert an existing pipeline either to a new service (typically from natural gas to crude) or to bi-directional service (typically seen with natural gas pipelines in the Northeast). Larger MLPs with ubiquitous footprints of pipeline assets and excess capacity on existing natural gas pipeline systems are ideally positioned to propose, fund and complete these conversion projects, which are typically cheaper and faster to construct and result in potentially much higher returns than new-build pipeline projects.
Invest in companies positioned to benefit from changes
Profound changes are coming: By the middle of the next decade, North America may be a net energy exporter of natural gas, natural gas liquids, crude oil, condensates and refined products (see the October 2013 Viewpoint, “Connecting the DOTs: The Role of North America’s ‘Emerging Markets’ in Achieving Energy Independence”). At PIMCO, we aim to identify the industries and individual assets favorably positioned to benefit from the changing energy landscape not only in the burgeoning Appalachian region, but in all of North America.
While many of the same drivers of U.S. oil and natural gas production growth are likely to remain in place over the next several years, longer-term investment success will likely depend on sorting the winners from the losers. Investors also should differentiate regionally and be ready to play both offense and defense given how energy supply/demand dynamics, government regulations and fundamental trends may change in the years ahead. Monitoring risk is important: The energy industry and markets are subject to unpredictable swings. In a recession, for example, global demand for energy can fall significantly, leading to lower prices and reduced transportation volumes. Additionally, new natural gas pipeline construction faces regulatory hurdles and is likely to attract opposition given concerns that a more balanced natural gas supply/demand market will lead to higher prices for consumers. Environmental concerns also remain very much in the public eye.