Natural gas prices have been under a lot of pressure in recent weeks. In our view, things could—and likely will—get worse. Natural gas is sloshing over the sides of storage caverns, backing up in the pipes, and you couldn’t attract an LNG tanker to the U.S. for love or money. There was no winter last year, gas is going to have to come out of storage, and in our view gas prices could see another leg down from here.

Why are we concerned? Let’s take a look at the factors that would support gas and those that might undermine it. We’re hearing that industrial loads are returning as gas prices have come down from their double digit peaks; fertilizer production, for instance, has resumed. Petrochemicals certainly favor using natural gas liquids over refinery naphtha at these levels, and it’s possible that electric power generation could turn to gas as we enter the nuclear refueling outage season. And, there’s always summer, which some weather pundits predicted would be a scorcher this year.

On the other hand, we’ve heard arguments for a crude oil retreat; certainly there is a geopolitical fear premium built in at this point, given Iran, Nigeria, and so on. But, the strength of the natural gas/crude oil linkage can also be called into question. Crude is a global commodity; gas is not, at least not yet. Fuel switching and returning industrial load can mop up some of the excess, but you can’t burn natural gas in your SUV.

There is also the speculative element. A lot of fast momentum money came into natural gas late last year as it was running toward $15. Certainly, it would seem that a lot of that has been chased out in the past several weeks, but perhaps not all of it. We’ll know the party is over if an LNG tanker docks on the East River, knocks on the door of a Park Avenue hedge fund, and says “Here’s your gas.”

The thing that perhaps concerns us most is storage as we have just concluded a very light withdrawal season. Most U.S. gas storage is in the form of depleted gas reservoirs, which are usually only capable of handling one to two turns per year. The gas goes in during the summer and fall, and comes out in the winter. As we understand it, those cycles are critical to maintaining geological integrity.

Storage is nearly roughly 60% above normal right now. Contractually, many owners of gas in storage are obligated to remove it by the end of the season. If they don’t want to remove it, they can ask the storage operator to hold on to it longer. To the extent they have capacity, storage operators can do that, but there are fees involved. And, there are probably a fair number of folks hoping for better prices trying to roll their gas right now, so the storage operator is in the driver’s seat. And, keep in mind the cycling requirements noted above. Owners of gas can also try to “float” their gas on the pipeline system, which is common on weekends, but the pipelines can and will impose heavy penalties for that kind of behavior.

If the gas has to come out of storage, it begins to compete with flowing gas, which is flowing pretty good right now, given the drilling response to high prices. While some marginal drilling may retreat, we don’t think the producers are going to retreat—especially the big guys, for political reasons if nothing else (see below). When physical gas-on-gas competition occurs because there’s more supply than demand, well, get out your Econ 101 book if you don’t recall.

So it becomes a question of capitulation. If you’re sitting on an underwater position, are you going to throw good money after bad, or are you going to throw in the towel? We think some of the bulls may try to hang in there or double down, betting on a hot summer or a more active hurricane season.

The low spark of high yield noise

Politically, of course, the current situation is very convenient. Energy prices remain a hot button issue, right below the Middle East and all of its angles. It’s an election year, poll numbers are in the tank, and we doubt that there are too many folks inside the beltway who would shed tears over a collapse in natural gas prices.

Apart from the odd lost campaign contribution, who cares if those New York speculators get fried in their own grease? Keep in mind also that the companies who have been taking most of the arrows on energy prices (can you say windfall profits tax?) are also the majors, who can and probably will drill right through a trough. Not only can they afford to, arguably they can’t afford not to.

Bottom line, we think it’s highly probable that natural gas could see another leg down from here. A five handle still can’t be ruled out. The impact on gas-related stocks could get ugly, and to the extent that earnings guidance rests on unhedged volumes being sold in the high single digits, we think there’s risk. Risks to our near-term thesis include a quick warm up, followed by a hot summer, another bad hurricane season, and geopolitical issues that spook the energy markets.

Despite all the gas that’s sloshing around in the market right now, we continue to believe that North America’s reserves are finite, that production in more mature basins will decline, and that replacing that will have to come from more distant (e.g. the Rockies, Alaska, offshore), deep/unconventional sources, and LNG. All of these will cost more. But for now, we’ve got more than we can burn.

The next punch

Here is an interesting quote: “The lawful return on equity in this proceeding is 9.34%.” There has been much discussion regarding the potential for pressure on return on equity (ROE) in the context of natural gas utility rate proceedings. As gas prices have moved up and driven higher all-in costs to end-use customers, it’s natural for state utility regulators to look for ways to keep a lid on ever-rising utility bills.

There’s not much they can do about the commodity price, but they can affect the cost-of-service side of the equation. As such, we’ve been concerned about the potential for lower return on equity as a salve to the consumer wounds being inflicted by higher gas prices, and indeed, there have been some single-digit ROEs recommended in recent utility rate proceedings.

The quote above, however, is not from a state proceeding. It is from an FERC administrative law judge (ALJ) in docket RP04-274-000, a pending rate proceeding involving Kern River Gas Transmission Company, which is owned by MidAmerican Energy Holdings, a Berkshire Hathaway company. In response, some people wondered: “A nine handle? From FERC?”

Historically, pipeline equity returns have been in the low double digit range—say 12% or so. As the pipeline business has become more competitive, we’ve argued that the opportunity—not the guarantee—of more robust returns is warranted by the sector’s growing risk profile. Unlike a gas distribution utility, a pipeline is not a natural monopoly. Pipelines compete against one another, and routinely negotiate rates below allowed tariffs at arm’s length with shippers and utilities.

Investors have been willing to allocate capital to pipelines in recent years for several reasons. One, the sector has been recovering from its post-Enron collapse. Two, while we’re awash in gas right now, the increasingly tight long-term U.S. gas supply picture favors a shift in production to new regions (e.g. the Rocky Mountains), which calls for new transport infrastructure to move that gas to market. Three, the market has perceived FERC as an enlightened and less political regulator that perceives the long-term value in affording the opportunity to earn a superior (but not outrageous) return for building infrastructure essential to long-term energy supply stability and security.

Rate cases and ROE

MidAmerican bought Kern River from Williams in 2002 as the latter was having a massive yard sale to pay the rent back. MidAmerican promptly carried out the expansion plans that WMB had shelved for lack of capital, and as part of that process agreed to come before FERC with a cost of service filing three years later; hence, the pending rate case. At the time, Kern negotiated rates at arm’s length with the shippers on the expansion. Ironically, one of those shippers (BP) submitted testimony in this case suggesting the 9.34% ROE that the ALJ is proposing to adopt.

With respect to ROE, the ALJ recommendation examines three proposed gambits. Kern proposed a 15% ROE, reflecting the expected yield plus growth on a basket of master limited partnership owned pipelines. Since Kern isn’t an MLP, one could make an argument on that one. FERC staff recommended 9% using a basket of utility and pipeline companies that appears to have included Williams and El Paso. There’s an argument in that one as well, as both of those companies were near death a couple of years ago and, while recovering, barely pay a dividend today.

BP, the shipper (one that presumably was party to the negotiated rates a few years ago) recommended that ROE be keyed to the yield plus growth of a basket of names that includes El Paso, Equitable Resources, Kinder Morgan Inc. (not KMP), National Fuel Gas, Questar, and Williams. Curiously, the analysis suggests a weighted average return of 9.34% for this group. And FERC’s ALJ bought it. Over the past five years, the dividends on shares of Williams and El Paso didn’t pay much. Questar stock doesn’t pay much of a dividend—it’s tied to the Salt Lake gas utility, which is a small part of the story—but its stock has increased substantially as its Wyoming gas production business has flourished. EQT presents a similar profile, but investors haven’t bought its shares for the opportunity to own a utility in Pittsburgh.

Our point? We believe staff and BP’s peer group is unreasonable on its face. In our opinion, this basket of stocks is half erstwhile basket cases and half E&P plays. Apply a dividend discount model? We don’t think so. There’s either no dividend, or if there is, it appears to be an afterthought.

Politics again

Will FERC adopt the ALJ recommendation? Hard to say; we are personally acquainted with all three of the sitting commissioners, and hold each in high esteem. Collectively and individually, we view the commissioners as astute, perceptive, independent, and largely apolitical. We also note that FERC’s number one over-arching goal, per its website, is to “promote development of a robust energy infrastructure.” That said, FERC is a regulator, and the commissioners sit in judicial roles. They must be objective, impartial, accountable and responsive to all constituencies that petition their agency.

Soap box time

In this case, a major gas producer and shipper (BP) has proffered a position that would result in the affected pipeline company earning not only well below its sought-after return on equity, but also well below what we believe is a historic norm that investors have generally come to accept. We have argued, and will continue to argue, that the strictures of a competitive market—rewards for superior and efficient operation, and penalties for inferior performance—can and should be brought to bear in this sector.

In large measure, FERC’s policies have already fostered a market environment. Pipelines compete with one another for customers, and routinely discount rates below allowed tariffs. Recent disclosures on the planned Rockies Express pipeline reflect that; agreed upon rates were well below the maximum $1.40 tariff. Contract terms have also grown shorter, meaning that pipeline operators must provide good and valuable service or risk losing business. New projects are subject to rigorous evaluation by both the energy and capital markets; again, the current race to bring gas east from the Rocky Mountain region is prima facie evidence of that.

Natural gas is a finite resource, and must increasingly be sourced from non-traditional fields and methods. It’s still out there, but it’s also deeper, farther away, and trickier and more costly to get. There’s risk involved. The biggest part of that risk occurs at the drill bit, where tens of millions of dollars can be committed to a dry hole. Doesn’t happen as often as it used to, but it still happens. The downstream end of the business—the pipes and plants—is less risky by definition, but its risk profile has grown.

Pipelines face a number of business risks today that they didn’t face ten to fifteen years ago when 12% ROE was the norm. Decline curves have gotten steeper, meaning that your 40-year pipe investment may need to pay out in ten years or less. Pipes compete with one another and routinely discount below allowed tariffs.

Contract terms have gone from ten and twenty years down to one to three. These risks increase the hurdle rate. However, pipeline tariffs are still set in a cost-of-service/rate of return context reminiscent of bygone days when contract terms were long, competition was minimal, and pipelines were a low-risk business. Yet today, it’s possible to commit capital to needed new capacity, as Kern River has done, and wind up having a customer that you negotiated with in good faith turn around and haul you in for a rate cut after you’ve committed a lot of capital over a multi-year time horizon.

Pipelines aren’t as risky as drilling, but aren’t as safe as a utility. And, they’re very needed, especially as long-term trends portend a shift to production in places where takeaway capacity is lacking, such as the Rockies or in new areas offshore. Investors have been willing to commit capital to new pipeline projects and expansions, but we doubt that equity capital would flow as readily if returns are going to start running three hundred basis points below expectations.

Looked at from another angle, the ALJ recommendation is something of a reverse self-fulfilling prophecy; a jarring recommendation of this nature sends a signal to the market about regulatory risk. As we’ve noted, FERC has been viewed as less political and more forward-looking than some of its counterparts at the state level. Shaking that view will arguably add to the industry’s perceived risk in the capital markets, which in turn could cause investors to demand a greater risk premium.

It’s important to keep this in perspective – this is an ALJ recommendation, not a FERC decision. We have seen FERC tested on similar issues in the recent past (e.g. the Lakehead issue on partnership-owned pipes), and FERC has put forth decisions consistent with the need to continue attracting capital to achieve goal number one. Our confidence remains with the Commission at this juncture, but this ALJ sends a bad message at a bad time. It is an issue that bears very close watching in the coming months.

The author

Samuel Brothwell is Director, Power & Gas Equity Research, Wachovia Securities, New York, New York.