Natural Gas – The Bright Idea
The business case for natural gas as a primary transportation fuel
Natural Gas – The migration to use natural gas for transportation fuel is sound logic based on business economics. Efficiently run companies always find ways of becoming more profitable by squeezing every last drop from their cost structure. Companies routinely chase after very small cost savings opportunities. Moving from diesel to natural gas for a logistics fuel has the potential to save companies 50% per gallon on their fuel costs. This equates to MILLIONS and MILLIONS of dollars in benefits for shareholders in companies like FedEx, UPS, Wal-Mart, Target, Waste Management, Pepsi and Coca-Cola, just to name a few. Companies will RUSH to carry out changes when millions of dollars are on the line, and when those changes give a competitive cost structure advantage over peers.
The natural gas train has left the station and adoption is occurring – as seen by the recent articles from major corporations like GE, Blackstone Energy, Westport and Caterpillar, just to name a few. We discuss some of the major factors working for and against natural gas below.
The primary factor working against natural gas adoption:
The lack of infrastructure to support exploding demand is the primary hurdle to adoption. This is, however, only an issue of time and has nothing to do with the economics. This issue of “infrastructure build out” is what provides the investor with an economically resistant and decade-long investment opportunity.
Factors working in favor of natural gas include:
Natural gas is abundant and inexpensive. It is available within the United States, and supplies are dependable. Worldwide demand for oil continues to increase resulting in upward pricing pressure. Instability within the Middle East continues to place a supply interruption premium on oil prices. Natural gas is environmentally more appealing when compared to oil, coal and nuclear energy. The pricing differential discussed graphically below substantially favors natural gas as a primary transportation fuel.
The chart above graphically illustrates the pricing differential between diesel and natural gas through March 2012 (our Nov 2012 pricing update should be out by next week). This pricing differential is the single most important reason for investing in natural gas related companies. As this relative price gap widens, the Return on Investment (ROI) payback period shortens and the incentive to invest becomes more attractive. Note: In March of 2012 natural gas hit a 10-year low, while oil prices (and therefore diesel prices) continue to rise.
What has changed in the natural gas market that has allowed pricing to fall substantially since late 2008? And what structural changes have occurred that lead us to the conclusion that this pricing differential is here to stay and therefore will support future investments?
Technology enhancements to the way natural gas is removed from the ground have resulted in significant production increases. Both horizontal drilling and hydraulic fracturing are major contributors to this rise in production. The use of horizontal drilling, which allows a 90-degree well to be drilled into formations that are not accessible with vertical drilling, has made horizontal drilling a very valuable technology. The use of “hydraulic fracking”, a process by which pressurized fluid is pumped down a well to fracture the rock, increases the flow of natural gas and directly results in higher production rates. The third factor affecting the long-term price of natural gas started in about 2008 when large natural gas production zones started scaling production. A small example is illustrated below from the EIA.
So in conclusion, the natural gas market has gone through a permanent structural change over the last five years as a result of better technology and large discoveries coming into production. This permanent change will translate into sustainable lower costs for natural gas in the long term.
How many trucks operate in the U.S.? What is the magnitude of potential savings?
Government statistics conservatively estimate that 2 million moderate- to heavy-duty vehicles (class 5 – 8) operate in the United States. Industry experts assume 30%-40% of the class 5-8 trucks are considered “high-mileage” vehicles. A high-mileage vehicle is defined as traveling 80,000 to 160,000 miles (or more) annually. These are the trucks that will benefit significantly by utilizing lower-cost fuel.
For illustrative purposes we will calculate the savings on 30% of the class 5 – 8 vehicles (only high-mileage vehicles) and use 120,000 annual miles as the “average” annual mileage. If we assume 5 miles per gallon (which can vary dramatically based on load weight), total fuel consumption calculates to 24,000 gallons (120,000 miles / 5 mpg) of diesel used annually. Now if the average cost of diesel is $4 per gallon and a 50% cost reduction (or $2 per gallon savings) can be achieved by switching to natural gas, this calculates to $48,000 ($2 savings x 24,000 gallons) per vehicle per year.
The following charts explain this savings calculation and also include detail on other outcomes when the underlying assumptions change. It should be emphasized that even significantly different assumptions still result in substantial cost savings. This further justifies the investment within the area.
Under almost any scenario, the fuel cost reduction on only the number of high mileage vehicles – 600,000 (2 million x 30%) is BILLIONS of DOLLARS in annual savings. This is absolutely ENORMOUS! A potential savings of this magnitude supports MASSIVE investments for engine conversions, infrastructure, and retail opportunities. Companies adopting the technology can earn HUGE returns on investments (ROI), which in turn gives substantial pricing power to the companies developing the technology and companies providing infrastructure components (expanding volumes and margins).
I could continue on with the lower-mileage heavy-duty trucks, medium-duty trucks, light-duty trucks and everyday cars, but- I think you get the idea that the demand for corporate efficiency and a competitive advantage will be driving industry adoption of natural gas for decades to come.
The reality is even better because as long as the structural price differences remain (natural gas prices less than diesel), the magnitude of savings (BILLIONS) will drive the paradigm shift toward adoption of natural gas and support billions of dollars in investments. Additionally, because of the ROI and competitive advantage for early adopters, this change will take place no matter what the overall economic conditions within the United States are at the time, making this a premier area to invest in over the short and long term.
Read that last paragraph again.
This case is closed!
Logistically oriented businesses will move to natural gas for their primary source of transportation fuel. The potential savings are so large that it offers a significant competitive advantage over peers and the possibility of financial hardships is real for late adopters due to their cost structure disadvantage.
Data points that could influence our investing thesis
A few factors could alter our investment thesis, like: peace in the Middle East (unlikely); significant change in the ratio of natural gas to diesel pricing (as previously discussed); new federal or state statutes relating to hydraulic fracking; or any pull back in the adoption rate as illustrated in the graph below which documents “Worldwide” natural gas vehicles from various sources. As you can see, other international markets (primarily Asia and the Middle East) where natural gas pricing has historically been lower than diesel, are significantly ahead of U.S. market adoption and infrastructure.
Now that the investment thesis has been plainly laid out, what types of companies should we be looking for?
Natural gas needs to be discovered, drilled, transported (via pipelines), liquefied and finally delivered to the filling stations / end user. Natural gas engines must be designed, manufactured and installed.
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