Why oil is the better energy play

Natural gas prices have really struggled as of late, selling off more than 40% since last November to a two-and-a-halfyear low of US$2.60-per-million British Thermal Units as low-cost gas from shale drilling flooded the North American market.

The reason: Companies responded to last winter’s rally in pricing to above US$6 to US$8 per mmBTU by setting new all-time high production records for the past 11 consecutive months, adding between six to seven billion cubic feet per day of new volumes.

Consequently, natural gas inventories now sit at 2.4 trillion cubic feet, up nearly 25% from levels a year ago and are now back to the five-year average. Compare that to last spring when supplies were more than 50% below the fiveyear average.

Unless cooler temperatures in the U.S. Northeast persist over the next few weeks in order to increase the draws from storage, it looks as though we could end the winter at 1.8 to 1.85 trillion cubic feet of unused gas.

This would bring gas inventories to 10% above the fiveyear average and nearly 120% higher than last year’s levels.

If this happens, the price of natural gas will likely remain near current levels for a while yet, at least until the yearover-year surplus is whittled away — certainly not an encouraging near-term outlook for natural gas producers.

The bad news is compounded for Canadian producers as more of this U.S. production growth makes its way into Eastern Canada due to ongoing pipeline expansions, thereby backing up our own supply and blowing out the basis differentials.

There is a bit of light at the end of the tunnel though. Last week’s Baker Hughes active rigs count fell to its lowest level since March 2010 and is down nearly 18% from yearago levels.

Natural gas drilling has been on a steady decline, but it’s important to consider the curtailment in oil drilling as natural gas has been a steadily growing byproduct of oil shale drilling.

For investors wondering how best to position for an eventual recovery, we think there is better upside potential in oil prices than natural gas due to the former’s global pricing power.

For example, there is always the potential for a geopolitical event to cause a production curtailment of oil and subsequent upward spike in pricing, whereas natural gas is still landlocked and susceptible to North American supply/demand fundamentals, which remain weak.

However, there has been an interesting dichotomy in the oil market worth considering.

Large Canadian oil producers such as Canadian Natural Resources Ltd. have actually hung in quite well compared to the large sell-off in oil. Specifically, CNRL’s U.S. share price is off only 6.5% over the past 12 months while WTI oil is off more than 47%.

As a result, we think there is better value in owning oil directly rather than the oil producers.

If you have to own natural gas companies, we would favour the low-cost producers or, even better, the liquids-rich producers that will benefit from the eventual recovery in oil offsetting any weak pricing in natural gas.

Fortunately, there are some great deals to be found as some of Canada’s best well-run gas companies can be bought at 20% discounts to year-ago levels.

Martin Pelletier, CFA, is a portfolio manager at Calgary-based TriVest Wealth Counsel Ltd.

We think there is better value in owning oil ... than the oil producers