Natural Gas Stocks Still Have Major Upside

After an epic, pandemic-induced crash in 2020, the U.S. stock market has gone back to winning ways and is enjoying yet another bumper season in the current year. The S&P 500 is already up 16.0% in the year-to-date and constantly taking out fresh all-time highs.

Few sectors of the market have, however, done better than the long-suffering energy sector. After years of underperformance, the energy sector has been a standout performer in the current year with the Energy Select Sector SPDR ETF (NYSEARCA:XLE) up 30.0% YTD, second only to the 49.8% YTD gain by the retail sector’s SPDR S&P Retail ETF (NYSEARCA:XRT).

The Delta variant of Covid-19 has cast a dark shadow on the entire market. Analysts, though, are saying the latest wave of infections is yet to translate into a decline in spending, with most consumer spending metrics such as air traffic, dining out and movie box office still in positive territory.

After a period of heightened volatility due to an OPEC+ spat on production levels, the energy sector is bouncing back, with Wall Street remaining largely bullish on the mid-term outlook.

The oil sector has lately been hogging the limelight after last year’s crash sent oil prices into negative territory. However, the natural gas sector has been even more impressive, with the best-known nat. gas benchmark, the United States Natural Gas ETF, LP (NYSEARCA:UNG) up 48.6% YTD thanks to an ongoing natural gas rally.

Natural gas futures were trading at $3.95/MMBtu on Thursday, putting them on track for their fourth straight month of robust gains. Natural gas has jumped 63.4% from the start of the year and 135.7% from a year ago, with prices back to levels they last traded at in December 2018, when gas last traded above $4.

Looking closely at those numbers, you will notice that natural gas stocks have lagged the commodity they track by almost 15 percentage points so far this year and a whopping 95 percentage points over the last 12 months.

That seeming anomaly can be chalked up to the fact that natural gas equities trade based on the price of longer-dated futures. While futures with near-term maturities tend to fluctuate based on near-term dynamics such as the weather, stock investors tend to be more concerned about what the market might look like in 18 months or more.

Bearing this in mind, here’s why many natural gas stocks could actually be undervalued at this point.

Bullish natural gas outlook

It’s a well-known fact that the fossil fuel sector is, by far, the biggest contributor to greenhouse gas (GHG) emissions. In fact, the EIA released a damning report that in 2018, carbon dioxide (CO2) emissions from burning fossil fuels were equal to ~75% of total U.S. anthropogenic GHG emissions and ~93% of total U.S. anthropogenic CO2 emissions (based on 100-year global warming potential).

Over the past half-decade, natural gas producers have been re-branding and touting the commodity as the perfect energy bridge that will continue to play a major role in our energy mix as the world gradually adopts cleaner energy sources. Natural gas emits 50 to 60 percent less CO2 when combusted in a new, efficient natural gas power plant compared with emissions from a typical new coal plant.

Unfortunately, this narrative has come under major threat over the past few years, thanks to rapidly falling costs for renewable energy. Solar photovoltaics (PV) has seen the sharpest cost decline of any electricity technology over the last decade, with a report by the International Renewable Energy Agency (IRENA) saying that between 2010-2019, the cost of solar PV globally dropped by 82%. If renewable energy production were to achieve cost parity with natural gas, it would lose its last line of defense as an energy bridge because natural gas is still orders of magnitude dirtier than the dirtiest renewable energy sources when accounting for lifecycle emissions.

Luckily for oil and gas bulls–and to the chagrin of clean energy buffs–the trend of rapidly falling solar costs appears to have come to an abrupt end.

Clean-energy funds have been taking a beating after Enphase Energy Inc. (NASDAQ:ENPH)–a popular holding–reported major semiconductor shortages and supply-chain issues. ENPH went through one of its biggest one-day crashes after dropping nearly 10% a day after reporting better than forecast Q1 earnings but issuing downward guidance for Q2 due to semiconductor shortages and supply-chain issues that have been worse than anticipated.

A global shortage in semiconductor chips has been wreaking havoc on the tech sector, clean energy, automotive industry, consumer electronics industry, and everything in between. After years of tepid demand, the COVID-19 pandemic spurred a huge tech buying spree, with manufacturers of personal computers, tablets, laptops, and gaming consoles caught off guard. 

The supply-chain bottlenecks could be a short-term risk, though.

Following checks with utility-scale solar developers including Array Technologies (NASDAQ:ARRY), FTC Solar (NASDAQ:FTCI), and Shoals Technologies (NASDAQ:SHLS), Cowen analysts have trimmed their earnings estimates for Q4 2021 and H1 2022 because the bulk of Q2-Q3 revenue was booked pre-inflation, noting inflation on panels and steel has led to ~10% increase in project costs, leading to 6-9 month pushouts for solar projects. Analyst Jeffrey Osborne says that he sees “more resilience” in residential exposure.

Related: The Net-Zero Narrative Is Riddled With Holes

However, Cowen says that their checks with utility-scale project developers suggest that the long-term trends remain “incredibly encouraging.” 

Still, there could be other long-term secular headwinds that could limit growth for the sector.

The solar industry is now mostly focused on making panels more powerful as it continues to squeeze as much efficiency as possible out of solar tech. However, according to Xiaojing Sun, global solar research leader at Wood Mackenzie Ltd, the reduction in the cost of module prices has slowed notably in the past two years. It is now going to be cost-of-electricity reductions that provide much of the upside for solar energy. This limitation means solar costs are unlikely to drop low enough to outperform their oil and gas rivals, even if oil prices weren’t soaring higher. 

The hydrogen ally

Last year, the European Union set out its new hydrogen strategy as part of its goal to achieve carbon neutrality for all its industries by 2050. 

In a big win for the renewable energy sector, the EU has outlined an extremely ambitious target to build out at least 40 gigawatts of electrolyzers within its borders by 2030, or 160x the current global capacity of 250MW. The EU also plans to support the development of another 40 gigawatts of green hydrogen in nearby countries that can export to the region by the same date. The EU aims to have at least 6 gigawatts of clean hydrogen electrolyzers installed by 2024.

Good news for natural gas companies: Although Brussels clearly favors “green” hydrogen produced by renewable energy, it has signaled that it will also encourage the development of “blue” hydrogen that is produced from natural gas paired with carbon capture and storage (CCS).

The EU has said that hydrogen will play a key role in helping decarbonize manufacturing industries and the transport sector. The organization says it will support blue hydrogen during a “transition phase.” Although natural gas producers would no doubt prefer centralized blue hydrogen, they will not be complaining too much since natural gas infrastructure can easily be repurposed to carry hydrogen.

The latest decision by European policymakers follows years of hard lobbying by more than 30 energy companies, including ExxonMobil (NYSE:XOM), ENI S.p.A (NYSE:E), Shell (NYSE:RDS.A) Total (NYSE:TOT), Equinor ASA (NYSE:EQNR) and other European natural gas companies which have called for a “technology-neutral strategy” arguing that renewables such as wind and solar cannot grow fast enough to power the “clean hydrogen” sector to meet decarbonization goals. The signatories have claimed the green hydrogen industry is currently too small to spark the growth of a large-scale European hydrogen economy in the space of just a decade.

Top Natural Gas Stocks

Given this backdrop, we believe that natural gas is likely to continue playing a major role in the U.S. energy mix as the most dominant fuel in electricity generation for many years.

John Gerdes, MKM Partners’ oil and gas analyst, has picked Antero Resources (NYSE:AR) and Southwestern Energy (NYSE:SWN) as the stocks trading at the largest discount to their implied value to gas price.

Our top picks in the space are Cheniere Energy (NYSE:LNG), EQT Corporation (NYSE:EQT), Range Resources (NYSE:RRC), and Cabot Oil & Gas Corporation (NYSE:COG).

By Alex Kimani for Oilprice.com

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