Offset the Natural Gas Crunch's Sting

Physician's Money Digest, August31 2003, Volume 10, Issue 16

Testifying before Congressthis past July, Federal ReserveChairman Alan Greenspanwarned for a second time in lessthan a month that the United Statesis facing a severe natural gas supplycrisis. If you're a doctor who heats orcools your home or business withnatural gas, you have already seenyour natural gas utility bill skyrocket.

There is an opportunity forphysician-investors to take advantageof the structural problems facingthe North American natural gasindustry: Invest a portion of yourportfolio in this industry for thenext 3 to 5 years. The investmentgains will more than offset the stingof higher gas utility bills.

GAS DRILLING HISTORY

In the early 1980s, oil and gassupplies in North America werevery tight and prices skyrocketed. Inresponse, the oil and gas industryvamped up drilling for new production.High prices eroded demandfor natural gas. The federal governmentimplemented price controlsand passed legislation providingstrong disincentives to consumenatural gas. By the late 1980s, naturalgas production in NorthAmerica far exceeded demand. Asprices plummeted, drilling companieswent out of business. Today,fewer than 1000 operational drillingrigs are left in North America.

It took almost 10 years to workoff the glut in natural gas productionand for demand to reverse itsdownward slide. Today, demand isgrowing at about 2% per year.About 80% of US homes andpower plants built in the past 5years burn natural gas for electricity.The federal government nowfavors natural gas production andconsumption over coal, oil, hydroelectric,and nuclear energy.

Still, the production of naturalgas declined about 5% in 2002 andis slated to drop another 5% in2003. This imbalance between supplyand demand caused a sharprun-up in prices in the winter of2000 to 2001 and again in fall2002. Wholesale natural gas pricesin the United States averaged $2.35from 1996 to 1999; $3.72 from2000 to 2002; and are currentlyaveraging $5 to $6 per mcf.

NO REPEATS IN STORE

There won't be a repeat of the1980's boom/bust cycle becausethere are less than 20% of the availabledrilling rigs today. Over 80% ofgeologists, rig hands, etc, have permanentlyleft the industry. In addition,existing gas fields in NorthAmerica are aging—the averageyear-over-year decline in productionin existing gas fields in NorthAmerica is 30% per year.

There are abundant supplies ofnatural gas remaining in NorthAmerica located on the northernslope of Alaska, in the RockyMountains, off the east and westcoasts of the United States, and offboth coasts of Florida. However,these gas reserves are off-limits dueto environmental restrictions or arevery difficult to produce and bringto market.

What about importing naturalgas? I predict that in 25 years, wewill import over 50% of our naturalgas from overseas on tanker shipsin the form of liquefied natural gas(LNG). However, even if we wantedto import more gas today, thereare only 3 operational LNG unloadingterminals in this country.The total offloading capacity of the3 terminals represents less than 1%of our current annual consumption.New LNG terminals will takeyears to build, and pending proposalsto build new LNG terminalsare meeting stiff resistance fromenvironmentalists.

MAKING A PROFIT

There are 2 ways to take advantageof this opportunity—invest instocks or invest directly in domesticnatural gas drilling ventures. If youare a stocks-and-bonds-only kind ofinvestor, talk to your financial advisorabout the best companies toown in the natural gas business.There are 3 types of companies inthe industry—drilling and drillingservice, transportation (pipelines),and gas marketing. Warren Buffetthas invested several billion dollarsin gas pipeline companies in thepast 24 months and is expected tocontinue. Drilling and service companieswill benefit financially as thehigher price of natural gas and risingdemand induces companies todrill more gas wells.

Another good method is toinvest directly with a drilling companyand own a direct interest inthe gas wells. If you make a directinvestment in drilling gas wells, upto 100% of your investment is tax-deductibleagainst your income inthe year of investment. This meansyou can recoup up to 50% of yourinvestment in tax savings alone(35% federal tax rate plus yourstate income tax rate). In addition,you should receive a long-termmonthly or quarterly cash distributionfrom the drilling company foryour share of the revenue producedfrom the gas well.

With today's gas prices averagingabout $5.50 per mcf, I am seeingconservative developmental gasdrilling programs that are distributing30% to 50% cash returns annuallyon a gross investment. Thismeans between the tax savings andthe cash distributions, you mayrecover your entire investment inabout 2 years and still have a long-termrevenue stream to boot.Additionally, about 25% of theannual cash flow you receive is shelteredfrom taxation.

DIRECT GAS INVESTING

The following are some guidelinesfor investing directly indrilling programs:

  • Dollar-cost-average into theindustry. Consider investing 5% to10% of your gross income in adevelopmental gas drilling programannually for the next 3 to 5years. There is still a 3- to 5-yearwindow of opportunity to invest indomestic drilling and reap largeinvestment returns.
  • Invest in developmental gasdrilling programs in the AppalachianBasin that have at least 20gas wells. Drilling success rates inthe Appalachian Basin are about95%, and a multiwell program providesyou with the equivalent of amutual fund of gas wells.
  • Always make sure that thedrilling company you select isinvesting at least 25% of the fundsto drill the gas wells, above andbeyond any profit they're chargingto drill the gas wells.
  • Make sure the program automaticallyconverts your investmentto a limited liability interest afterthe drilling is complete—this eliminatesyour financial exposure afterdrilling is completed.
  • The drilling program shouldallocate 100% of the "intangibledrilling cost" to you as the outsideinvestor, this makes your investment100% deductible againstyour income.

Like any industry, some drillingcompanies have better track recordsthan others. Do your homeworknow and make an informed choicewell before the year's end.

David P. Dyer, a licensed taxattorney, is president of AllianceAffiliated Equities Corporation,a NASD registered broker/dealer specializing in tax-advantagedinvestments, memberNASD. He welcomes questions or commentsat 800-453-5155 or office@aaeconline.com.