It looks like the climate bill has about the same chance of passing this year as a snowball in… well… a very hot place. Though that hardly means the coal industry is safe. Congress may not be able to get anything done. But United States environmentalists have a lot more fight left in them. Wall Street doesn’t know it yet. But a large number of U.S. coal-fired power generation plants will close over the next five years. That will force the country to rely on new resources to supply its energy needs. In this day and age, that can only mean one thing: natural gas. Greater reliance on the commodity will naturally send prices skyward. And when that happens, natural gas stocks should shoot higher than an oil well.

Coal’s Loss is Natural Gas’ Gain

One way or the other, coal’s grip on the U.S. is doomed. If the climate bill fails, its supporters will simply turn to indirect controls under existing laws. The Clean Air Act includes the Maximum Achievable Control Technology provisions.

• Those limit pollutants such as sulfur dioxide, nitrogen oxide and mercury. And coal plants produce all three.
• Specifically, the provisions require coal-fired plants to emulate the “best” in their class. However little hazardous pollutants, the top 12% produce is exactly how much the rest can emit.
• Once an industry rule comes down from the EPA, the clock starts ticking. Each operation has no more than four years to bring its emission levels down appropriately.
  For coal plants, the EPA has to legally issue new proposed rules for pollutants by March 2011. And final rules will go into effect by that November.

The new regulations will essentially force utilities to make very expensive modifications. So expensive, in fact, that it will make more sense to just shut down many of the older plants. Both utility companies and environmentalists agree on that point, at least. In all, such closures could affect up to20% of all coal-fired power generation by 2015.

That works well for the environmentalists, who see it as a great way to reduce carbon emissions. According to them, the U.S. population can just deal with the loss, learning to live on less.

Yeah. Like that’s gonna happen…

Increased Natural Gas Demand

Many utilities will probably turn to natural gas to make up for the cut in coal. Hugh Wynne, utilities analyst with Bernstein Research, predicts demand for the product rising 10% by 2015. Now, you may have heard the U.S. has a nearly unlimited supply of shale gas at the present price of $4 to $5 per million BTU. But that assumption is absolutely wrong. Many industry insiders believe that the real cost of shale gas can’t be covered without an increase to $8 or $9 per million BTU.

Just ask Aubrey McClendon, the CEO of Chesapeake Energy (CHK). He doesn’t believe that natural gas’ low prices can last. For example, Chesapeake earns about 4% on invested capital. Yet it has an estimated capital cost of 8% – 10%. And it’s one of the industry’s strongest players. Ben Dell, also of Bernstein Research, believes the full cost of finding, developing and operating shale gas wells – and paying an average return on capital to investors – requires a spot gas price of $7.50 – $8 per thousand cubic feet. He points to the short supply in horizontal rigs needed to drill shale gas wells. So his assumption that “there will be a 15% – 20% increase in costs from last year to this year” makes some sense.

In addition, gas producers tried to combat weak prices over the past year by hedging. Those hedges are now expiring though, and new ones have to be put on at lower prices. So the bottom line for many gas producers will show a fall in revenue and a rise in costs… Hardly ideal conditions for any large production increases.

Two Natural Gas Investments

To guarantee new levels of supply, natural gas has to reach – and stay at – $8.00. It hasn’t yet, but it will. And when it does, Southwestern Energy (SWN) should profit nicely. The company focuses almost completely on natural gas, with a large exposure in the prolific Fayetteville shale gas field. Better yet, it only hedged a fraction of its 2010 production. So it is more sensitive to short-term natural gas prices. And it sports low debt and one of the lowest production costs in the industry.

Investors can also look into Chesapeake Energy (CHK). It is the second largest natural gas producer in the United States and the leader in natural gas production from shale rock. Both investments are sure to power your portfolio in the years ahead.

Good investing,

by Tony D’Altorio, Investment U Research

ETF Options:

To gain your best access to Tony’s two recommended stocks through an ETF, you may want to look at the iShares Dow Jones US Oil & Gas Ex Index (IEO).The iShares Dow Jones US Oil & Gas Ex Index has 4.07% of its holdings in  Chesapeake Energy, and  3.92% of its holdings in Southwestern Energy.  Another ETF containing these two companies is the SPDR S&P Oil & Gas Exploration & Production (XOP). The SPDR S&P Oil & Gas Exploration & Production ETF has 3.15% of its holdings in  Chesapeake Energy, and  3.26% of its holdings in Southwestern Energy. 

Other natural gas ETFs to consider would be:

United States Natural Gas (UNG) which seeks to replicate the performance, net of expenses, of natural gas. The trust will invest in futures contracts on natural gas traded on the NYMEX that is the near month contract to expire.

First Trust ISE-Revere Natural Gas (FCG) which seeks to replicate, net of expenses, the ISE-REVERE Natural Gas index. The fund invests at least 90% of assets in common stocks that comprise the index. The index is an equal-weighted index that consists of exchange-listed companies that derive a substantial portion of their revenue from the exploration and production of natural gas.

Direxion is also began trading two new leveraged gas ETFs today. The new funds are the Direxion Daily Natural Gas Related Bull 2X Shares (FCGL) and the Direxion Daily Natural Gas Related Bear 2X Shares (FCGS). The funds seek daily investment results, before fees and expenses, of +200% and -200% of the price performance of the ISE-Revere Natural Gas Index respectively.

IEO, NYSE:FCG, NYSE:FCGL, NYSE:FCGS, UNG, XOP