This Market Could Keep Cooking With Gas

Natural gas prices are hot. The most closely watched spot-market price, the Henry Hub, was $3.60 per thousand cubic feet in January. Compare that with December's average of $2.31, or January 1995's average of $1.61. "No one expected gas prices to go through the roof like they have," says Michael Smolinski, First Albany's gas analyst. Why? Experts think the industry was unprepared for this season's colder-than-normal temperatures after five years of mild winters--including that of 1995, one of the warmest on record.

But why jump into these stocks just as gas prices begin to ease off their seasonal highs? In 1989 and 1993, prices spiked, and everyone was calling a market turn. But this time, many industry watchers are predicting prices to be higher than expected, at least for the next six months. Precariously low gas-storage levels, Canadian pipeline constraints, and strong electric and industrial demand could put pressure on gas supplies through the year, buoying prices and leading to gains for producers.

NATURAL HIGH? What's more, "these companies have strong fundamentals and are relatively cheap," says Richard Weiss, the value-seeking manager of Strong Opportunity and Common Stock funds. This sector is trading at the low end of its historical range--7 times cash flow. "They are still 15% to 20% below their previous cyclical peak cash-flow multiple, which was 9 in 1993," notes Curt Launer of Donaldson, Lufkin & Jenrette. Like shares of many other industries, natural gas stocks have been carried up with the market and are trading near their 52-week highs. But the group's average return was less than half the 34% (not including dividends) of the Standard & Poor's 500-stock index in 1995, which means they may have room to grow.

Low gas inventory levels for the next six months could work in the industry's favor. Expecting another warm winter, utilities filled gas storage to only 93% of capacity, the lowest level in 20 years. Northeastern and Midwestern cold snaps strained these already-low stockpiles and reduced them 25% under last year's level. With some winter left and the need to refill storage this spring and summer, gas prices could remain strong.

Canadian pipeline constraints may also help to keep prices up. Canadian imports, which have grown 12% per year since 1990, have slowed because of limited capacity. So supplies may be squeezed until the Northern Border Pipeline is completed in mid-1998.

Strong demand is another factor when it comes to supply problems. Electric utilities are using more gas to meet rising electricity needs. The load for electric power has grown 46% in the last 20 years, which in turn has begun to test the industry's capacity limits, notes Smolinski. The ability to turn coal, hydro, and nuclear power into electricity has been limited because new capacity has not been ordered since the 1970s. Last August, electric utilities generated 44.3 billion kilowatt hours using gas--that's the highest rate in 20 years and nearly 20% more than the previous year. "As load continues to grow, capacity limits will begin to show up in off-peak months, too," argues Smolinski.

Investors should focus on companies with heavy gas exposure, low-cost production and development, and high reserve replacement rates--the rate at which a company replaces the oil and gas it produces, says S.G. Warburg's Paul Buongiorno. Enron Oil & Gas is a pure play on natural gas, which constitutes over 85% of its total reserves. Anadarko Petroleum has about 60% of its reserves in natural gas, and it boasts a high 250% replacement rate.

Much of Noble Affiliates' 60% natural gas reserve base is concentrated in the higher-priced area of the Gulf of Mexico. That's good news, says Benjamin Rice of Brown Brothers Harriman. Some gas-producing regions have had lower prices because of weak regional demand and transport problems.

ENERGETIC PLAYS. A few small companies, including Cairn Energy USA and Chesapeake Energy, have higher risk but may have greater reward should natural gas prices remain strong. Cairn and Chesapeake have more than 80% of total reserves in natural gas. These aggressive-growth companies are high-volume producers, depleting wells in three to five years, compared with the industry average of eight to ten. Chesapeake uses advanced horizontal drilling, which reduces the company's production costs to 15 cents per thousand cubic feet, well below the 60 cents industry average, says Buongiorno.

Still, as with any commodity-based shares, proceed with caution. A possible oil-price drop, should Iraq move back into the market, could depress gas prices in some regions. Increased gas supplies as a result of improved technology and exploration or a cool summer could also squelch these stocks. But if the industry bulls are right and gas prices hold, these companies will stay fired up.

Before it's here, it's on the Bloomberg Terminal.