Smart Ways to Play the Natural Gas Rally

The rebound in natural gas prices from seven-year lows over the past two weeks has been impressive, but investors who believe they're getting bargains in the independent exploration and production (E&P) stocks that would benefit most from higher gas prices may want to think again.

The front-month futures contract on the New York Mercantile Exchange has jumped about 52%, from $2.50 per thousand cubic feet on Sept. 1 to $3.80 on Sept. 17, but it's down from $7.25 on Sept. 2, 2008. The Amex Natural Gas Index (XNG), which is comprised of 15 of the most highly capitalized companies involved with natural gas exploration and production, as well as pipeline transportation and transmission, is up 15.3% since Sept. 1.

"A lot of investment is being attracted to the group, [with people] thinking they're buying a trough, where there's never been any expectation of a $3 to $4 gas price" over the long term, says Nick Pope, an analyst at Dahlman Rose in New York.

The equity markets are smart enough to know better than to react to where gas prices are now—or may be in the next two months—agrees James McElligott, manager of Fidelity Investments' Select Natural Gas Fund (FSNGX). He thinks E&P stocks are currently pricing in a much longer-term price for natural gas. Indeed, the November 2011 futures contract on the New York Mercantile Exchange traded at $6.79 on Sept. 17.

Watch the Supply Glut That implies limited upside for most of the natural gas-weighted companies in the E&P group. But for those who believe the price of natural gas will reach $7 or beyond by 2011 or 2012, there is likely still room for some of these stocks to appreciate, says Pope at Dahlman Rose.

There's a lot of skepticism about the sustainability of higher prices given that U.S. natural gas storage levels are more than 16% above their five-year average. Inventories were 3.46 trillion cubic feet on Sept. 11, vs. the average of 2.97 trillion cubic feet from 2004 to 2008, according to the weekly storage report released by the Energy Information Administration.

This supply glut, driven by lower industrial demand because of the recession and lower consumption by electric utilities during this summer's unseasonably cool weather, helped push gas prices sharply lower through the beginning of September. Fidelity's McElligott expects gas prices to be extremely volatile from now until early November as the market continually assesses what full storage will turn out to be before winter withdrawals begin.

With production down sharply amid a 56% decline in the number of land-based rigs drilling in the U.S. from a year ago, the recovery to a balanced market is already under way, according to a research report by Natixis Bleichroeder on Sept. 10. Natixis expects withdrawals from storage this winter to be higher than the historic average of 2 trillion cubic feet due to improvement on the economic front and declining supply on less drilling activity.

"We are confident that storage will be higher than the five-year average of 1.375 trillion cubic feet come Mar. 31, 2010, but below the prior year's level of 1.674 trillion," wrote Roger Read, senior energy analyst at Natixis, in the report.

Why Investor Confidence Is Up Contrary to what you might expect, shares of E&P companies that produce more natural gas than oil weren't punished by investors even amid the free fall in gas prices from early summer to the end of August, when the spot price broke below $2 per thousand cubic feet. Yet large- and mid-cap E&P stocks had appreciated 57% year-to-date as of Sept. 15 and 30% since the start of the third quarter, while small-cap E&P stocks were up 66% year-to-date and 56% since June 30. according to research compiled by SMH Capital in Dallas.

It's no surprise the shares of larger companies with stronger balance sheets and better economies of scale experienced most of their gains earlier in the stock market recovery than those of smaller, more vulnerable producers, says Pope at Dahlman Rose. "I see [the weaker] companies going up at the end of the move rather than the beginning," he says.

The fact that there's yet to be a change in the oversupply-weak demand scenario and that prices have moved up so quickly makes analyst Mark Gilman at Benchmark in New York suspect that the rally has been driven entirely by speculators rather than long-term investors. He warns that natural gas futures could give back at least one dollar of their gains and believes the most recent moves in stock prices will also prove illusory.

But Michael Bodino, senior E&P analyst at SMH Capital, can think of multiple reasons behind the gas price bounce, starting with the psychological significance of the spot price breaching the $2 level for the first time since the aftermath of the September 11 terrorist attacks. That gives investors confidence that prices can't get any worse, so they're more willing to bet on the commodity's upside, he says. Bodino figures gas supplies should continue to fall as producers delay new production until January, when the gas price is projected to be much higher, and with 1.5 billion to 2.0 billion cubic feet of U.S. production shuttered due to pipeline-maintenance projects. Improving economic forecasts bode well for higher industrial demand, and commodity speculation should boost prices further, he notes.

Advanced Drilling Whatever the stock valuation outlook, most analysts favor companies with exposure to unconventional gas plays that will be bigger drivers of earnings growth than conventional gas resources in the years ahead. Unconventional gas is found in more dense rock formations that require more technologically advanced drilling methods. Traditionally these have made economic sense only when gas prices are above a certain level, say $7. But that has changed as producers get a better understanding of these formations and use more effective drilling techniques, says Bodino.

The three unconventional plays currently getting the most attention are the Marcellus shale formation in the Appalachian Mountains—spanning New York, Pennsylvania, Ohio, and West Virginia; the Eagle Ford shale formation in south Texas; and the Haynesville shale formation in north Louisiana and east Texas.

The Haynesville and Eagle Ford plays are company-changing projects for Petrohawk Energy (HK), which is the dominant player in both basins, says Bodino. He's projecting that earnings before interest, taxes, depreciation, and amortization, or Ebitda, will grow 20% to 25% over the next 20 years. Those gains will all flow to Petrohawk's bottom line as long as per-unit production costs and pricing stay flat.

Southwestern Energy (SWN) has done a lot to improve its core resource in Arkansas's Fayetteville shale formation by trimming costs, increasing recovery from wells, and using superior well-completion techniques, says Pope. The company has drilled only 10% to 15% of its potential reserves and has preserved shareholder value by keeping equity issuance to a minimum over the past several years. He ties recent pressure on the shares to pipeline problems that have curtailed some production and says the market to some extent underestimates the company's long-term prospects.

Falling Service Costs One of the few stocks Bodino is recommending that investors reduce their exposure to is Range Resources (RRC). Although he likes the company, which has a sizable acreage position in the Marcellus shale formation, Bodino says he can't justify buying it at 14.7 times projected 2010 Ebitda when larger companies such as Chesapeake Energy (CHK) and XTO Energy (XTO) have much lower valuations, 7.5 times and 5.9 times, respectively.

With gas prices at seven-year lows, Natixis' Read questions E&P companies' ability to generate internal cash flow and get access to credit in 2010. Although he expects lower prices, expiring hedges, and declining production to hamper incremental spending next year, a decline in service costs by an average of 30% to 50% means each dollar spent on exploration, drilling, and well completion will buy a lot more than it did last year.

Given the roughly 60% drop in the number of U.S. land-based rig count from last fall, Fidelity's McElligott thinks the market is underestimating the drop in supply likely to be seen over the coming year. If the demand rebound turns out to be as strong as some of the leading economic indicators suggest—and U.S. gas supply falls by 6% to 9% this winter—the outlook for prices would be "much more bullish," he says.

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