advertisement
For most of the country, autumn temperatures have stopped short of a deep freeze. But for natural-gas stocks, things have gotten downright chilly.
The culprit: the dreaded "shoulder months." From August to October, there's a lull in demand between the time when air conditioners are turned off and heaters are turned on. Natural-gas prices plummet as storage levels soar.
The effect was exaggerated this year, as high storage levels have persisted since last year's warm winter. Gas in storage was recently 13% above the five-year average. That helped push natural gas briefly below $4 per million British thermal units (Btu) in late September -- prices not seen in three years. Prices were more than three times as high a year ago, after Hurricane Katrina disrupted supply.
The reversal has investors clearing out of natural-gas plays. Companies such as Southwestern Energy (SWN, news, msgs), Apache (APA, news, msgs), XTO Energy (XTO, news, msgs) and Chesapeake Energy (CHK, news, msgs) are still well off their highs of a few months ago, despite a rally in the past week.
If history is any guide, the smart thing to do now is to buy the downtrodden gas stocks, says Ken Sill, an energy-sector analyst with Credit Suisse.
Over the past 10 years, natural-gas prices have declined 22%, on average, from their June-July peaks to their August-September lows. But then they've rebounded an average of 77% to their November-December highs. "We think you can improve your returns by adding to positions in the group while the stocks are on sale, before a strong earnings season and colder weather spark a rally," Sill says.
Will colder weather show up? It's a gamble. The National Oceanic & Atmospheric Administration forecast calls for weather that's 2% warmer than normal this winter but 5% to 10% colder than last year.
More from MSN Money
Any cooling from last year's levels could spark a rebound for the stocks. After all, the excess gas in storage equals only about what the nation uses in seven days. "The overhang is not that large. We could burn it off pretty quick," says Walter Goodrich, the chairman and chief executive of Goodrich Petroleum (GDP, news, msgs), a natural-gas producer.
Traders seem to agree. Natural gas for November delivery recently sold for $7.20 per thousand Btu. But gas for delivery in January and February recently traded for $8.40. Unseasonably cold weather this coming winter could push natural-gas prices even higher.
Again, the big "if" is the fickle weather. An El Niño pattern may bring unseasonably warm weather to the northern U.S. this year, says Joseph Magner, an analyst with energy-specialist brokerage Petrie Parkman. That would hurt demand for natural gas. So unless you're a gambler, it's a mistake to buy these stocks as a bet on a cold winter.
But you don't have to. There's an underlying bullish trend in natural gas that should bring healthy profits for long-term investors. "Even if we do get a mild winter, we think there is a lot of upside in these stocks over the next year or two," says Eric Chenoweth, an analyst who follows the group for Morningstar.
To see why, keep in mind that natural gas, unlike oil, can't be readily imported to North America from around the globe, at least until more terminals to receive liquefied natural gas are built. That won't happen for four or five years. So the North American market for natural gas is a "local" market, in which producers have exhausted the easy pickings.
"As an industry, we are drilling smaller wells, and the decline rates are steeper than five or 10 years ago," says Harold Korell, Southwestern Energy's chief executive. "Those basic forces are acting to make gas fairly tight." Since January 2003, the gas rig count has increased 85%, but U.S. natural-gas production is down more than 4%, points out Petrie Parkman's Magner. The bottom line: Limited supply will continue to support solid pricing.
In the near term, two other factors could help these stocks.
- Lower natural-gas pricing means some companies are trimming production. This in itself supports natural-gas prices. But it also brings down costs and boosts profit margins because there's less competition for rigs and gas-field services, says Goodrich, of Goodrich Petroleum.
- Producers of ethylene, used to make plastics, recently shut down 10% of their capacity for maintenance. That should come back on line and add to demand by the end of this month, says David Khani of Friedman, Billings, Ramsey.
Here are seven stocks for the natural-gas rebound:
- Southwestern Energy was among the first energy companies to recognize the vast potential for natural gas in the Fayetteville Shale reservoir in Arkansas. As the first mover, it got some of the juiciest positions. Still in the early stages of exploiting its 880,000 acres, Southwestern is a favorite natural-gas play of Friedman, Billings, Ramsey analyst Amir Arif, who has a price target of $52 on the stock.
- Chesapeake Energy followed Southwestern to the Fayetteville Shale reservoir and is the largest leaseholder there. Through other aggressive acquisitions, the company has built extensive holdings in Louisiana, Texas and the Appalachian basin. Prudential Equity Group's Jason Gammel believes the company's reserve potential is nearly twice its 8.3 trillion cubic feet equivalent of proven reserves. Chesapeake owns drilling rigs and rig companies, which serve as a hedge against higher rig costs. The company also has most of its 2007 and more than half its 2008 natural-gas production hedged at levels substantially higher than today's prices. Lehman Brothers analyst Jeffrey Robertson has a $41 price target on the stock.
- Devon Energy (DVN, news, msgs) is the sixth-largest natural-gas producer in the United States, just ahead of Chesapeake. It has a large position in a promising deep-water natural-gas play in the Gulf of Mexico. Devon also has sizable natural-gas reserves in Texas' Barnett Shale and a stake in the Alberta oil sands. "Devon has a host of new projects slated to come online over the next few years, which should meaningfully boost production," says Morningstar's Justin Perucki. It's a favorite natural-gas play of Khani at Friedman, Billings, Ramsey. The latter has an $80 price target on the stock.
- Instead of exploration, XTO Energy sinks nearly all of its time and money into acquiring oil and gas reserves in established areas and exploiting them with new technology. The strategy has worked "brilliantly," says Morningstar's Chenoweth. XTO's operating margins and return on capital are among the best for independent producers. Natural gas makes up about 80% of XTO's proven reserves. Petrie Parkman's Joseph Magner has a $57 price target on the stock.
- Goodrich Petroleum is a small-cap play on the promising Cotton Valley Trend in eastern Texas and northern Louisiana. Earlier this year, Goodrich was increasing production 20% a quarter. One factor that could boost growth: Goodrich planned to begin its first horizontal well in the Cotton Valley Trend this month. Horizontal drilling can produce higher rates of return at lower costs. Devon recently posted "very positive results" from a Cotton Valley horizontal well test, says Bear Stearns analyst Ellen Hannan. She has a $40 price target on Goodrich.
- Delta Petroleum (DPTR, news, msgs) has a solid base of productive assets. But owning shares of this small company is really a bet that Delta hits it big with exploration projects for natural gas in the Columbia River Basin in Washington state and an oil formation called the Central Utah Overthrust. Petrie Parkman's Larry Busnardo says both hold "staggering exploration potential" that could double or triple Delta's reserve base. One caveat: The company says test wells should yield results over the next three to six months. If tests come up dry, the stock could fall sharply because a lot of money is already riding on this bet.
- Petrohawk Energy (HAWK, news, msgs) has been building its assets through acquisitions, with the goal of being bought out over the next six to 18 months. Friedman, Billings, Ramsey's Khani thinks a buyout could happen in the second half of next year -- at $21 a share. The stock recently sold for $10.90. Insiders are betting on a big markup. Since March, they've bought $2.6 million worth of stock for prices between $10 and $12.85.
Expert picks
As of this column, I'll add all seven of these stocks to my Company Focus portfolio in our Expert Picks section, and we'll see how they do from here.At the time of publication, Michael Brush owned shares of Petrohawk.
Rate this Article
High