Natural gas? Play the Rocky Mountain high

No one yet knows how much energy one of these plants, running at full scale, would require to produce a barrel of oil. And no one knows exactly how much water these plants would consume in oil production. (For example, one technology, mine and retort, would use 2.1 to 5.2 barrels of water to produce every barrel of oil.) And no one knows if it's possible to design a production process that doesn't pollute local ground and surface water. (The Natural Resources Defense Council has produced a report on the environmental effects of oil production from shale and tar sands. Here's a link for a summary that will take you to the full report.)

While the pilot projects go on, we're still a long way away from producing oil from Rocky Mountain shale in any quantity. But with the Green River Basin alone promising total reserves of 800 billion barrels of oil -- about three times the reserves of Saudi Arabia -- I doubt the oil companies will simply walk away this time.

A buying opportunity

The biggest obstacle in the way of expanded natural-gas production from the Rockies is the lack of enough pipeline capacity to get gas out of the region to consumers in the Midwest and East. This lack of transport has produced a local glut of natural gas that has left the price in the region at $5 per million BTUs, below the Louisiana Henry Hub price in June. Growing production has just made the problem worse: In 2004 the discount averaged just 89 cents but had climbed to $1.55 by 2005.

According to Wood Mackenzie, natural-gas export capacity from the region is now maxed out and supply growth will stabilize. In June, for example, supply from the region is likely to grow by just 600 million cubic feet per day, a drop from the 1 billion cubic feet a day added to supply in June 2006. By September, Wood Mackenzie projects, growth is likely to drop to just 350 million cubic feet a day.

Rocky Mountain natural-gas producers will be caught in a tight spot, with both lower natural-gas prices and lower supply growth squeezing earnings. That's likely to lead to analyst downgrades and earnings disappointments that will punish stock prices for regional producers.

Relief, however, is on the way. The Rockies Express pipeline will link producers in the region to Cheyenne, Wyo., this year, to Mexico, Mo., in 2008 and to Clinton, Ohio, by 2009. And since this new pipeline uses higher pressures to move higher volumes of gas, transportation costs for Rocky Mountain natural gas will be lower than for competing gas from Texas and Louisiana.

That should result in a complete reversal of the 2007 squeeze on earnings, as natural-gas volumes climb and the price discount to the Henry Hub benchmark price narrows or vanishes.

If you want a lower-risk way to play this turnaround, go for the shares of a bigger producer like Anadarko (APC, news, msgs) or Encana (ECA, news, msgs). A big company like this can still get a considerable part of its natural-gas revenues from the Rockies -- 50% of Anadarko's natural gas comes from the Rockies, for example -- but the same large portfolio of other energy assets that lowers the risk of these stocks also limits the upside from a turnaround in Rocky Mountain gas prices.

My picks

So I prefer smaller producers with more of their eggs in the Rocky Mountain basket. My three favorites, in order of preference:

XTO Energy (XTO, news, msgs) placed a huge bet on Rocky Mountain natural gas in early June when it acquired 1 trillion cubic feet of proved reserves in Texas and the Rockies from Dominion Resources (D, news, msgs) for $2.6 billion. In addition to the proved reserves (95% natural gas), XTO Energy also picked up 542,000 acres of leasehold, of which 235,000 are undeveloped. The bulk of the reserves are in the Uinta, San Juan and Green River basins. In June, XTO Energy boosted its production guidance for 2008 by 15%, to 580 billion cubic feet of natural gas. That would be roughly a 35% increase from 2006 production.

Ultra Petroleum (UPL, news, msgs) is the leading producer of natural gas on the Pinedale and Jonah formations in the Green River Basin. The company expects to see production climb to 135 billion cubic feet in 2008 (from 114 billion cubic feet in 2007) and to 160 billion cubic feet in 2009. As of the end of the first quarter of 2007, the company had price hedges in place for about 15% of its 2008 production. Ultra Petroleum's other big exploration effort is in the waters of China's Bohai Bay.

Cabot Oil and Gas (COG, news, msgs) owns unconventional natural-gas reserves in the Rockies, in Canada, in Texas and in the Appalachian Mountains. About 57% of Cabot's Rocky Mountain natural-gas production is hedged for 2007 with a $7 floor so that Cabot is likely to sell off relatively less in the tough period before the Rockies Express pipeline kicks in. But despite this "handicap," I recommend Cabot on any dip. The company has one of the highest returns on equity among similarly sized natural-gas producers at 16.2%. (That trails only XTO Energy at 23.4% and Chesapeake Energy (CHK, news, msgs) at 17%.) The company's very clean balance sheet, with a 16% debt-to-capitalization ratio, gives Cabot plenty of room for a strategic acquisition or two if it wants to increase the efficiency of existing fields.

If you do manage to pick up any of these three on weakness over the next few months, I think you can safely put them away for five years or more.

Continued: Updates to Jubak's Picks

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