Natural Gas Stocks
By Michael Brush
October
03, 2003
Unlike oil, natural gas can’t be moved around the globe too
easily. Believe it or not, that simple concept is half of all you need to
know, to understand the dynamics behind a serious shortage of natural gas in
North American. It’s a shortage that will drive impressive growth at several
potentially lucrative energy plays for years to come.
The other half?
In the past decade, high-tech production techniques have
finessed more and more natural gas out of our energy fields in North America.
Now, the easy pickings are all gone. So what’s left is only coming out at
higher prices, because it is so much more difficult to get.
Higher
prices for at least five years
These factors explain why the price of natural gas – used
in everything from heating and cooking, to making cement – is now double
what it was for most of the 1990s. The bad news for consumers: Natural gas
prices will stay this high, or higher, for at least another five years.
What’s bad for consumers, though, can be great news for
investors savvy enough to pick the most vibrant companies in the natural gas
sector. Let’s think of it in terms of three groups. First, you can expect
higher natural gas prices to boost profits at exploration and production businesses like Chesapeake Energy (CHK),
EnCana (ECA), and Devon Energy (DVN). Next, oilfield
services companies like Patterson-UTI Energy (PTEN) and Ensco
International (ESV) will also gain. Finally, smaller
niche plays like Heartland Oil & Gas (HOGC: OB) and Cheniere Energy
(LNG), are working on less conventional – but profitable – ways to bring
natural gas to market, now that prices are higher.
Here’s why analysts think the dramatic shortage of natural
gas in North America will last – and boost profits at companies like these
-- at least until 2008.
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The gas fields have been worked over so well, the easy pickings are gone. “The
depletion of the existing fields is running amok,” says Charlie Maxwell, a
veteran energy analyst with Weeden & Co., who is one of the best, having
followed the industry for decades. “Even though we do find more each year,
it basically replaces what is taken out of the system.”
Check in with the oil patch, and you hear the same story. “We
went through the low hanging fruit back in the 1970s and 1980s,” says Al
Reese Jr., the chief of finance at Houston, TX-based ATP Oil & Gas (ATPG).
“With the advent of computer technology we are now able to access smaller
and smaller fields to make them more productive, but we have been doing that
for ten plus years. By now, no matter how much technology you throw at a
field, we are not going to be able to increase productivity like we have in
the past.”
Maxwell believes that in North America, we hit “Hubbert’s
peak” – or the peak production year -- in 2002 for natural gas. This
industry argot is borrowed from the name of the famous and controversial
geologist M. King Hubbert who tried to forecast when energy production would
peak, back in the 1950s. What’s the big deal if production peaks? After all,
we can just import some from abroad, right? Because the worldwide Hubbert’s
peak for natural gas won’t arrive until 2050. Unfortunately, it’s not that
easy. Here’s why.
For the next several years there won’t be alternative supplies available
from other countries. The reason? It will take several years, at least, to
get the infrastructure in place to bring natural gas to the U.S. from
elsewhere. Expect three to four years to pass before more pipelines are built
to import extra natural gas from Canada, says Tom Petrie of Petrie Parkman
& Co, Denver-based research boutique that follows energy stocks. Pipelines
from Alaska? Five to seven years. Another option – importing liquid natural
gas (LNG) – is far off in the future, too. New receiving terminals are only
just now going through the approval process, and they won’t be on line until
2007 or 2008. “Pipelines and LNG are all weighted to the later part of the
decade,” says Petrie. True, deepwater development in the Gulf of Mexico and
some new supplies in the Rocky Mountains will help out before then. “But
that won’t be enough to upset the apple cart,” says Maxwell.
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Meanwhile, growth does look like
it’s coming back, which increases demand for natural gas.
“We are at a point where the economy is showing signs of recovery,” says
Petrie. “And with the decline in the production base, that’s going to move
us into a fairly tight supply-demand equation for a while.”
A volatile ride
As compelling as these trends seem, investors should know
that owning natural gas stocks will bring some scary moments. There are two
reasons for this.
First, you can expect sharp pullbacks in the price of natural
gas at any moment. And that will knock down natural gas stocks as well. We saw
this scenario play out in the summer of 2003. Natural gas hit a peak of $6.50
per Mcf (thousand cubic feet) in June. But then the summer turned out to be
unseasonably cool, which lightened energy demands. Meanwhile, frugal users
began switching to less expensive fuels – or they shut down production
altogether. Finally, once it was clear the U.S. was socking away enough of
this energy source for the winter, natural gas prices fell even more.
All told, the price sank 25%, to just north of $4 per Mcf by
September 2003. This summer sale on natural gas shaved 11% off the Oil Service
Index, as speculators cleared out of these stocks. More volatile names in the
space moved down much more sharply. And that won’t be the last white-knuckle
ride for natural gas stockholders over the next five years.
After all, not only do natural gas prices move around a lot,
but another factor creates volatility in these stocks: Energy service and
exploration companies have long had a reputation as a group “to rent, not own.” So longer-term
buy-and-hold players, like mutual funds and pension funds, shy away from these
names. Instead, energy stocks
are a popular playground for hedge funds. This way of thinking probably
won’t go away – even though it should, since the long-term fundamentals
favoring higher natural gas prices are so convincing. So you can expect hedge
fund games to continue to move these names around.
As scary as all the volatility can be, long-term investors
should actually welcome any pullbacks – because they serve as convenient
entry points in stocks that will ultimately see gains of 50% to 100% in the
next several years.
“I see
natural gas trading for an average of $5 per Mcf over the next three years,
inside a range of about $4-$6,” says industry expert Rikard Ekstrand of
First Pacific Advisors, whose FPA Capital Fund (FPPTX) has a 16%
annualized return in the past ten years.
Right now, his firm has positions in service stocks like Patterson and Ensco.
“With that kind of outlook for the price of natural gas, I would
expect these stocks to double from here,” he said in September, when both
stocks were trading for around $27 per share.
One potential source of excitement just around the corner: If
winter weather is unusually cold – like last year – expect natural gas
plays to jump as the price of natural gas itself moves up sharply.
Here’s a closer look at some promising plays in this group.
The drilling services companies
Higher natural gas prices, of course, mean that exploration
and production companies have more money
– and a bigger incentive – to drill and produce more. That’s good
for oilfield service companies, which could see a boom in business over the
next three years.
First Pacific Advisors owns
Patterson-UTI Energy for its exposure to North American land drilling. It
is the second largest land-rig company serving North America. It also has a
solid balance sheet. Patterson has a lot of exposure to smaller independent
operators. This gives the company strong earnings potential but limited
visibility, so expect a volatile stock.
The other oilfield service company Ekstrand owns, Ensco, has
jack up rigs used in the Gulf of Mexico. Like Patterson, the company has a
strong balance sheet – what you’d expect for a holding of a value shop
like First Pacific Advisors. The investment firm also owns National-Oilwell,
Inc. (NOI), which makes parts used in rigs, like draw works and mud pumps.
“As companies bring out more old rigs, this company will make a lot of money
on replacement demand,” says Ekstrand. “They have a very high market share
in North America.” National-Oilwell should also benefit as Russia continues
to improve its natural gas infrastructure. The company does business in the
Middle East, West Africa, and China, as well.
Two niche players
Back before many people knew that there was a natural gas
shortage coming, Heartland Oil & Gas was quietly snapping up the rights to
drill for gas in eastern Kansas. Why there? Because that’s home to the
coal-rich Forest City Basin and Cherokee Basin, which contain lots of natural
gas. Heartland’s early move into the region gives it an edge over
competitors now moving in like Anadarko (APC) and Evergreen Resources (EVG),
says Alexander Montano, a Zacks All Star analyst who was recently ranked the
top oil and gas analyst in the U.S. by the Wall Street Journal. His firm, the Irvine,
California based CK Cooper, recently completed a $12 million financing deal
for Heartland.
“We were among the first to map out this area and drill some exploration
wells,” explains Don Sharpe, a founder of Heartland Oil & Gas and now a
director at the company. “So we could pick and choose, and we think we have
a really attractive land position. We have 165,000 acres in what we think is
the thickest part of the basin.”
Underground coal beds like the ones found there typically
contain lots of natural gas. And Heartland believes it has the technology
needed to extract natural gas from the kinds of coal seams common to this
region – long thin seams that force exploration companies to work several
seams at once to make it profitable. Sharpe thinks some of the half dozen or
so wells already dug will be producing methane before the end of 2003. The
companies entire land holding could eventually support 2,000 wells, says
Sharpe. He won’t give a time schedule for bringing new wells on line. “But
we think we are going to have a lot of wells over the next few years,” he
says.
Another advantage to producing coal bed methane in this region: It’s close
to transport grids, and one of the big end markets, Chicago.
Here’s another way to get more natural gas on the U.S.
market. If you cool down natural gas to minus 260 degrees, it turns into a
liquid known as liquid natural gas, or LNG. It also shrinks by around 600
times. That’s key, because it means natural gas can be loaded in this form
into large thermos bottles on ships, and efficiently moved around the world.
Given that there’s so much natural gas in places like
Russia, Algeria, Indonesia, Qatar and Trinidad, importing LNG in this manner
looks like a great way to help solve the shortage in the U.S. While production
has peaked in North America, that won’t happen until 2050 worldwide, says
Maxwell.
But there’s a snag. The U.S. does not have enough LNG
receiving terminals – the sites where the stuff can be off loaded, and then
processed and shipped to users. “There are only four LNG receiving terminals
in the U.S. and we need at least twelve to make a dent in the problem,” says
Maxwell.
Enter Cheniere
Energy, a small Houston, TX-based company planning to put in three LNG
receiving terminals in Texas and Louisiana by 2008. Cheniere is still in the
process of getting approval and financing to put in terminals. But the climate
is favorable in Washington, D.C. Even Alan Greenspan, chairman of the Federal
Reserve Board, is an outspoken supporter of increasing LNG imports. If all
goes well with the approval process, Cheniere could be breaking ground in late
2004, on terminals that could be in place by 2007 or 2008. Cheniere’s not
offering profit estimates that far out. But the company may keep as much as 2
billion cubic feet per day in LNG processing capacity after financing, or a
third of the overall capacity. A little math suggests that could eventually bring in
cash flow of $10 per share, before taxes. That would support a stock price in
the $40-$60 range. In the fall of 2003, the stock was trading for around $5.80
per share.
Exploration and production companies
Chesapeake Energy is known for its
expertise in deep drilling for gas in western Oklahoma. Roughly 40% of its
wells reach three miles below the surface of the earth. The company is also an
aggressive buyer of rights to gas fields. This makes sense, since Chesapeake
has an extensive 3-D seismic database covering 5,300 square miles in Oklahoma,
intelligence that gives it an edge over sellers. Chesapeake also takes advantage of the volatility in
natural gas prices by entering hedges that lock in high future selling prices.
Analyst downgrades based on
valuation appeared to be holding this stock in the $10 range in the autumn of
2003, despite the long-term natural gas shortage in this country. But one
insider, with a stellar record for timing the purchase Chesapeake shares over
the past decade, was an active buyer again recently. During
the past decade that he has worked at Chesapeake, Tom Ward, now president of
the company, made bets on his own stock netting him 66% gains on average in
the subsequent six months. At the end of July, Ward plunked down $2
million to buy shares at $9.53. Chesapeake chief executive Aubrey
McClendon bought $1 million at the same time. That’s a pretty strong signal
from Chesapeake insiders.
Maxwell likes EnCana, the largest producer of natural gas in Canada. EnCana
has decent reserves and growth, but that’s not its biggest asset. “Above
all it’s got a huge Canadian land position, which gives you a shot at future
reserves,” says Maxwell. “In the U.S., most companies have gone over the
top in gas production,” says Maxwell. But drilling densities are far lower
in regions of northwest Canada where EnCana has the right to explore.
Finally, perhaps the best-known play on natural gas price
strength is Devon Energy. Through a series of well-thought-out acquisitions,
it has built a large position in coal bed methane and natural gas production
in New Mexico, the Gulf of Mexico, the
Mackenzie Delta of Canada, the Campos Basin of Brazil, and West Africa.
“The company has visibility on sources
of future production growth that extends to the end of this decade – a truly
distinctive position versus all of its peers,” says an analyst at Petrie
Parkman. Problem is, Devon’s bright prospects may be priced in to the stock
at recent levels of around $48. In the fall of 2003, Oppenheimer
analyst Fadel Gheit was telling clients Devon is attractive under $40, and
expensive above $50.
Risks
To be sure, there are significant risks to owning natural gas
stocks. Unusual weather or an economic slowdown could cut demand. Big natural
gas users like oil refiners and electricity generators will continue switching
to other energy sources like oil or coal. Environmental regulators recently
relaxed the pollution control rules for coal-fired power plants – so you can
expect more electricity from this source as opposed to natural gas. A decline
in oil prices -- if things stabilize in Iraq, for example -- would put
downward pressure on natural gas. And what if the U.S. government decided to
open up lots of federal land to natural gas drilling? All of these things
could throw the bullish scenario for natural gas off track. More likely,
they’ll contribute to some of that volatility that will give patient,
long-term investors decent entry points for natural gas stocks.
Michael Brush
Michael Brush writes a weekly market column for CNBC on MSN
Money. Mr. Brush has also covered business and investing for the New York
Times, Money magazine and the Economist Group. Mr. Brush studied at Columbia
Business School in the Knight-Bagehot Fellowship program. He is the author of
Lessons From the Front Line, a book offering insights on investing and the
markets based on the experiences of professional money managers.
Michael Brush owns shares in Cheniere Energy.
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InvestorIdeas 2004
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