Geographic Distortion in Natural Gas Prices

Regional distortions magnify new low prices for near-month natural gas futures, coinciding with new low prices for natural gas producers including buy recommendations Cimarex Energy (XEC) and Hugoton Royalty Trust (HGT), as well as hold-rated San Juan Basin Royalty Trust (SJT). Real-time wellhead price in the fourth quarter of last year dropped from a normal ratio near 0.9 to as low as 0.56 times the Nymex (New York Mercantile Exchange) Henry Hub benchmark (see chart below, Natural Gas Price/Benchmark).

Normally, the typical regional differential might be $0.50 a thousand cubic feet or million Btu. The steep discounts reported for the latest quarter ranged from more than $2 for XEC to $3 for HGT. Though the spreads have not narrowed much so far in 2009, the forward markets and common sense indicate a narrowing with tightening of supply/demand conditions.

The largest producers protect themselves with marketing, transportation or hedging insurance. The smaller producers may see some predatory activity working to their disadvantage temporarily, but not likely to a large degree for long, we hope. Meanwhile, low McDep Ratios point to appreciation potential in the better days we believe lie ahead.

Deflation Resistance, Inflation Protection and Return on Investment

Revamped valuation tables present the most important characteristics in selection of income and small cap stocks. For another measure of financial strength to resist going out of business in tough times, we add the ratio of Enterprise Value to Market Cap. It supplements Debt/Present Value. In each case, lower is stronger. While both oil and gas offer inflation protection, the smaller stocks tend to offer more natural gas exposure. Excluding buy-recommended Canadian Oil Sands Trust (COSWF.PK), which we count as part of the Canadian group in our separate Large Cap Weekly, the two buy recommendations are concentrated mostly on natural gas. Our primary measure of potential return on investment, the McDep Ratio, is complemented in an adjacent column with distribution yield, a necessary requirement for income investors.

The small number of buy recommendations reflects the need to be patient in today’s stock market as well as a limit to our capacity to provide the more intensive coverage of rated stocks. For, example all six of the U.S. Royalty Trusts as well as Dorchester Minerals (DMLP) are high quality, long-term commitments that can fulfill the triplet objectives of deflation resistance, inflation protection and return on investment, in our opinion.

Rank by EV/Ebitda should normally match rank by PV/ Ebitda with exceptions for some stocks with long histories and/or revenue royalty characteristics. Finally, Distribution/Equity Ebitda above 1.10 indicates in a few cases that the current rate may need to be reduced if current depressed commodity prices prevail too long.

Tables can be viewed here (pdf file).

Originally published on February 20, 2009.

Comments

[optionsgirl:]

excellent article, thanks.

Mar 18 05:20 PM

[Conan the B...:]

KMP is usually recommended beause the value of what it ships is not relevent. But the drop in value suggests less is being shipped, less demand.

Is KMP vulnerable?

Mar 18 09:46 PM