Avoid (Natural) Gassy Stocks

By Sheraz Mian

Growing optimism about the economic outlook has pushed the equity markets significantly higher from the March 2009 lows. Crude oil and most of the other commodities have been active participants in the rally.

As this first chart shows, natural gas has largely been absent from this rally. In fact, natural gas prices have been particularly weak in the last couple of days, erasing the gains made in the preceding three weeks and pushing the commodity back under the $4 level.



Blue line: Oil; Red line: Natural Gas (Source: wsj.com)

This decoupling of natural gas prices from other commodities in general and crude oil in particular is rooted in natural gas’ peculiar supply-demand fundamentals. As we explain below, this trend is expected to remain in place over the coming months, even as confidence in the economic outlook further improves.

This has major sub-sector and stock selection implications. In the oil and natural gas sector, we would prefer to own "oily" names over "gassy" names -- service players with more of an international rather than U.S. focus, and deepwater rather than onshore U.S drilling exposure.

We remain wary of natural gas centric oilfield service players, though they have been beneficiaries of the ongoing rally. Plenty of drilling and pressure pumping capacity was added in the last cycle, which will keep dayrates and margins under pressure at least through 2010, way after the rig count has stopped falling.

As such, we see no justification for the recent strong gains made by Nabors (NBR) and the Patterson-UTI (PTEN), major land drillers in the U.S. We would also avoid BJ Services (BJS), one of the largest pure-play pressure pumping players.

Among exploration and production (E&P) players, we prefer to own companies with exposure to the shale plays and attractive hedge positions. Companies like EnCana (ECA), EOG (EOG), and Chesapeake (CHK) would fall in that category.

While natural gas’ demand side should benefit from the improving economic outlook, particularly demand from industrial consumers, it is the supply side of the equation that, in our view, will keep pricing gains in check. For our near- to medium-term supply needs, there is plenty of natural gas in storage.

The Energy Information Administration (EIA) reported on Thursday that current storage levels are 32% above the year-earlier level, and more than 22% above the 5-year average. As the following chart from the EIA shows, current storage levels are close to the top end of the historical range.

The outlook for domestic natural gas production is as good as it has been in decades. This is due to the discovery of prolific shale gas fields in the last few years and the refinement of more efficient drilling and completion techniques. The significant drop in the rig count from the late-summer 2008 all-time high (it has already dropped by more than 50%) is expected to moderate production growth rates.

But with the credit markets coming back to some level of normalcy, it would not take long for the growth momentum to resume. Oilfield cost deflation and the emergence of these shale plays has brought down the breakeven natural gas price required by exploration and production (E&P) players.

Comments

[Charles Pet...:]

The article is good but the only flaw with your thinking is the chart you have of the market v. natural gas. In this example of course natural gas will underperform during the time period as it is the traditional bottoming season for prices as weather warms up. This type of move (not the exact numbers but this direction) has been priced into the curve year after year and it should come as no shock to those familiar with the energy markets.

That being said, the Chesapeake call is a great one. The stock is still suffereing from CEO Aubrey McClendon's margin call debacle and on a NAV basis the shares are worth probably 40% less than what they should be even with natural gas at these levels.

May 25 11:07 AM

[Bruce Pile:]

I've been saying for over a year now that there will be a growing disconnect away from the traditional oil/gas pricing ratio of around 6. For the several decades of the oil age, this ratio was a pretty reliable pricing guide where, if it got too far out of synch, you could expect oil to come down, gas to go up, or whatever. But since about 2006, when this disconnect first started to be noticed and written about, there have been two big changes from the previous decades - one, conventional oil has come up against the forces of peak oil, and two, the shale nat gas recovery advances have made the impending North American gas shortage a thing of the past.

If you look at a gas/oil ratio chart like $NATGAS:$WTIC at SharpCharts, you see that we have recently broken below the trading range bounded by about .07 at the low end for the first time in years. This really makes the whole nat gas stock investing area a little too unpredictable for my taste. Aubrey McClendon of CHK seems quite confident in the gas business with his large insider buying, and he isn't the only gas company official grabbing up insider shares. He is very aware of the plentiful supply of gas and has even hinted at the notion of building more LNG facilities here in America so we can export to the global LNG trade. The technical behavior of the gas stocks sure doesn't suggest doom and gloom for the industry.

As for the domestic land drillers behaving well in the face of low gas prices, I can see that because the new shale gas, while plentiful, is much more drilling intensive than the old conventional gas - and getting much more drilling intensive very quickly. It has been referred to as an accelerating treadmill by industry experts, where the athlete is the driller who must keep running harder just to keep the supply constant.

May 25 02:05 PM

[harammph:]

The recent spike in Nat Gas means that there is a lot of pent up demand for this commodity.

When it starts to move up in ernest it won't be by small increments.

Find a buy point in your favorite stocks and wait.

Look for High dividend plays like LINE which is about 60% nat gas.

May 25 09:21 PM

[whisperonth...:]

LINE has been good to me. I wait for the drops and get more; this one will be with me for a while.

May 25 10:49 PM

[joeevan:]

Yes, LINE is one of the best.


On May 25 09:21 PM harammph wrote:

> The recent spike in Nat Gas means that there is a lot of pent up
> demand for this commodity.
>
> When it starts to move up in ernest it won't be by small increments.
>
>
> Find a buy point in your favorite stocks and wait.
>
> Look for High dividend plays like LINE which is about 60% nat gas.

May 26 11:17 AM

[Shareholder...:]

Gas prices in Asia are 2-3x those in the US. An exciting exploration play there is InterOil:
seekingalpha.com/artic...
shareholdersunite.com/.../

May 26 04:04 PM