Natural Gas Phenomenon: Chesapeake, Cummins Stand To Benefit From Paradigm Shift

 |  Includes: CHK, CMI
by: Naomi Lazarus

There are two macro events that have been occurring simultaneously in the U.S. economy over the last few years that will provide investors with ample opportunity to benefit from shifts in these two long term trends. A number of stocks will be affected positively by this paradigm shift as the tides turn to provide unbelievable long term plays for superior returns. While both of these events have been causing headaches for investors and some specific sectors in recent years, the ongoing advances in one particular area may prove to be a turnaround event and catalyst for positive changes over the years to come. A long term downtrend in natural gas prices, coupled with falling interest rates, have positioned some companies to outperform expectations over the coming years.

Led down by an increase in supply partly caused by technological advances in shale gas production, natural gas prices have been steadily declining over the last five years. The drop in natural gas prices has been dragging natural gas stocks down along the way. As gas prices have dropped drastically while oil and gasoline prices have risen, many companies have started to convert cars and trucks in commercial fleets to natural gas engines in an attempt to cut costs.

According to Pike Research, the number of Natural Gas Vehicles that are in use globally is approximately 12.6 million. It also goes further to estimate the number of Natural Gas Vehicles to reach 19.9 million by 2016. The full cost of converting a diesel truck to natural gas can now be recouped in just over two years, making this an attractive capital investment for many companies. As the technology for the gasoline-to-natural gas engine conversion evolves along with continued improvements in the storage and transport of liquefied natural gases, more companies will convert at lower costs, increasing demand for natural gas and driving prices back up to normalized levels.

Natural gas is being used in more industrial areas as well. The early release of the Annual Energy Outlook 2013 estimates that natural gas use in the industrial sector alone will increase by 16% through 2025 and that natural gas prices will remain below $4 per million Btu through 2018. Improved pipeline supply and long range transport will provide the ability to export more natural gas as well. This increase in domestic demand coupled with improved ability to export will cause natural gas prices to rise further, breaking the long term downtrend in prices and benefiting energy companies focused on natural gas production. Companies providing trucking, transportation, and pipeline supply and transport will benefit along with natural gas companies

The second trend of falling interest rates due to the Federal Reserve's loose monetary policy would typically be cause for concern in stock prices when rates start to rise again. The Federal Reserve having driven rates to historical lows has distorted the probability distribution curve such that we can move no lower and the only place to go is up, which may cause some to shy away from stocks and long term bonds. However, we know that a few sectors can still perform well in periods of rising rates, and those include energy, commodities, and consumer staples. While rising rates may squeeze profits of some companies, those with low debt loads and/or the ability to pass cost increases on to consumers will hold up.

Chesapeake Energy (NYSE: CHK) is the second largest natural gas producer in the United States. Chesapeake was in the spotlight last year after several criminal and civil probes into the company relating to personal work performed for former CEO Aubrey McClendon with company resources. Shortly following these accusations, the stock fell more than 30% in early 2012, exacerbating the five year decline in stock price already caused by falling natural gas prices. While the company has certainly had its challenges over the last 18 months, recent moves by management to improve profitability and develop alternate revenue sources may be putting the company in a position to rebound as natural gas prices tick upward.

The shale drilling technology used by the company to drill for natural gas has also allowed it to produce oil from rock formations previously thought impossible to drill. With this technology, the company plans to expand on oil production, while continuing to drill for natural gas. After aggressively acquiring land and drilling leases over the last few years, the company is just now starting to realign initiatives to focus on drilling the existing land rather than continuing to acquire. So far, this has paid off, with oil and natural gas production increasing 54% year-over-year from 2011 to 2012. With planned asset sales of $4 billion to $7 billion over the coming year and continued drilling of existing land holdings, the company stands to improve efficiencies drastically in the near term.

Because of the short term troubles facing the company, it is now trading at .8x price to book, which is the lowest it has been since the stock market bottom in March 2009. Granted, the balance sheet it not superb and asset sales may reduce book value, but a continued focus drilling existing land and non-core asset sales, along with rising natural gas prices, could significantly increase revenues. This tide may already be turning, as the company showed a 41.5% increase in revenue year over year from 1st quarter 2012 through 1st quarter 2013. With average oil and gas distribution companies trading at an average of 2 to 3.5x book, Chesapeake looks like an enticing buy, provided management can successfully carry out its planned initiatives.

As with any "turnaround" play, there are positives and negatives to address. The company's .5x current ratio is obviously a little daunting, but by taking the necessary steps to sell non-core assets, the company is working to improve cash balances. The negative operating and profit margins over the trailing twelve months is also nothing to write home about, but with growing revenues the company may do well.

So on to the good...

Great value buy at .8x Price/Book. 5.9% dividend growth over 5 years with current dividend yield of 1.8%. 5 year revenue growth rate of 9.6% vs. the average S&P 500 company growth of 7.1%. 41% revenue increase in most recent quarter year over year. Many investors have been discounting Chesapeake because of recent years performance, but looking at the headwinds the company has faced will falling gas prices, massive acquisition initiatives, and a CEO under legal scrutiny, the company has actually faired well. With a little help from rising natural gas prices, more demand, and continued above average production of oil and natural gas, this company may be a strong turnaround story over the coming years, not to mention the possibility of a takeover by a large oil company looking for a stronghold in natural gas. And when interest rates rise, a natural hedge will be in place with natural gas production.

Cummins in the picture

Cummins, Inc. (NYSE: CMI) is perhaps the opposite of a turnaround play. With its strong performance over recent years and solid management, this may be a solid growth opportunity pushed further by changes in natural gas trends. While the most recent quarter revenues declined 12% year over year, the company proved its position as a leader in the large engine market. Even with the global heavy duty truck engine markets down 37% over that same period, Cummins managed to hold onto a large portion of the market with much smaller declines.

Cummins is a solid company with healthy gross profit margins of 25% and Net Profit Margins of 9.4% vs. the sector average of only 5.8%. The average 5 year profit margin also looks strong at 8.3% vs. a mere 3.1% across other companies in this space. With debt to equity of only .1, the company will not be hit by an increase in debt service as interest rates rise. With recent quarter disappointments in revenue, the company is trading at only 14.2x earnings, but full year guidance remained in place. Along with that, the 3 year dividend growth rate of 37% and 5 year dividend growth rate of 33.2%, certainly don't hurt. Through Cummins 2001 joint venture with Westport Innovations, it has been providing natural gas engines since 2001 and is poised to be a leader in this space with continued products rolling out to meet new demands.


Like Chesapeake, Cummins is in a strong position to benefit from natural gas paradigm shift that is underway. With a strong desire for energy independence, US has realized the power of natural gas, and these two companies stand to reap the rewards.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.