Will the last be first or at least not last? We are talking about natural gas, which among major industrial commodities was the worst performer of 2009. While we would not take bets that gas will lead the commodity pack in 2010, we would not be surprised to see it perform much better – perhaps outperforming oil, which we also expect to be strong in 2010. But strong gas prices will not necessarily translate into gains across the board for gas stocks. You will have to selective. Two of our current recommendations which stand out are energy giant ConocoPhillips (NYSE:COP) and contract driller Nabors Industries (NYSE:NBR).
Ironically, one of the strongest pieces of evidence that augurs strong natural gas prices is the recent proposed takeover of independent gas giant XTO Energy (XTO), by the world’s largest energy company, Exxon Mobil (NYSE:XOM). At first glance it would seem that the XTO shareholders got an excellent deal. Exxon will pay (inclusive of debt) a 25 percent premium, which works out to about $52 a share. But XTO’s stock is still trading well below $52. One reason is that the acquisition is an all-stock deal. But we think something else may be at play…
While some may argue the reason for the big discount (more than 10 percent) are the anti-trust questions surrounding the deal, we doubt that’s the true reason. If Exxon was able to take over Mobil – a company many times the size of XTO and in businesses far more complementary to Exxon – it is stretch to argue that anti-trust concerns account for the very large discount.
What is most striking to us is the behavior of Exxon stock since the deal was announced. The stock is currently trading near $68, down about 7 percent since word of the deal hit the wires. If investors were so worried about the purchase not going through, then why put Exxon through the wringer? After all, a 7 percent drop amounts to over $20 billion in lost market capitalization.
It seems clear that investors on both sides are not thrilled about the deal. If you own XTO, the current price is about the same as the average price in 2006-07, when natural gas was trading at the same value it is today. Moreover, the targeted price was below a number of Wall Street targets. For example, only a few days before the merger, Barclays raised their target on the stock to $57. Even assuming the stock makes up the huge discount, the end price will still be nearly 10 percent less than what Barclays was willing to value the stock. We single out Barclays not to demean them but for the opposite reason – they have had a very good record in the energy patch.
So what did so many miss? After all, XTO has one of the strongest positions in shale. Indeed the company has positions in virtually every major shale play – Barnett Shale, Woodford, Fayetteville, and Bakken. The company has stated that the potential reserves in these plays could exceed 30 trillion cubic feet of natural gas – or more than two times its current reserve base. So how much did Exxon pay for these potentially enormous reserves? At the current price of XTO, very little. If the takeover is consummated in the mid to high $40s, where it is currently trading, the implicit value of XTO’s proved reserves will be about $2.50 per thousand cubic feet, which almost matches how the market values the proved reserves of other large independent natural gas companies.
Indeed even at $52, for XTO the value of the undeveloped shale reserves would be shy of $0.50 per thousand cubic feet of these reserves. But obviously Exxon shareholders may even think that is far too much, or why would Exxon have tumbled so much since the takeover announcement?
A lot of ink has been spilled on the enormous reserve potential of the shale gas deposits. Some have argued that based on these putative enormous reserves, the country has much less to worry about should the oil doomsters be proven right. Evidently the shareholders and managements of XTO and Exxon demur. Or at least they are saying that if there are massive reserves in the shale formations there, those fields are not going to be easy to develop.
We cannot take full credit for these observations. Some goes to Matt Simmons, whom we interviewed about a year ago. His comment on the shale formations at that time was that it would take more energy to develop shale than you would get out. I must admit that at the time I just thought Matt simply had an axe to grind as he has been indefatigable in his campaign for developing alternative to fossil fuels. The dynamics of the Exxon-XTO deal strongly suggest that Matt may have been on to something.
The real beneficiaries of natural gas
What are the investment implications? First, there is likely a lot less natural gas in the country than most analysts believe. Shale gas is not going to be our savior. What this means is that if the U.S. economy does start to recover, natural gas is likely to become much more scarce than commonly thought. As a result, natural gas prices could indeed rise sharply – especially if there is a carbon tax, as natural gas is the cleanest of the fossil fuels.
Rising natural gas prices should benefit virtually all producers of natural gas but will especially benefit those most leveraged to proved gas reserves as opposed to those companies that have massive amounts of potential gas reserves locked up in shale. Of these potential beneficiaries, our favorite is the major oil company most overlooked by the market, which is ConocoPhillips (COP).
COP has been a terrible underperformer for many reasons. One is that they have a number of non-productive assets such as refining. They are in the process of selling these assets. Another reason is that the company is highly leveraged to natural gas, which has dramatically underperformed oil. Indeed every $0.25 increase in natural gas prices adds 3 percent to COP’s bottom line. The figure for the next most leveraged major is 0.7 percent.
Thus even if natural gas’ performance only goes from worst to so-so, COP’s performance among major oil companies could easily go from worst to best. Also, investors earn a 4 percent yield while waiting for the turnaround. We also have to mention one other stand-out, and that is Nabors (NBR), which is clearly the best and largest land driller in the world. Nabors is also one of the most leveraged companies to natural gas prices but at the same time has enough international exposure to hold its own if natural gas does not cooperate. Its 22 percent premium to book value is one of the lowest valuations the stock has ever sported.
Disclosure: The author has no position in either COP or NBR.