Five small cap natural gas buy recommendations Hugoton Royalty Trust (NYSE:HGT), Dorchester Minerals (NASDAQ:DMLP), San Juan Basin Royalty Trust (NYSE:SJT), Birchcliff Energy (OTCPK:BIREF) and Cimarex Energy (NYSE:XEC) may appeal to investors seeking to protect against the declining value of the Euro in the face of government debt failures. Income and small cap oil and gas stock prices have advanced along with gold while the euro has declined. We believe in oil and gas as real assets whose nominal value should adjust upward as currencies inevitably lose purchasing power. Yet, our main investment case remains that energy is a growth investment because it is essential to the economic progress that nearly all strive to achieve.
Other background factors besides Euro debt problems include the economic recovery underway to which small cap stocks generally may be more sensitive. Also, higher spill risk in deep water oil, mainly under development by large cap companies, makes all other energy sources more valuable. Finally, there may be a turn in natural gas pricing ahead that reverses the long decline of the past few years. In the context of the trillions of dollars of government funds essentially wasted in order to avoid economic collapse, it would not take much in trading funds to have an impact on the clean fuel languishing at a third the price of oil.
Small cap and income stocks can more directly reflect resource value. The discipline of takeover potential works more readily than on the largest companies. Income distributions may give investors a quicker, tangible response to change in resource value.
Whatever the explanation, income and small cap stocks have opened a modest valuation premium to large cap. In an advancing market that premium could widen further just as it could shrink in a declining market. We resolve that uncertainty by recommending that investors have a sixth of oil and gas investment in the group, not counting the largest income stock. For weighting purposes, we count income stock Canadian Oil Sands Trust (OTCQX:COSWF) in the large cap Canadian group, covered separately in Meter Reader, where we would also have a sixth of oil and gas investment.
McDep Ratios near 1.0 suggest that valuation is in line with oil and gas values. Those resource values are likely to rise over time. Oil is already ahead of our long-term price assumption for estimating McDep Ratios. Natural gas is behind, but its appreciation potential may be stronger than that for oil. Our five natural gas buy recommendations, three income stocks and two growth stocks, trade at a median McDep Ratio of 0.95. The three income buys trade at a median distribution yield of 6.8% for the next twelve months. Considering liquidity and trading limitations, investors may supplement recommended stocks by income or capital gain, top line or bottom line, oil or gas, debt or no, hedging or no, and value.
Meanwhile, like most of the stocks, average futures price for oil for the next six years at $89 a barrel is above its 40-week average of $86. Natural gas for the next six-years at $6.26 a million Btu is below its 40-week average of $6.47. We believe the prospects are favorable for the natural gas trend to turn up before next winter.
Originally published on May 14, 2010.