3 Reasons to Like Natural Gas Companies

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 |  Includes: CRK, HK, RRC, SWN
by: SL Advisors

We continue to find attractive value plays amongst the natural gas E&P names. We like this sector for a number of reasons:

1) The U.S. is self-sufficient and has many decades of domestic reserves. Shifting some of our consumption away from foreign oil would reduce our reliance on a volatile region for our energy supplies and is clearly in our self-interest

2) Natural gas generates around two thirds of the CO2 of crude oil-based products and only 50% that of coal. Therefore, natural gas has to be part of any serious effort to reduce our carbon-based pollution.

3) Natural gas is far-cheaper than crude oil on a BTU-equivalent basis. In fact at current prices natural gas produces energy at about a third the price of crude oil.

And yet, there are still serious obstacles to the U.S. altering its mix of energy sources. As a replacement for gasoline, natural gas suffers from a shortage of infrastructure to provide retail distribution. It also has to be stored at extremely high pressures and at temperatures as low as -260 degrees F, which makes it harder and more expensive to handle. While T. Boone Pickens argues relentlessly in favor of converting the U.S. fleet of trucks to natural gas, it’s unlikely to happen without Federal tax breaks and these don’t appear to be on the horizon.

Over half the nation’s electricity is produced from coal-burning power plants. The oldest among these are the dirtiest, and while there’s little sign of Congressional action to reduce greenhouse gases by law there are some indications that the EPA will use new and existing regulations to effect change anyway by requiring expensive scrubbers to clean emissions from coal-based power plants. For older, dirtier plants it often makes no economic sense to upgrade them and as a result they may be decommissioned earlier than would otherwise be the case. Natural gas is a beneficiary of this effort, although estimates are for a modest (less than 10%) increase is consumption over the next five years (and in some cases nuclear power is replacing coal-generated electricity).

The shale gas plays have really trasformed the economics of the domestic natural gas market. By allowing access to abundant supplies, shale drilling has both improved our position of self-sufficiency while propagating uneconomic production as E&P companies drill in order to retain the leases they’ve bought. While the low returns on capital that result should be self-correcting, for the bulls on natural gas and their related E&P stocks it’s an interminable wait.

This is why so many names appear attractive – their prices are weak for a reason. And while a clear catalyst to higher prices in the form of any of: (i) Federal government support for natural gas, (ii) threatened oil supplies by Mid East instability, (iii) reduced shale gas production, is not apparent we are taking the opportunity to rotate among the names we like as their relative values change. We recently added Comstock Resources (NYSE:CRK) to our buy list. As with some of the other names, we like that it is trading at a discount to the net present value of its likely reserves.

Market Cap (BN)

Price/Book

Price/Tangible NAV

Net Debt:Mkt Cap

Unit Cost ($ per MMCF

RRC

$5.8

2.2

75%

28%

$3.60

SWN

$11.0

4.1

82%

9%

$2.83

HK

$4.6

1.3

91%

59%

$3.55

CRK

$1.0

0.9

59%

39%

$2.77

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Source: JPMorgan, SL Advisors, Company Reports

The table above lists four names we particularly like. They are all focused largely or exclusively on natural gas, have low levels of debt, low production costs and are priced attractively relative to their reserves. In some cases unproven reserves are substantially greater than their proved reserves; HK has proven reserves worth around 80% of its market capitalization but potential reserves of as much as 24 Trillion Cubic Feet Equivalent (TCFE), about one year’s entire U.S. consumption. CRK has potential reserves of about 6 TCFE, worth more than three times their proven reserves after deducting costs for drilling, replacing, G&A and debt interest. In cases like these we regard proven reserves as providing some type of downside support while unproven reserves offer potentially interesting upside.

As the chart below shows, nat gas E&P has been a miserable place to be invested over the past several months. However, solid homework can reveal good values and there are often relative value trading opportnities amongst similar names which can mitigate the mark-to-market costs of being long at the wrong time. We recently sold HK to buy CRK based on our assessment of relative value, but will likely reinvest in HK at some point in the near future.

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Disclosure: Long SWN, RRC, HK, CRK