The common shares of buy-recommended independent oil and gas producer Cimarex Energy (XEC) are close to a McDep Ratio of 1.0 where stock price would equal Net Present Value (NPV) of $100 a share, up from $92. Believing the industry and market trends to be favorable, we maintain our buy recommendation. At the same time, investors who have an over weighted position in the stock as a result of appreciation may wish to rebalance. Indeed, members of management have been doing just that by cashing in some of their stock, reaping a partial reward for many years of diligent effort.
Looking back a few years, management’s quick adjustment to step up oil drilling has enhanced cash flow at a time of low natural gas price. For a company once predominantly in natural gas, half of NPV now derives from oil. Currently, natural gas price may be strengthening short term on strong winter demand and long term on compelling value relative to all other major fuels. While rising service costs threaten profitability, we can count on management to invest only when the profit looks attractive. Presuming a continuation of recent trends, our cash flow projections provide ample support for NPV.
Positive Signs for Natural Gas Price
Natural gas in storage dropped sharply as reported on January 20. We know the variables that determine storage levels, but predicting how weather, industrial demand, drilling and even floods in Australia interact is what markets are all about. No one can know the future, but pricing decisions have to be made. Lower storage levels at this time of year can mean higher prices for the rest of winter.
Longer term, the discount for natural gas relative to oil will likely compel new investment to use more natural gas if the discount persists. U.S. Energy Information Administration analysis tracks natural gas price at less than a third of oil on a heating value basis. Our view is that the discount will close fast enough to reward producers and persist long enough to reward users who build capacity to use more natural gas instead of more expensive alternatives.
The implications are probably more important for coal, nuclear, hydro, biofuels, wind, solar and just about every alternative fuel. Cheap natural gas makes it less necessary to sacrifice health with coal-burning. Governments need not go bankrupt promoting alternative energy with subsidies or economy-killing mandates. Abundant natural gas supplies are a gift to enhance our physical and economic well-being.
Originally published on January 21, 2011.