Investment Considerations Within Natural Gas Sector

by: SL Advisors

By Simon Lack

Around 8 million households in the U.S. use heating oil to heat their homes (according to the most recent data available from the U.S. Energy Information Administration). Staying warm is not only more costly because of growth in China and India, but also because of the developing civil war in Libya. Relying on such an unstable region for part of our energy is once again looking like a poor bet. Meanwhile, secure supplies of natural gas are domestically abundant, cheap and cleaner than fuel oil. While there’s unlikely to be a change in energy policy (or indeed, any energy policy) in the U.S. until the next election, many of these 8 million residential consumers might benefit from implementing their own policy and switching to natural gas to heat their homes.

Investing so as to profit from this has been challenging. Shale gas drilling technology has been so successful that it’s depressed prices and the profits E&P companies can earn. Drilling continues even on uneconomic terms since many drilling leases require minimum levels of output to retain the lease. But there are some signs of strategic investments recognizing the inevitability of exploiting this domestic resource. BHP Billiton (NYSE:BHP) recently paid Chesapeake (NYSE:CHK) $4.75 billion to acquire shale gas assets. UPS (NYSE:UPS) just announced it is converting another 44 trucks to run on liquid natural gas (LNG) on the corridor between Ontario, Calif., and Las Vegas, bringing to 1,100 its total number of LNG-powered vehicles. The American Gas Association has commented that stable natural gas prices are drawing interest from utilities as they contemplate building new power plants. While coal is far more widely used to generate electricity, the 20-plus year useful life of a new power plant requires consideration of a carbon tax or other restrictions on emissions beyond the life of the present administration.

For our part, we continue to be invested in natural gas E&P focused companies with low levels of debt and low operating costs at an attractive discount to the NAV of their reserves.

We own Range Resources (NYSE:RRC), with its potential 50 trillion cubic feet of reserves (over two years supply for the entire U.S.). The company may not ultimately turn all this potential into proved reserves, but assuming a $1 per 1MCF (thousand cubic feet) operating profit this represents $50 billion in value, compared with a market cap of $8 billion. The company's finding and developing costs are among the lowest in the industry at 0.71 cents per MCF.

Comstock Resources (NYSE:CRK) stumbled during the fourth quarter in that the company was unable to secure needed drilling services and consequently production dropped. However, assuming it can meet ongoing cap ex needs through operating cash flow and asset sales (including the sale of 3.8 million shares of Stone Energy Corp. (NYSE:SGY), worth approximately $105 MM), rather than issuing equity, it should continue to grow production and expect to be profitable this year.

Southwestern Energy (NYSE:SWN) is a larger and less risky name than the others with operations in Texas and the Marcellus Shale in Pennsylvania.

Finally, Petrohawk (NYSE:HK) recently discussed enhancements to the fraccing material they use (named HiWay on their recent call). They reported that they currently have an exclusive arrangement with service provider Schlumberger (NYSE:SLB) until enough of the modified fraccing material becomes available for use by other drillers. In certain fields it allows for greater ultimate recovery of natural gas, although the precise benefits are still under review.

This is a sector worth considering while successive Arab populations overthrow their autocratic rulers, forcing up the cost of driving and staying warm in the U.S.

Disclosure: I am long RRC, SWN, HK, CRK.