2 Plays On Natural Gas

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 |  Includes: CQP, ECA
by: Cabot

By Chloe Lutts

For almost the entire time I’ve been editing the Dick Davis Digests, experts have been predicting that natural gas prices would rise. Their reasoning is that, per dollar, you can currently produce much more energy from natural gas than from oil. Since the energy produced by each is indistinguishable, the experts argue that the cheaper fuel should gain popularity, even driving its price up into parity with oil’s.

Economically, of course, their argument makes sense. But due to a variety of real-world factors–existing infrastructure for using the two fuels, and the relative growth in the supplies of oil and gas, for example–parity has still not come to pass. In fact, thanks to the rapidly growing number of productive natural gas wells in the U.S., natural gas prices have fallen more than 20% since the beginning of 2011.

Now, that doesn’t invalidate the economic argument for oil and gas price parity. And in the eyes of parity believers, the slide in natural gas prices has only made investments in the sector better deals. The United States Natural Gas Fund (NYSEARCA:UNG), for example, is down 33% from the beginning of the year. If you think natural gas prices have to go up eventually, it looks like a pretty good bargain right here.

Of course, you may have to wait quite some time for your prediction to come true, as investors who bought into the fund a year or more ago have already discovered.

Our most recent Dividend Digest spotlight stock was also a natural gas play for patient investors. Encana Corp. (NYSE:ECA), a Canadian company that is listed on the New York Stock Exchange as well as in Toronto, is one of the leading producers of natural gas. In fact, its production lags behind only ExxonMobil’s (NYSE:XOM). While the stock’s chart is both lousy and boring, ECA was recommended by two of our most well respected contributors at the same time, earning it Spotlight Stock credibility. The first, Nathan Slaughter, editor of StreetAuthority’s Scarcity & Real Wealth, wrote in his October 31 letter:

Just about every energy producer sells both oil and gas. They each favor one over the other. And most have been tilting toward oil over the past couple years. But Encana Corp. makes no bones about being a natural gas specialist and is an outspoken industry advocate. Natural gas accounts for fully 96% of the company’s production mix (versus 4% for oil). … That skewed weighting puts Encana at a disadvantage in the current pricing environment. But if you’re looking for a well-managed pure play that is perhaps the most leveraged to rising natural gas, this is it.

The Canadian company has secured 11.7 million acres to explore and develop. Much of that land lies north of the border in the Bighorn, Cutbank Ridge and Horn River gas basins in Alberta and British Columbia. But the firm also has a major presence in some of the top U.S. plays, most notably the Haynesville Shale in Louisiana and East Texas. Encana has acquired nearly 430,000 acres in the Haynesville Shale, which overtook North Texas’s Barnett Shale last year as the nation’s top producer with production rates now topping 5.5 billion cubic feet (Bcf) per day. The company was an early mover in the play, in keeping with its strategy of quietly beating other rivals to the punch and scooping up land before hype drives up lease costs and royalty rates. Encana’s latest target is Michigan’s Collingwood Shale, which underlies the Utica Shale in spots. The company has recently amassed 250,000 acres in this region for just $150 per acre, mere pennies. The value of this shrewd move is just now becoming obvious. According to Morningstar, recent Collingwood auctions have been closing as high as $5,500 per acre. With dominant positions in low-cost supply basins throughout North America, Encana has built up a massive base of 14.3 trillion cubic feet (Tcf) in proved gas reserves–23 Tcf if you include reserves characterized as probable. … The company can easily accelerate production growth if it wants to. But there’s no sense in rushing to get gas out of the ground today for less than $4 per Mcf [million cubic feet]–not when you can wait and sell it tomorrow for $6 per Mcf or more. So management is targeting slow but steady 5% to 7% annual growth for the time being.

In the meantime, profits aren’t exactly suffering. Last quarter, the company generated $1.2 billion ($1.57 per share) in cash flow, amply covering the $0.20 per share dividend. And that’s with rock-bottom prices. Imagine the bottom line potential when those 3.5 Bcf per day are being sold at more favorable prices. For now, Encana isn’t stuck just taking what the market will give. Management has locked up more than half of its 2012 production (2.0 Bcf/day) at an average NYMEX (New York Mercantile Exchange) price of $5.80 per Mcf. That’s a hefty 48% premium to the going rate.

Looking ahead, Encana also has several additional catalysts on the horizon. First, the company just pocketed $800 million with the sale of a gas plant and other midstream assets, money that will be deployed into more profitable upstream projects. On that front, management is plowing $1 billion into liquids-rich plays from Mississippi to Colorado–and daily production of higher-priced oil and NGLs [natural gas liquids] is expected to double from 25,000 barrels to 55,000 barrels over the next three years. Elsewhere, Encana has a 30% ownership stake in the Kitimat LNG facility, which recently received an export permit from Canada’s National Energy Board. This is one of just a small handful of LNG export hubs in North America, and the facility will be equipped to ship 1.4 Bcf of gas per day to Pacific Rim customers. Finally, Encana is also an emerging leader in natural gas transportation fuels. … If natural gas prices turn higher, Encana will be among the biggest winners. The company has a high-quality asset base and a 50-year inventory of low-cost drilling sites to juice future production and earnings. As an added bonus, the shares offer a nice 3.6% dividend yield, roughly double their peer group average.

The other recommendation came courtesy of Patrick McKeough, editor of The Successful Investor, who recommended the Canadian shares. In his November issue, he wrote:

Encana is down 29% since the start of 2011. The company is partly a victim of its own success. … New technologies that Encana helped develop have cut the cost of extracting shale gas, which has let other companies expand their own shale gas production. This has greatly added to the supply of natural gas, and pushed down gas prices. However, like most commodities, gas prices are inherently volatile. In particular, one cold winter could quickly push up prices.

Longer-term, the outlook for gas remains bright. A growing gap between gas and oil prices could prompt more transportation companies to convert more of their trucks and trains to run on natural gas. Moreover, plans to ship liquefied natural gas from British Columbia to Asia should spur demand. Encana’s shares trade at a high 49.1 times the $0.42 U.S. a share the company will probably earn in 2011. However, they trade at a more reasonable 3.9 times its projected cash flow of $5.34 U.S. a share. … Encana is a buy.

For patient investors who believe in the inevitability of gas and oil price parity, Encana is the place to be. If you want to make a quick buck though, stay away from this one.

Less-patient investors don’t have to be left out in the cold, either. There are a few natural gas plays for which depressed prices are actually a boon.

One of these is Cheniere Energy Partners LP (NYSEMKT:CQP), a master limited partnership (MLP) with a whopping 10% yield. Cheniere owns most of a liquid natural gas ((NYSEMKT:LNG)) terminal in Louisiana called Sabine Pass. The terminal is currently used to unload LNG from ships and turn it back into a gas, after which it can be transported to end markets by pipeline. However, Cheniere is in the process of converting Sabine Pass into a two-way terminal, so it can export natural gas as well: liquefying it and loading it on to ships bound for foreign ports. So while Cheiere’s current business already leaves it with minimal exposure to low natural gas prices, the expansion will actually make Cheniere a prime beneficiary of low prices, which incentivize U.S. producers to export their cheap gas to places where it isn’t so cheap.

Cheniere was recommended in the latest Dividend Digest by Gregory Spear, editor of The Spear Report. In his October 28 issue, he focused on Cheniere’s plans to begin exporting LNG:

This past Wednesday, Sabine Pass Liquefaction, a subsidiary of Cheniere Energy Partners, signed an $8 billion deal with BG Group, a large integrated natural gas conglomerate headquartered in the U.K. The 20-year agreement commits BG Group to purchase 3.5 million tons per annum (mtpa) of liquefied natural gas from CQP’s Sabine Pass terminal facility in Louisiana. Cheniere will super-cool the gas and BG will ship it to Asia and Europe. This one deal is expected to reap more than $8 billion for CQP over the life of the contract ($400-$500 million/year).

Sabine Pass is an 850-acre LNG transportation facility with a 40-foot ship [deep] canal and five tanks capable of storing nearly 17 billion c/f of natural gas. The facility is 90% owned by Cheniere. Construction of the liquefaction facilities, which will cost about $6 billion, is expected to commence next year and actual exports are slated to begin in 2015.

Due to new advances in horizontal drilling, natural gas is now extremely abundant in the U.S. Based on current demand, we have nearly 100 years’ worth of the clean fuel, which is why prices remain depressed (about $4 per million BTU). Meanwhile, natural gas prices in Asia have doubled over the past six months and sit north of $15 per million BTU. The economics make the development of LNG terminals in the U.S. a no-brainer. We therefore expect Cheniere to undertake more deals with other global players and at significantly higher prices. … Shares of the non-dividend paying arm of Cheniere (LNG) soared more than 60% on the BG news, but CQP has remained under its 200-day moving average. Meanwhile, the stock pays a hefty dividend, so investors get paid handsomely to wait.

Of course, you may have noticed that Cheniere won’t be able to begin exporting LNG until 2015. If the parity believers are right, natural gas prices will already have risen significantly by then.

Today’s bottom line, then, would seem to be that investing based on expected long-term trends in commodity prices is no easy feat. Luckily, both of these companies will pay you a nice dividend while you wait to see what actually happens.