Sifting Through The Hype - What's The Play On Natural Gas?

by: The Stock Hawk

With new technologies leading to enormous field discoveries in the U.S. and around the world, the investment community has become infatuated with the potential of natural gas. Indeed, the resource presents a huge opportunity for the U.S. and businesses throughout the globe as a cheap, clean fuel that can provide energy independence from the Middle East. Tellingly, it was a major focus in President Obama's recent State of the Union address. Nonetheless, investors need to take a closer look before buying into natural gas stocks, as confirmed by several recent headlines.

In short, natural gas supply is vast - and growing - while demand lags behind. As a result, current prices are so low that complicated drilling techniques barely yield profits for many companies. This oversupply is not expected to end any time soon, as conversion to natural gas powered machinery (or cars) is a significant and lengthy investment for companies to make. The most cautionary sign may have come just this week, when Chesapeake Energy (NYSE:CHK), the second-largest natural gas producer in the country, announced that they will cut gas drilling by almost half due to low prices. While this news spurred CHK and its rival stocks on hopes of higher prices, it is unlikely that these cuts have a significant, long-term effect on the price of natural gas.

Similarly, Halliburton (NYSE:HAL), another major player in the U.S. gas landscape, warned that it expects customers to scale back shale drilling due to the low prices. The company aims to focus more on oil drilling in the near future.

So, what's the play?

When it comes to natural gas, there are a few main themes to consider:

1. Prices will likely remain low for the foreseeable future. Although widely expected, this reality should not be overlooked by investors who are overzealous about the long-term potential of natural gas. Natural Gas accounts for about more than two-thirds of the reserves of Devon Energy (NYSE:DVN), a leading gas producer in the U.S., making it especially vulnerable to low prices. Its forward P/E around 10 and PEG above 2 make it a tough buy compared to more oil-focused peers with similar valuations in the current energy price environment.

2. Although reduced drilling is clearly not good for oil service companies, I love the value found in this sector right now. Despite Chesapeake's announcement, shale drilling will remain active, and these service companies are flexible enough to shift their focus to oil drilling at any time, a more lucrative field with a bright future given high petroleum prices. Furthermore, new and expensive drilling techniques (fracking, deeper offshore drilling, etc.) will provide a big boost to revenues and profits for this industry.

My favorite in this area is Halliburton, which is trading at a forward P/E of 8.4 and dirt-cheap PEG of 0.4. The company is a leader in its industry, and has a healthy balance sheet and strong earnings. I also have high expectations for industry-leader Schlumberger (NYSE:SLB), a high-performing company that trades at a slightly higher (but still cheap) forward P/E of 12.5 and PEG of 0.6. Baker Hughes (NYSE:BHI) is another attractive one, with a valuation a little bit cheaper than Halliburton's but with slightly shakier financials in our view. These companies carry the potential upside found in increased natural gas drilling, but without the reduced margins from low prices since they do not sell the gas themselves.

3. With gas prices low for the foreseeable future, the next play is to look for companies that can benefit from buying cheap natural gas. One play could be a natural gas exporter such as Cheniere Energy (NYSEMKT:LNG), which has already signed some big contracts to export gas overseas. A second could be utility companies with significant natural gas business, as input costs have dropped and the benefits of natural gas have gained public attention. These stocks are naturally safe and stable, but pay out solid dividends in the process.

Piedmont Natural Gas (NYSE:PNY), provides gas utilities to the southeastern U.S. and pays a 3.5% yearly dividend. As a related option, Spectra Energy (NYSE:SE) is a leading natural gas infrastructure company, meaning that its business improves with increased use of natural gas. As Washington becomes more serious about building natural gas infrastructure, companies like Spectra stand to score big. The stock pays a 3.5% dividend, but with solid upside potential. Investors should, however, be aware that the stock has run up recently and is near its all-time high.

One final idea for taking advantage of cheap natural gas is through natural-gas engine makers. The biggest maker is Cummins-Westport, a joint venture between industrial giant Cummins (NYSE:CMI), and Westport Innovation (NASDAQ:WPRT). It is no secret that natural gas is cleaner and cheaper than petroleum for automobile use, and lawmakers are taking notice. While it will take a long time to develop the infrastructure needed for consumer cars to run on natural gas, commercial natural gas vehicles are much more plausible. These trucks, which include 18-wheelers, busses and more, can plan routes to hit natural gas fueling stations, and can save big on fuel even before potential subsidies related to the environmental benefit. This is where Cummins-Westport comes in.

The company received an order for 1000 natural gas engines from UPS in 2011, while Daimler North America recently built its 1000th truck powered by a Cummins-Westport natural gas engine. Using Cummins' relationships and expertise in the truck engine market along with Westport's natural gas capabilities, this joint venture provides loads of opportunity.

Of course, investors must choose which stock to buy to get involved. For the risk-takers, Westport is fully focused on natural gas engines, and sells them across other joint ventures as well. The company has not turned a profit in a decade, but is the market leader in natural gas engines and has huge upside if the technology catches on. It also has a healthy balance sheet to give it some cushion. Meanwhile, natural gas engines are only a small part of CMI's business. The overall company is strong though, so it remains a solid pick for more conservative investors who want a safer play in this field.

In the end, natural gas has incredible potential to become the country's primary fuel source over the next few decades. However, slowly increasing demand is not likely to keep up with supply over the next few years, meaning that prices will remain low. With oil prices high in contrast, investors must adjust their energy investments accordingly. These are a few suggestions on how to benefit from the natural gas situation, but further discussion is welcomed in the comments below.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.