Exxon Will Rocket On Natural Gas Rebound This Year

May. 7.12 | About: Exxon Mobil (XOM)

Exxon Mobil (NYSE:XOM), as the world's largest producer of natural gas, should benefit from the recent rally in natural gas prices. A single day rise of nearly 4% in natural gas prices late in the week signals that the reversal may be gaining momentum. June futures closed at $2.34, up 23% from the recent decade-low of $1.91. While it may seem unusual to speak of a 23% rally as showing the potential of momentum, this retracement is small compared to the potential rise. Prices were significantly higher within the last year. Should prices return even a significant portion of the way back to where they once were, the return potential is significant. Using United States Natural Gas (NYSEARCA:UNG), the largest natural gas exchange-traded-fund (ETF), as a proxy, the return potential may be several hundred percent. UNG traded three times higher within the last year.

The return potential above is by no means guaranteed and refers to investments directly in natural gas. Commodity investments of this nature tend to have significant potential, but highly uncertain paths. The volatility that might be manifested as natural gas prices work their way higher could be significant. This level of volatility, coupled with the lack of certainty that prices will remain at higher levels, makes an investment directly in natural gas appropriate only for experienced investors who can tolerate this level of risk and uncertainty. For most investors, choosing stocks that have ample exposure to natural gas will offer handsome return potential without the same level of volatility as a direct commodity investment.

Choosing Stocks

Investors who wish to benefit from the potential reversal in natural gas prices, as well as a continued rise in oil prices, but not be subject to typical commodity volatility, are best suited to buy select energy stocks like Exxon Mobil. Other candidates that should be considered, and compared as peers, include Chesapeake Energy (NYSE:CHK), the second largest producer of natural gas, Chevron (NYSE:CVX), ConocoPhillips (NYSE:COP) and BP (NYSE:BP). Each of these names has exposure to commodity prices, but the effects will not be as severe or as immediate. The result is that while returns may be more modest, the volatility will be significantly reduced. This is a great blend for many investors.

In terms of pure valuation, as measured by the trailing twelve month price-to-earnings ratio, Exxon Mobil is somewhat more expensive than its peers. Exxon Mobil trades at a multiple of 10.2 relative to 7 for Chesapeake, 5.4 for BP, 5.8 for ConocoPhillips, and 7.6 for Chevron. While Exxon Mobil is more expensive on this basis, the company's asset mix is a significant part of the attraction. The natural gas play has likely hurt the company in terms of valuation because the earnings from natural gas have been scant of late. As this changes, the valuation will stabilize, but by the time that happens, a significant portion of the return potential may have been lost.

Another important consideration is the efficiency with which the company is run. This is best measured by considering the operating margin of the various companies under consideration. Exxon Mobil has an operating margin of 11.9% relative to 22.7% for Chesapeake, 7.5% for BP, 9.7% for ConocoPhillips and 16.6% for Chevron. In the arena, Exxon Mobil stacks up well against the other major oil companies. Chesapeake stands well above the pack on this basis, but Chesapeake's primary oil business is focused on shale. The operations of Chesapeake are, therefore, different in nature from the other companies, making a comparison somewhat spurious on this metric.

Long-term Concerns for Exxon Mobil?

A recent report on Exxon Mobil suggested that one of the primary issues with the company is that its "blue chip" long-term strategy is too conservative and has led to a degree of stagnation. Management's desire to remain evenly diversified between oil and gas is blamed for the less that brilliant earnings results. The company recently announced that first quarter profits fell by 11%. Reasons cited for the decline included lower oil production and smaller profits from the chemical division. This analyst takes issue with the company's natural gas exposure, claiming that the company's asset structure makes it unattractive as a short-term play. The piece says that the company is satisfactory as a longer-term holding but does not see the near-term potential of the company as positive.

I believe this view is inaccurate because it significantly underestimates the return potential in the natural gas industry. The idea that gas prices could remain at these anemic levels is simply naïve. History has seen prices drop to these levels before, but such drops are regularly followed by significant rebounds. Furthermore, in the midst of a U.S. presidential election, natural gas is likely to get a lot of attention as an alternative energy option. This attention alone is likely to lead to a price spike in natural gas. The CEOs of most major natural gas producers have vowed to bring attention to this resource and put pressure on legislators to give it greater attention. When the impact of election attention is combined with the natural rise off of an established price floor, the result should be very favorable for natural gas. Under such a scenario, companies like Exxon Mobil are going to be significantly benefited. When this benefit is taken in light of Exxon's overall strength, the timing is right for this stock.

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