We believe Chesapeake Energy (CHK) and Apache (APA) are the best stocks to buy in this phase of the natural gas rebound. Natural gas prices have increased by 10% to $3.2/mmbtu, which is justified by the 6% increase in consumption in the last one week with the start of the winter season. Due to the discovery of hydraulic fracturing and horizontal drilling, it has become feasible for natural gas drillers to extract natural gas from tight rock formations. This phenomenon of shale gas extraction led to excessive supply of natural gas, which in turn triggered a decline in natural gas prices. Natural Gas prices reached a low of 1.94/mmbtu in April 2012.
The United States Energy Information Administration estimates that natural gas consumption for space heating in the country is expected to rise by 13.8%, with the major increase coming from the east of the Mississippi River. The increase in natural gas consumption by households will significantly raise heating expenditure, as shown in the graph below. Natural gas is mostly used for the household heating space, with more than 58.3 million homes heating their household space using natural gas; 43 million use electricity, 7.2 million use oil, 5.7 million use propane and 2.5 million use wood. Natural gas prices are expected to increase with the rise in household gas consumption.
We can see an imbalance between demand and supply in the United States, as shown in the graph given below. Excessive supply of natural gas in the last six months is primarily because of cost effective gas extraction through hydraulic fracturing. However, natural gas consumption is expected to increase to 67.5 thousand cubic feet this winter (October 2012- March 2013), up from 59.3 thousand cubic feet during last year's winter.
The excessive supply of natural gas had exerted a downward pressure on natural gas prices. After looking at the downward pressure on prices and the bright future prospects of hydraulic fracturing, a structural shift has started taking place from oil and coal towards gas. Many vehicle manufacturing companies have decided to shift from oil to gas, particularly heavy truck engine manufacturers like Westport Innovations (WPRT) and Cummins Inc. (CMI). Another important shift in electric utilities has been witnessed; they are shifting from coal-based generators to environment-friendly gas-based generators.
In our opinion, Chesapeake Energy is an important beneficiary of the natural gas rebound, as it is the second largest natural gas producer. It has a production volume of 3,000 MMcf/day in the United States. Despite the decline in natural gas prices and the macro economic problems, the company has managed to register a promising growth of 39% in profit margins over the course of last one quarter. The recent insider buying reflects CHK's attractive valuations. It is currently trading at a forward price to earnings of 14.7x, at discount in contrast to its peers EV Energy Partners LP's (EVEP), Anadarko Petroleum's (APC) and PetroQuest Energy's (PQ) forward price to earnings of 40.9x, 16.7x and 18.22x, respectively. It is engaged in the sale of E&P assets to Chevron (CVX), and the sale of some other assets in the Permian Basin, to reduce its funding gap. Looking forward, we believe that the natural gas rebound and the company's operational efficiencies would further enhance its profitability and make it more attractive for investors.
Apache is another key player in the natural gas rebound due to its high natural gas production volume of 831 MMcf per day in the second quarter of 2012. It has increased its international gas production to 100 million cubic feet in the last one year. In our opinion, the company will contribute considerably to the upcoming natural gas demand by increasing its drilling activities. Moreover, APA's high momentum of growth, increase in rig count, development in vertical drilling in the Dead Wood region and transition towards horizontal drilling would enhance its profitability position going forward. Due to the cost efficiencies in its business operation, Apache has higher operating and gross margins of 84% and 46%, respectively, compared to its peers in the industry. Furthermore, APA is trading at a forward price to earnings of 8.1x, at discount when compared to its competitors Newfield Exploration's (NFX), Anadarko Petroleum's and ConocoPhillips' (COP) forward price to earnings of 11x, 16.1x and 9.9x, respectively.
Therefore, due to attractive valuations and strong future prospects of Apache and Chesapeake Energy, we have recommend investors buy these stocks on a natural gas rebound.