4 Natural Gas Producers: Which Will Energize Your Porfolio?

Includes: CHK, COG, SD, SWN
by: Cris Frangold

One of the more salient debates in the recent political scene is the alleged "war on coal" being waged by Democrats. Privately-held Murray Energy laid off much of its staff the day after the election due to owner Robert Murray's belief that the counter war against Obama is not winnable. But just how true is this claim?

Every President from Nixon on has stated his desire to wean America from imported oil. This was a campaign commitment from both Governor Romney and President Obama. "Clean Coal" was a buzzword of the campaign from both candidates. The problem is, of course, that the process of making coal "clean"- carbon capture and sequestration- has never been used on a commercial scale, and models show that it is so energy intensive that roughly 25% of any coal burning plant's energy would have to go toward the energy needs of the sequestration program.

Clean Coal is not an answer. Each pound of coal burned puts out about 2.5 pounds of carbon dioxide, along with nitrogen, mercury and other heavy metals. Natural gas has the advantage of being roughly one half the carbon release as coal per BTU used. I wanted to take a look at some natural gas companies to see how they are doing as America shifts more and more of its energy use to natural gas.

The modern practice of hydraulic fracturing, or "fracking' has opened previously closed areas to natural gas drilling. The EPA has been considering heavier regulation on the practice, and the natural gas industry insists there has been no documented problem with drinking water stemming from fracking. Of course, anyone can search for incidences of ground water and drinking water contamination. In early October, 2012, probably the most significant indictment against a fracking well causing groundwater contamination occurred in Northeast Pennsylvania, on property developed by Cabot Oil & Gas (NYSE:COG).

Cabot has been on a great run of late, rising from under $30 per share in May by 65% to nearly $50 per share of late. In the third quarter of 2011, Cabot took advantage of increased production, along with increased oil prices and gas prices well off its yearly low to post earnings of $36 million, or $0.17 per share. This compared with $0.14 a year ago. Adjusted earnings in the quarter came to $0.21 per share, a cool 50% surprise to analysts who had expected adjusted earnings of $0.14.

At its core, Cabot is a natural gas company, and the third quarter bore that out as Cabot produced well over ten times the equivalent of natural gas as it did liquids. Cabot has greatly benefited from a rise in price from about $1.90 per mmBTU in the spring to a more recent price of about $3.50. I am highly bullish about the future of natural gas prices. Cabot anticipates ramping up shale drilling dramatically in the fourth quarter and beyond, but right now, the company stock trades at a PEG of over 5. One can find companies with similar quality fundamentals that are much more reasonably valued today.

When one says "natural gas", I think Chesapeake Energy (NYSE:CHK). A few years back, this natural gas producer doubled down to become the leading fracking driller in America, somewhat to its peril. When natural gas prices were eight dollars per mmBTU or more, as they were prior to 2009, Chesapeake could handle its leverage and debt burden. The glut caused by fracking is what caused natural gas prices to fall, ensnaring Chesapeake shares in a free fall.

In the third quarter, on a GAAP basis, Chesapeake continued its losing ways, posting a loss of $2.06 billion, or $3.19 per share. Adjusted earnings, which take various mark to market write downs out of the equation, came to $33 million, or ten cents per share. Analysts' had expected adjusted earnings of nine cents, so the quarter was more or less a success.

In the wake of sustained low dry gas prices, Chesapeake determined earlier this year to direct more of its resources toward the production of liquids (oil, propane, ethane, butane, etc.) and less toward dry gas. As a result, Chesapeake is going to miss the full benefit of the fourth quarter run up in dry gas prices. In fact, Chesapeake has hedged 76% of its expected natural gas production in the fourth quarter at an average price of $3.06. The bad news is that on the open market, dry gas is selling on Nymex at about $3.50 per bcf. Another problem for the gas industry is that Chesapeake and others are responding to rising gas prices by ramping up production, potentially causing a glut and re-collapse of gas prices.

Chesapeake sold its midstream assets and most of its Permian assets for a disappointing $6.9 billion, in an effort to help retire some of its crushing debt. But more than anything, new Chairman Archie Duncan must commit the company, and its unpredictable CEO McClendon, to "live within" Chesapeake's cash flow, and not borrow to fund capital expansion.

The year 2013 will be a telling one for Chesapeake. Because it came up some $2.7 billion short of its goal in selling its Permian Basin assets, Chesapeake must dig deeper than it had previously planned to get its debt under control. Until then, Chesapeake is for no one but the most risk tolerant of investors.

SandRidge Energy (NYSE:SD) is another big gas producing company under siege, this time not from its creditors but rather from its own shareholders. The stock has fallen over 30% this year, and two leading shareholders place the blame on the existing board generally, and CEO, founder and Chairman Tom Ward in particular. I don't see SandRidge digging out of this one without a management shakeup, up to even a sale of the company. Speculators take note.

Southwestern Energy (NYSE:SWN) has held up better than the others through the natural gas price collapse in large measure because its balance sheet was and is in relatively solid shape. In its third quarter, overall production was up 12% from the third quarter of 2011, and it suffered a net loss of $145 million, or $0.42 per share. After adjusting for one-time items, most in the form of write downs due to gas and oil price declines, income came to $132 million, or $0.38 per share. Southwestern runs a relatively low cost and well leveraged operation, and will do well assuming natural gas prices do not fall because of oversupply or another unusually mild winter in the Midwest. I do not like any natural gas producer, but if I had to choose one, Southwestern would probably be it.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.