The Exciting Side of 'Classical Gas' and Huge Opportunities Among E&P Companies

by: Marc Courtenay

First an update on Brocade Communications (NASDAQ:BRCD). On April 12th on strong volume it tested a lower price of $5.69 per share. This took it slightly above its 200-day moving average of around $5.63. The next day it popped up as high as $5.93 on less impressive volume. Let's see if it tests the 200-day M.A. Insiders have been selling when the stock pops above $6.10 or so, and I'm waiting to see if they start buying if the price drops below the 200-day M.A.

Now back to another topic. Back in 1968 guitarist Mason Williams released his instrumental recording titled "Classical Gas" and it remains one of the most successful popular instrumental hits of the 20th century. Hearing it again the other day reminded me of the energy version of "classical gas" - good old, nice and cheap natural gas.

The time to load up on any asset is when the supply seems unlimited and therefore the price is cheap. A couple of years ago I wrote an article on this same subject.

Back then I mentioned Southwestern Energy Company (NYSE:SWN) which at the time was selling for around $25 a share - and natural gas prices had plunged below $3 a mmBtu (per million British thermal units).

Those who purchased SWN at that point were able to double their money and sell in early January 2010 for over $51 a share. Today the stock is back down around $38, and natural gas prices are up to $4.14 as I write.

As of December 31, 2009, the company estimated its proved natural gas and oil reserves were approximately 3,657 billion cubic feet of gas equivalent. The most recent 10-K is most certainly to show that number has increased.

What really excites me right now are the overlooked and less talked about smaller producers with cheap reserves and great undeveloped reserves in some prime locations.

These are stocks that could exponentially outperform the big players like SWN, Chesapeake Energy (NYSE:CHK), Anadarko Petroleum (NYSE:APC), Range Resources (NYSE:RRC) and the "800 pound gorilla" that paid dearly for XTO and now is the nation's largest natural gas producer, Exxon Mobil (NYSE:XOM) - which has the upside potential of a leaky blimp in my opinion.

I like many of the above "big players," but the chance for astronomical profits are most likely to be found in the smaller, less popular ones.

On the "smaller" side I'm excited by companies like GMX Resources (GMXR) with a market cap of around $300 million and Advantage Oil and Gas (NYSE:AAV) with a market cap of nearly $1.4 billion.

Of course these are both "grasshoppers" compared to the behemoths in the industry. AAV converted from a royalty try back in January of this year. It controls around 135 million barrels-of-oil-equivalent (BOE) in reserves, with over 40% of that being natural gas.

AAV gets its cash flow from its conventional oil and gas wells, which will produce oil and gas for an estimated 15 years or more. These wells are mainly in Alberta and southern Saskatchewan, Canada.

The most exciting thing about AAV is that it is enthusiastically drilling for more natural gas. It evidently plans to increase its Montney Shale gas production from 50 million cubic feet per day to 100 million per day by the end of June this year.

If it pulls off this kind of production increase, it is estimated the company will generate close to $125 million in cash flow if natural gas prices stay where they are now. If they go up closer to $5 mmBtu that would improve the results to nearly $160 million.

There's talk that AAV may bring in a partner to share costs and increase the number of wells drilled. There are plenty of potential partners like Petrochina (NYSE:PTR) or perhaps an unexpected one like Petrobras (NYSE:PBR).

Bringing in a partner would provide more working capital and would secure its financial ability to meet its ambitions.

The shares of AAV trade at close to book value, and I hear that the market doesn't show this company much respect. Very few analysts talk it up or even like it, and that's why it might surprise to the upside, especially if natural gas prices move higher.

The shares of AAV I own were purchased at under $7.70 per share, and it is quite feasible that share prices will drop down to that level in the months ahead. If purchased below $8 a share, and if this company were to trade near the average of its peers, a double or even a triple in share price is not unreasonable.

GMXR is a small natural gas producer that's trying to produce more oil. On the plus side it holds big-time acreage in the Haynesville shale of Louisiana and East Texas. It has even a bigger stake in Texas' Cotton Valley sands.

It has around 59 million BOE of resserves, and the vast majority of that are natural gas. Over 60% of those reserves haven't been developed yet, which might change if natural gas prices move higher or if they find a rich partner.

In the meantime the company owns some acreage in east Texas where it is drilling some oily "Texas tea," and it estimates it will produce 473,000 barrels of ol in 2011, which may equal gross income of close to $100 million with today's oil prices.

In 2012 the company is saying it may be able to increase that production to nearly 1 million barrels of oil and as a result gross earnings could leap above $150 million.

It does have some debt issues, but to mitigate that GMXR raised $100 million by issuing 21 million new shares. This increased the shares outstanding to 53,285,968.

But the sale of new shares reduced the bank debt down, covered its capital expenses for 2011 and allowed them to roll over some long-term bonds too.

The company has some other non-essential assets it's planning to dispose of (like its interest in a natural gas gathering pipeline). And like AAV, its shares are priced below the 2.6 times book value of GMX's peers.

In fact, GMXR's book value is around $4.06 a share, so I won't touch them until they drop to below $4.25, although I may raise my price target if it continues to show good results.

Today (4/13/2011) the shares closed at $5.63, and yesterday the company announced that it set a company production record in the first quarter.

The Oklahoma City company said it produced 6 billion cubic feet of natural gas equivalent in the first three months of the year, an 89% jump from the same period last year. GMX said it expects to produce 6.1 billion cubic feet in the second quarter and 25-26 billion cubic feet for the entire year.

As we've all heard, after the Japanese disasters and the nuclear power plant meltdowns, natural gas has moved up the "pecking ladding" as the energy superstar of the future.

Whether you buy the big names in natural gas production sector or the small ones, be patient in accumulating them so you'll be sure to pay as low a price as possible. Hopefully you'll also be a buyer while natural gas prices are down at current levels.

These factors will add to your chances of experiencing some rich results over time, just like they did the last time natural gas was considered a "cheap gas" instead of a "classical gas" - one that the world will rely more and more on in the future.

Disclosure: I am long CHK, AAV.