How To Invest In The Most Undervalued Asset In The World: Natural Gas

Includes: CHK, GST, UNG
by: Pitbull Trading

Throughout many investor circles, a popular strategy for success is based upon the theory of value investing. This is an idea that has been touted by the likes of Warren Buffett, Benjamin Graham and other highly successful investors. While it's doubtful that value investing will ever be as popular as buying trendy, high-growth, or risky momentum stocks, it has withstood the test of time as a worthy strategy.

One of the key aspects in searching for value is that you have to find an asset that is generally unpopular among investors. In the current market environment, with a majority of stocks hitting their 52 week highs, I would like to bring your attention to an asset class that remains extremely undervalued.

I will also outline two companies for your portfolio that are well positioned to provide you large profits in the future. One of my picks has the potential to be a 10 bagger stock in the next 5 years for those willing to take a look at an under-the-radar equity.

Why Natural Gas?

The asset that I am recommending for your consideration is Natural Gas. Natural gas prices are sitting at decade lows, largely because of advancements in drilling technology, creating a vast amount of natural gas that is now easily accessible. In addition, the ratio of crude oil to natural gas is also currently at all time highs. This situation offers great opportunity for practical investors with a focus on the future.

The pricing of natural gas is a supply and demand issue at heart, as there is more gas currently available than we know what to do with, and storage facilities across the country are at maximum capacity. Oil & Gas companies are shuttering wells; there is talk of converting commercial fleet vehicles to natural gas to take advantage of low prices, and utilities are switching to gas over coal and other energy sources.

Investing in natural gas is a trade that may take some patience, but will ultimately reward investors handsomely as increasing demand will begin to whittle away at excess supply. It would seem apparent that the negativity and lack of interest in this asset has been priced into the sector. It is hard to picture a bleaker outlook for natural gas than what is currently believed in the marketplace, and the downside from here is certainly limited.

That is why it makes perfect sense to invest in this asset right now. It takes a bit of contrarian thought to outperform the broader market, and natural gas is one of the few investments available that offers great value.Another positive catalyst that will boost the sector will be when companies begin to export Liquified Natural Gas (LNG) to world markets with much higher price points. In parts of Asia, prices are currently at $15/per MMBtu, in Europe they are $10/per MMBtu; compare that to the US market's average price of $2.30 and you can see how this gap will eventually narrow.

Natural Gas Vs. Crude Oil

From a pure energy standpoint, one barrel of crude oil should be priced at 5.8 times 1 MMBtu of Natural Gas; this is because it takes 5.8 MMBtu of gas to produce the same amount of energy as 1 barrel of crude oil. This ratio is now at an all time high (26.2). If this ratio was to return to 5.8, gas would be priced at $17.00 per MMBtu, an increase of 739% from current prices!

Politically, there has been talk of the U.S. becoming the Saudi Arabia of Natural Gas, with lobbyists and politicians repeatedly emphasizing the talking point of America becoming energy independent. Proponents of the Natural Gas industry are becoming more vocal; you will continue to hear more proposals such as the Pickens Plan, by legendary energy guru T. Boone Pickens, and other political movements favoring this abundant American resource.

Also, with higher oil and gasoline prices beginning to hurt consumers, the summer driving season on the horizon, and this being an election year, I expect to hear more exciting initiatives for natural gas in the near future from our politicians.

The economic reasons for the pricing variances can be explained as oil being priced in a global market, while our natural gas supply is priced in a domestic market. We are unable to unload our excess supply at this time onto other markets and drive gas prices toward a better ratio.

The free market will ultimately help solve this supply glut, with future exportation of LNG, as well as utilities and businesses increasingly moving toward this economical and domestic energy source.

How to Invest in Natural Gas?

While it is possible to find a pure play on Natural Gas by investing in the U.S. Natural Gas Fund (symbol UNG), the structure and costs associated with this product cause you to lag the true performance of the underlying asset.

I would instead recommend buying individual companies who have large exposure to exciting natural gas opportunities domestically, strong fundamentals, and offer significant upside in a future that will see higher gas prices. I will outline my favorite two picks below with some details on the companies and their prospects.

1. Chesapeake Energy Corporation : (NYSE:CHK)

This is one of the purest plays in the natural gas sector for investors looking to get a broad, diversified blend of assets from a domestic company. Chesapeake owns gas plays in nearly all of the most exciting and prolific gas fields in the U.S., including newer shale plays. They are also vertically integrated into all aspects of the business, including marketing, compression, midstream and oilfield services, either directly or indirectly.

Here is a statement from the company itself, "We're the second-largest producer of natural gas, a Top 15 producer of oil and natural gas liquids and the most active driller of new wells in the U.S. Headquartered in Oklahoma City, the company's operations are focused on discovering and developing unconventional natural gas and oil fields onshore in the U.S."

This company's stock has performed poorly over the past year, down around 27%, and would not be considered to have much 'momentum' or popularity among traders. The stock has indeed languished along with the spot prices of Natural Gas, and at its current price, offers a great buying opportunity for investors looking to profit from Natural Gas' exciting future. The stock has a current P/E ratio of just over 10, pays a $0.09 quarterly dividend (1.43% annual), sports solid profit margins (~15%), and has a very low payout ratio(11%).

The low payout ratio shows plenty of room for dividend increases in the future; they are only paying out 11% of their earnings as dividends, reinvesting the rest into a business which remains undervalued. This company has been disregarded by the markets, and with many stocks currently overbought, Chesapeake Energy offers a compelling investment for shrewd investors.

2. Gastar Exploration Limited: (NYSEMKT:GST) My potential 10 bagger stock

Gastar Exploration is a small independent company, based out of Houston, Texas, that is engaged in the production of natural gas in some of the most exciting gas plays in America. They are focusing currently on one of the prolific gas reservoirs ever found, the Marcellus shale, and they own acreage in this play that are rich in condensate or Natural Gas Liquids (NGL's). These liquids are sold at prices that trade similarly to crude oil, an obvious benefit.

They stated in their most recent annual report that 33% of their proven reserves in the Marcellus shale are comprised of oil and natural gas liquids. This allows them a lot of flexibility for their drilling programs, and the ability to adjust capital expenditures based on current market conditions.

Gastar is also ramping up production in a huge way; they have 27 planned wells for the Marcellus on their current drilling schedule. 10 of these wells are currently producing, 5 more will be online by April, and the rest to be completed soon thereafter. They estimate a total of 74 wells to be drilled in this liquids rich portion of the Marcellus play alone. As they keep increasing their gas production, you will see the share price rise dramatically as well.

The stock price for Gastar Exploration has seen a decrease of over 30% over the past year. This performance is because of a lack of investor confidence in the sector and historically low prices, rather than a lack of execution in their core business. The company currently operates on a forward P/E ratio estimate of 6.26, trades below its current book value of $3.29, and has a very solid management team in place.

This equity offers a great opportunity for investors who are willing to accept the risk of investing in an unknown, small-cap natural gas explorer with fantastic future potential. This company also could be purchased outright by a competitor as they keep developing and proving up their significant reserves.

For those investors who are seriously risk averse or income orientated, I would have you take a look at Gastar's only debt instrument, a preferred stock- symbol GST-A- with a yield of 11% at its current market price.

Disclosure: I am long GST.