Playing A Rebound In Energy - Part 1

Includes: CHK, ECA, KOG, REXX, SD
by: Matthew Smith

We have made a decision for playing a rebound in commodities as it pertains to coal. We have long thought that we would simply wait for a bottom there and then move in and play it via direct exposure. That is how we usually like to invest in these sorts of recoveries, however we have decided to merge two of our ideas and set up our trade that way once the time is right.

We have seen coal stocks hit new lows over the past few trading sessions, and being short or on the sidelines has been the correct side of the trade to be on for some time now. We do not think that the industry is going to go out of business, some companies may do this but as a whole we expect the industry to flourish going forward due to growth overseas. If natural gas prices continue to rise then coal will do better here in the U.S., but that will take gas prices moving higher paired with price stability above the breakeven point (of using natural gas vs. coal) in power plants.

So what are we doing? We see that demand has been crushed in the U.S. as natural gas prices fell and thus coal prices have fallen too. It is obvious that the two commodities have become coupled, and now investors must realize that with the current economic situation coal can only trade as high as natural gas allows. So if one thinks that coal is going higher, you would also have to believe that natural gas is going higher and that the move would have to come first. That just appears to be the fact of the current situation and thus our interest in investing in some plays with natural gas exposure.

So here are five stocks in which we would look to buy as a basket to play this. Keep in mind that we would rotate out of these and into coal shortly after coal becomes more economical to use in power plants here in the U.S. or the Chinese economy picks up to previous levels of growth in power consumption. We will of course update readers when we do make the move into this trade, but here is our thinking behind the assembly of the basket.

Chesapeake Energy (NYSE:CHK)

This is the second largest natural gas producer here in the United States and the company has considerable exposure to natural gas prices as they took their hedges off a few months ago in what turned out to be a horribly timed trade due to the fact that natural gas prices fell off of a cliff shortly after that move. This one has a lot of problems outside of the price of natural gas, but the truth of the matter is that whether they are drilling in dry gas plays, wet gas plays or oily plays they will be having significant amounts of dry gas produced from their wells. The company also shut in a good bit of production earlier this year so they have capacity they could quickly bring back to market should that move be justified. The company also has drilling locations in some of their richest dry gas fields which they are not drilling right now due to the fact that they are HBP (held by production) lands now. We think that this one could be one of the bigger movers due to the lack of hedges. It is a bit ironic that what has hurt the company so badly could be what allows it to outpace peers moving forward.

Encana (NYSE:ECA)

The company has undergone some changes over the past few weeks and honestly it seems that they attempting to become the Chesapeake of Canada with their recent moves. The company is now focusing heavily on liquids and will spend heavily this year -- over their expected cash flow levels just as Chesapeake has done for many years. Encana did move to sell off non-core natural gas assets right before the prices fell off a cliff, so their timing in those sales was impeccable. So the company has the cash to make this move towards wetter production, but investors were not happy when this move was announced. In this market those who can operate within their cash flow generated are rewarded and those who cannot are punished. One thing investors should watch out for here is the recent revelation that Encana may have been in cohorts with Chesapeake to keep land prices in federal land auctions low in Michigan. We view it as less of a problem with Chesapeake as it could be the last straw for Aubrey's tenure there, but Encana could seriously be hampered by this if anyone in their management team is required to fall on their sword. There can be many negative outcomes here for the shares, but we think that a bounce in natural gas prices answers more questions than it creates.

Rex Energy (NASDAQ:REXX)

We like this one due to its exposure to the Marcellus and Utica Shales. Obviously the Marcellus is a huge dry gas play and the Utica resembles the Eagle Ford in Texas with three windows -- dry gas, wet gas and oil. Rex has an interesting prospect with the Warrior property and they already have partners helping them develop it while they attempt to add acreage to the package. The company adding liquids to the portfolio is a good thing in our opinion as it diversifies the revenue streams while increasing production dramatically moving forward. The company is hedged moving forward so a rise in natural gas prices has little impact on the earnings when compared to Chesapeake, but it does warm investors to these shares, which we have seen in the past have a tendency to get propelled upwards when good news comes out.

SandRidge Energy (NYSE:SD)

This is one of our favorite oil plays, but long-term it will have more and more production from its Mississippian play, located in Oklahoma and Kansas, as those assets age. As oil prices fall the company is insulated by the hedges they put in place and investors have to like the production growth as well as the cost of that production growth. The Mississippian is not a shale play, but rather an unconventional one, and due to the difference SandRidge can drill for around half the cost that their shale counterparts must spend to drill their wells. Their land acquisition costs are still low in the play, but the company now appears happy with the package they have assembled and will be focusing on getting to cash flow positive from an operating standpoint in the next two years. We think that this is a good way to insulate this basket from a complete downturn in natural gas should that happen.

Kodiak Oil & Gas (NYSE:KOG)

Kodiak would be the second stock which would be in this basket to offset any potential headwinds that arise in the natural gas market. The company is now going to be able to sell the natural gas from its wells in the Bakken area (Williston Basin) now that pipelines are being built and will realize a higher price for its oil production as well. Earnings will increase on this alone, but production continues to rise from successful drill programs and it is our opinion that with over 90% of production from oil that it is necessary to place this one in the basket. This and SandRidge are smaller players, but we think on the right track and we will be looking to build positions here as we could see a rise in what is essentially by-product production for each.

Coal has been weak now for some time, and we are beginning to see the market realize how bleak the situation is as there are freighter sitting off of the Chinese coast waiting to find buyers as their original ones have backed off of their commitments and rating agencies begin a round of debt downgrades for the industry. Revenues are going to trend lower in the industry as the underlying price of the commodity falls as well as production due to curtailments and closings, so natural gas is what one should watch for a heads up. It is after all what got us to this point, so it should also lead us out.

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

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