What The Reduction Of The Natural Gas Glut Means For Energy Stocks

by: Convex Strategies

The Outlook For Natural Gas

Baker Hughes (NYSE:BHI) and Schlumberger (NYSE:SLB) reported excellent earnings on Friday morning (July 20), as both energy services companies beat estimates on both revenues and EPS by wide margins.

Both companies' stocks were dealing with depressed expectations considering the tough quarter for natural gas. With natural gas going under $2 as oversupply flooded the market, gas producers quickly closed rigs and rapidly decreased production as operations become largely unprofitable.

Energy services companies like BHI, SLB and Halliburton (NYSE:HAL) depend on strong activity from clients who purchase their drilling, field, and technological services and equipment. With the weak industry dynamics for the second quarter well understood, these companies' share prices declined markedly.

Friday's Baker Hughes' rig count report showed that rigs in operation are down to their lowest level since 1999, and that figure is expected to decline by year's end. Although 2012 production is still likely to set a record, producers have taken serious steps to reduce supply relative to demand. With natural gas prices on the rise in the face of a slowing global economy, their efforts appear to be working.

The earnings out of SLB and BHI are very promising for the natural gas industry for two reasons: 1) production, while lower, is still strong, which indicates strong demand for natural gas, and 2) margins and efficiencies must be improving for producers, since production investment is still high, in spite of significantly lower rig counts.

The Outlook For Coal

The weakness in coal stocks has been a major story in 2012. While the trend in domestic coal usage has been largely downwards, particularly since the inception of the Obama administration, global coal consumption was up 5.4% in 2011.

The divergence of domestic and global consumption is due to the EPA's regulation and natural gas prices that are far higher overseas than in the US. For example, natural gas prices can get as high as $12 in China, the world's largest consumer of coal. As a result, coal consumption is still largely on the rise in rapidly growing emerging markets.

The dynamics that brought Patriot Coal (PCX) to its knees are widely understood. Temporarily low natural gas prices led to broad conversions from coal generation to natural gas, and with sharply lower revenues, servicing its massive debt (accrued over a string over quarterly losses) load became a worse choice than filing.

The fears that coal is a completely dead, or even dying business, are misguided. Coal consumption is on the rise globally; it's cheap, abundant, and a quality source of energy. A look at valuations among even the healthiest in the industry reflects the sentiment that these companies will be lucky if they remain solvent.

With natural gas prices on the rise, using coal is slightly more attractive as an energy source even domestically. While the cost of coal consumption has risen thanks to the EPA's regulatory initiatives, natural gas under $2mmBtu was a steal for industrials and utilities during the winter. However, with prices above $3, Reuters reports that users are starting to switch back over to coal.

Conclusions Regarding Both Industry Dynamics

Both Natural Gas related and Coal companies can do well in this environment. Production, margins and profits appear to be strong in the natural gas industry, while coal companies may be getting a catalyst in higher domestic coal utilization due to the rise in natural gas prices.

Of course, coal companies with rapidly declining revenues and high relative debt levels are not out of the woods yet. To invest in the industry, the company must have a reasonable capital structure and a manageable level of debt. Typically, I find that total net debt levels three times gross profits are reasonable.

As for the natural gas industry, some coal-conversions by utilities and various industrials will be more than offset by prices. Additionally, as previously mentioned, efficiency appears to be improving.

Potential Natural Gas Investments

  • Halliburton: I recently wrote an article recommending HAL, but noted that we may see a better entry point. With a big discount to broader market multiple and strong growth trends, with EPS up 152% since 2009.
  • EOG Resources (NYSE:EOG): A tad expensive on a trailing basis, but has assets that are potentially worth more than the total market cap of the company. Additionally, has a strong crude oil portfolio to guard against times of weak natural gas prices.

Potential Coal Investments

  • Peabody Coal (NYSE:BTU): Very manageable debt burden, and has 93% of sales under long-term contracts. Has weathered industry downturn quite nicely and is an excellent long-term investment.
  • Alpha Natural Resources (ANR): It may have negative EPS, but free cash flow generation has actually been solid; trailing FCF is about $90 million, with $2.5 bb in net debt.

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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