Natural Gas: Watch Your Leverage

by: Roger S. Conrad

Is the natural gas rally for real?

Since bottoming at less than USD2 per million British thermal units (MMBtu) in late April the clean fuel has surged north of USD3.50. That's a level not hit since early December 2011.

This reversal of fortune is partly due to weather. The winter of 2011-12 was one of the mildest on record. But the summer of 2012 was not quite so temperate. And at least the early indications are the winter of 2012-13 will be much closer to normal, and a lot colder.

Natural gas is, however, also benefiting from an historic shift of North American power generation away from long-time mainstay coal. For the first time ever power utilities are using more gas than coal to produce electricity. Gas-fired generation is up 21 percent this year from last and now accounts for 36 percent of all US gas consumption.

On the other side of the ledger are the vast reserves of natural gas in the US and Canada buried in shale that are now accessible and economic, thanks to hydraulic fracturing. New drilling stalled this year in the wake of prices that fell to nearly USD1 per MMBtu in some parts of Canada.

Overall production, however, is still expected to rise 4 percent this year. Moreover, inventories of the fuel are still well above the five-year average. Should rising prices encourage more gas drilling supply will rise all the more, virtually guaranteeing a rapid retreat.

Then there's coal, which has seen a sudden price decline as global demand has fallen.

Given the black mineral's potential environmental costs, USD3.50 may not be enough to convince US utilities to switch back. But every cent higher from here makes that option more attractive.

Several Canadian stocks offer substantial exposure to gas' upside.

Shares of Peyto Exploration & Development Corp (OTC: OTCPK:PEYUF), for example, have surged into the black for the year after being down nearly 40 percent this spring.

ARC Resources Ltd (OTC: OTCPK:AETUF) is also up after slipping nearly 25 percent to mid-April.

More than 90 percent of Peyto's output and two-thirds of ARC's is natural gas. That's more than Pengrowth Energy Corp's (NYSE: PGH), as that company focuses on ramping up oil output from the properties of the former NAL Energy Corp.

But Pengrowth too has seen a solid recovery since hitting a low of USD5.87 in late June. And that's despite cutting its dividend from a monthly rate of CAD0.07 (USD 0.07) per share to CAD0.04 (USD 0.04) in early July.

Should gas prices continue to head up into the winter these stocks will almost certainly follow. But even if they don't, these companies are now locking in the best selling prices of an otherwise dismal year by hedging. And as they've proven time and again they have the financial strength to outlast the price cycles in the commodities they produce.

That's a stark contrast, however, with most companies in their industry. And that's why it still makes sense to avoid small and more heavily indebted natural gas producers such as Advantage Oil & Gas Ltd (NYSE: AAV), AvenEx Energy Corp (OTC: OTC:AVNDF) and Perpetual Energy Inc (OTC: OTCQX:PMGYF) as well as stocks of companies such as Enerplus Corp (NYSE: ERF) that have rebounded without any hard numbers to back them up.

Yes, all of these companies will have a lot further to run if gas prices do push higher in coming months. Another dip in prices, however, could prove fatal to at least one of them. There's just no point in taking that risk, particularly when stronger companies provide just as attractive a play on a further gas rally.

Limiting leverage is also good policy outside the energy sector as we enter the fourth quarter of 2012. As of now there's no reason not to expect the Canadian dollar to remain strong against the US dollar, or the Canadian economy to remain steady and largely free of inflation.

Many investors have decided that a rising share price connotes safety, while a retreating one is a warning of imminent disaster. They pile into stocks that are going up and bail out of stocks that are losing ground. And the result is routinely jagged volatility when there's absolutely no justification in terms of the underlying business.

As we wait for companies to report their calendar third-quarter numbers, there's undeniably a dearth of hard information. As a result rumor and opinion are what carry weight.

In the days leading up to second quarter reporting season, for example, we saw rumor and opinion jump-start panic-selling of several high-yielding stocks. Falling prices convinced other investors that dividends were at risk, leading to further selling. When the actual numbers were announced fears were quelled, and the stocks rebounded.

That could well happen again over the next few weeks. And volatility could be further exacerbated by political and economic uncertainty in the weeks ahead.

If that does happen, remember this: It only makes sense to sell if something really is wrong with a company's underlying business. And only a company's numbers can answer questions about its health, not an opinion that might be written by someone with an interest in a stock's further demise. If there is trouble at a stock I'll sell. Unless that happens, though, there will be a rebound.

Don't overload on any one stock, sector or stock market investing theme. And above all don't overpay for any company, no matter how attractive it looks now.

That's how to stay fully invested in what should still be a profitable fourth quarter for strong Canadian companies. And that's how to limit your risk in case the situation doesn't evolve quite that well. I highlight several other Canadian dividend stocks in my free report.

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. I have no business relationship with any company whose stock is mentioned in this article.

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