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The natural-gas rally hasn't passed you by
Watching energy-stock prices rise and fall may lead you to believe the sector is already in play. But with a long-term shortage looming, the action has just begun.
By Michael Brush
Now that even Fed chief Alan Greenspan is publicly fretting about a shortage of natural gas, anyone looking at stocks in the industry has just one question:
Is it too late to join a rally thats seen the group advance as much as 50% over the past several weeks?
The short answer is no.
Sure, there will be pullbacks -- like the retreat following the Greenspan-induced jump in the stocks last week as the Fed chairman warned Congress to encourage more imports. But long-term imbalances in supply and demand for natural gas mean these stocks could still advance 50% to 100% more over the next two to three years. Thats at least how long it will take for enough fresh supply to make a difference.
Between now and then, expect continuing shortages to boost earnings at service companies, which supply and maintain the equipment used to bring natural gas up above ground. Among the expected winners: Patterson-UTI Energy (PTEN, news, msgs), Ensco International (ESV, news, msgs) and National-Oilwell (NOI, news, msgs). The industry dynamics also should benefit exploration and production companies like Devon Energy (DVN, news, msgs), Southwestern Energy (SWN, news, msgs) and Stone Energy (SGY, news, msgs). These are the companies that look for natural gas fields or buy access to them, and then set up rigs to bring the gas to the surface. Many natural gas exploration and production companies also produce oil.
Businesses that can help increase the import of liquefied natural gas (LNG) also stand to gain. These include Chicago Bridge & Iron (CBI, news, msgs) and the tiny Cheniere Energy (LNG, news, msgs).
It's early yet
Obviously, stocks in the group have advanced a lot, but its still not late from an investment standpoint, says Tom Petrie, an energy-sector analyst with the Denver-based Petrie Parkman & Co., a sell-side brokerage. There is pretty good reason to believe that it will take several years to straighten things out.
Whats lit a fire under natural gas stocks recently is the leap in the price of natural gas to about $6 per thousand cubic feet on average, this year. Thats double the $3 average from 1998-2002.
Industry executives and analysts like Rikard Ekstrand, of the money management firm First Pacific Advisors in Los Angeles, see natural gas trading for an average of $5 per thousand cubic feet over the next three years, inside a range of about $4-$6. That is the price needed to increase drilling out there, says Ekstrand, who expects natural-gas-related energy-services stocks his firm owns to double from here.
Despite the bullish views of Ekstrand and others, skeptics abound. But their abundance simply ensures that a truly bullish outlook isn't yet priced in to natural-gas-related stocks.
What are the doubters doubting? They worry that unusually cool weather this summer, or an economic slowdown, could cut demand and ruin the whole bullish scenario. They fear that natural-gas users will simply switch to other energy sources such as oil or coal.
But heres why things probably wont work out as they foresee.
A matter of supply and demand
Today, wells yield less than they used to. With the advent of technology, we have been able to access smaller and smaller fields and make them more productive, says Al Reese Jr., the chief financial officer for ATP Oil & Gas (ATPG, news, msgs). But we have been doing that for 10-plus years. And by now, no matter how much technology you throw at a field or a well, you are not going to be able to increase productivity like we have in the past. Meanwhile, solutions such as importing more from Canada and Alaska through pipelines, or bringing in more LNG, are still three to seven years away.
The natural-gas supply is low. A cooler-than-normal winter ran down the amount of gas in storage, and it will take a big effort to top off the storage tanks to be prepared for next winter. The nations gas storage stands at around 600 billion cubic feet, and Americans typically need about five times that much by the time the autumn rolls around to meet winter demand. At the current rate the industry is socking it away, the supplies will be adequate. But if summer heat drives up demand for natural gas used to create electricity to run air conditioners, all bets are off. If we have a hot summer, you are going to see gas spike, says Allen Connell, the director of investor relations at Carrizo Oil and Gas (CRZO, news, msgs). That also could cut into how much the nation is saving for next winter, worsening the shortage.
The economy does look like its coming back. This alone could increase demand for natural gas.
If the price of natural gas really does stay high, here are some of the companies that will benefit the most.
The drilling services companies
Higher natural-gas prices mean that exploration and production companies have more money -- and a bigger incentive -- to drill and produce more. Thats good for oilfield service companies, which could see a boom in business over the next two or three years. A powerful oil service stock rally is likely, as we enter the next phase of the drilling cycle, says Robin Shoemaker of Bear Stearns.
He thinks rig usage has to increase another 10% -- from current levels of around 1,000 rigs in service -- for drilling services capacity to be tight enough that services companies gain significant pricing power. Watch for an increase in offshore drilling, which is flat year-to-date, to confirm to investors that demand for drilling services is back, driving up these stocks even more.
First Pacific Advisors owns Patterson-UTI Energy, the second-largest land rig company, and Ensco, which has so-called "jack-up" offshore rigs used in the Gulf of Mexico. With the prices of natural gas improving, jack-up rates are starting to move up, and that will drive profitability for this company, says First Pacific's Ekstrand.
Another holding: National-Oilwell, which makes parts used in rigs. As companies bring out more old rigs, this company will make a lot of money on replacement demand, says Ekstrand. They dominate. They have a very high market share. National-Oilwell should also benefit as Russia continues to improve its natural-gas infrastructure. The company does business in the Middle East, West Africa and China, as well. Shoemaker, of Bear Stearns, says a recent surge in business suggests the equipment-spending cycle has turned.
Exploration and production companies
Here, of course, the play is obvious. Companies that have reserves will be getting more money as natural-gas prices stay high and hedges come off. Petrie likes Devon Energy, Remington Oil & Gas (REM, news, msgs), Cimarex Energy (XEC, news, msgs) and Westport Resources (WRC, news, msgs). (Petrie has a personal position in Westport Resources.)
Another way to find potential winners is to look among the smaller companies that have the best upward earnings estimate revisions and the cheapest valuations relative to the group. The upward revisions suggest good and sustainable business trends are in place. And the lower relative valuation means theres potential room for upside as the company catches up.
A scan of the investment database generated by IBES International, a company that tracks Wall Street analysts' earnings estimates, turns up Stone Energy, with a market cap of $1.1 billion, trading at about .65 times the group's average forward price-to-earnings ratio. Others include Southwestern Energy, with a market cap of $516 million, trading at .6 times the groups valuation, and Cabot Oil & Gas (COG, news, msgs), which has a market cap of $970 million and trades for .8 times the groups forward P/E.
Dig down among the really small players and youll find ATP Oil and Gas, with a market cap of $137 million, trading for under half the groups value. Carrizo Oil and Gas, with an $87 million market cap, trades at .6 times the groups valuation.
LNG plays
If you cool down natural gas to around minus 260 degrees, it turns into a liquid known as liquefied natural gas, or LNG. Importantly, the cooling shrinks the volume of the substance by about 600 times. Thats key, because it means LNG can be shipped more easily (inside large tanks that are essentially thermos bottles to keep it cool).
Since theres so much natural gas around the world, in places ranging from Trinidad and Russia to Algeria and Indonesia, importing LNG seems like a great way to help solve the current shortage.
Problem is, we dont have enough LNG-receiving terminals; these are the sites where the stuff can be offloaded, processed and shipped to users. Thats one of the problems Fed chief Greenspan was referring to last week when he told Congress to act to encourage the building of more receiving terminals.
Given the outlook for sustained higher natural gas prices, it now makes sense financially for private companies to line up financing to build natural gas receiving terminals. All they need is the cooperation of regulators -- to approve the projects -- and those approvals are likely to start sailing through.
If so, at least two companies stand to benefit. First, the engineering and construction company Chicago Bridge and Iron builds and repairs LNG terminals and storage tanks.
Next, the little-known Cheniere Energy has been hard at work trying to line up government approval to build terminals. That helps explain why the companys shares moved to $5.50 from $4 June 11, the day Greenspan told Congress it needs to make importing LNG easier.
The shares have since retreated back under $4, but the company plans to have several terminals up and running a few years from now. Wed like to be involved with three or four of them, says Chief Financial Officer Don Turkleson.
He thinks his company should get approval by the middle of next year to put in three terminals. They will take about 2 years to build. Cheniere will swap about two-thirds of the overall capacity in financing deals. But it will operate the rest at what are likely to be healthy profit margins. If so, anyone who bought at the peak of the frenzy Greenspan created in Cheniere shares last week should see healthy gains -- even despite a pullback of 25% in the stock since then.
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