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I Can Make a Bullish Case for Natural Gas, I Just Don’t Know if I Believe It

December 14, 2011 | About:
CanadianValue

CanadianValue

210 followers
I have a dream. A dream where I spend the next year buying natural gas producers on the cheap while the commodity lingers at current depressed levels. Then my dream gets better. We enter a multi-year bull run for natural gas prices and my collection of natural gas producers double, triple and quadruple in value.

Is this dream really all that unrealistic? I think there are a lot of reasons to think that the price of natural gas will improve significantly in the years ahead.

Reason #1 – Any energy company that can move capital spending away from natural gas drilling and into oil is doing so. Why would anyone drill for natural gas that offers little if any return on investment when they could drill for oil at $100?

Consider this presentation from Chesapeake Energy (CHK) which indicates that 75% of capital spending next year will be directed to oil and liquids compared to 10% in 2009. This is the most active natural gas driller in the U.S. and it is basically shutting down its natural gas spending. The fact that multiple companies are doing this has to impact supply at some point.

Reason #2 – Drilling required to hold acreage has pretty much ended. In many of the big gas shale plays (Haynesville, Barnett) a condition of leases is that the property must be drilled within a specific window of time. That means companies drill wells to retain their lease interests even though they would rather not. That forced drilling has pretty much ended. Now that a company has a choice, it is going to drill an oil well, not a gas well.

Reason#3 – U.S. LNG import facilities are being converted to LNG export facilities. Natural gas is not like oil; it is mainly a local commodity as it is difficult to transport. For the past few years that has meant that US natural gas production has been stuck in the United States getting low local prices. With the actions of Cheniere and others, starting in 2015 natural gas can be transported away from the states and sold into the global market via LNG exportation.

Reason #4 – A continued shift from coal to natural gas as a source of power. Historically there have been concerns about the availability of a long term supply of natural gas for power generation. Those concerns are gone and the economics now make sense. So does the environmental impact. Demand from power producers for natural gas is only going to increase in future years.

Reason #5 – At some point won’t the government get behind a plan to move to natural gas as a transportation fuel? Instead of having to rely on the Middle East, Venezuela and Nigeria to provide oil to the U.S. wouldn’t it make more sense to use natural gas which the U.S. has in abundance? Boone Pickens has been taking this plan to Washington with so far limited success. It may be that the current administration isn’t interested in any medium to long-term fix that involves a fossil fuel. Perhaps 2012 will bring a change that embraces the vast resource of natural gas that the country has.

So we seem to have a pretty good reason to believe in a rebound in natural gas prices on both the supply side (drilling reduced, exporting LNG) and the demand side.

How does one try and take advantage of a rebound in natural gas prices through equities?

You could buy a pure play conventional natural gas producer like Contango Oil and Gas (MCF). Contango is fairly low risk as it is one company that can make money at current natural gas prices. A rebound in natural gas prices only makes them more profitable. You also get an option on Contango hitting successfully on another big exploration well in the Gulf of Mexico.

You could buy a pure-play shale gas producer like Southwestern Energy (SWN) which would not only benefit from a rebound in natural gas but also from any technological advances which increases the amount of gas they can recover from its properties or decreases cost. Not an unrealistic possibility given how young shale gas production truly is. Every year shale wells keep getting better through what is being learned from existing wells.

My favorite idea is to buy a company that is likely undervalued based only on its oil assets, but has big optionality with natural gas properties that are currently not being exploited. That way you have investment success through oil exposure and an option should natural gas take off. Examples of that would be Sandridge Energy (SD) which has moved aggressively to oil production through acquisitions and Petrobakken Energy which currently has a production weighting that is almost 90% light oil but is also sitting on a couple of TCF of natural gas in the Horn River and Montney shale plays.

But while I have some ideas, and I think the bullish natural gas argument has some merit, I just can’t convince myself that we won’t have another five years of depressed natural gas prices. These arguments made a lot of sense a year ago and the supply/demand situation for natural gas has only gotten worse.

So instead I stick with my oil-weighted companies, because high oil prices is something I believe in. Of course if I wait to see an improvement in the natural gas market it may be too late to get into these equities at attractive prices.

About the author:

CanadianValue
http://valueinvestorcanada.blogspot.com/

Rating: 3.5/5 (21 votes)

Comments

vgm
Vgm - 2 years ago
CV, a year or more ago you did an impressive in-depth analysis of Chesapeake, valuing it at more than 3x its price. It's been up 50% and back down since then. If that analysis of CHK is still valid, isn't the way to play this situation to buy on a company-specific basis rather than attempt to make a macro call on natural gas?

I think the case for CHK remains strong, whatever balance of oil to gas it chooses. It was very encouraging to see Lou Simpson, ex-Berkshire now-CHK director, buy 100,000 shares recently. He's not only a CHK insider now but one of the best value investors around. He paid around $27. CHK trades around $23 today.

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