Gas burns brighter

Lanny Pendill has been around long enough to know that, when people get too bearish or bullish on a commodity, he should take the opposite view. That’s why, in 2007, when natural gas prices were about $15 per thousand cubic feet (Mcf), the St. Louis–based senior analyst at Edward Jones was telling people that the good times were soon going to end. “I knew that price wasn’t here to stay and that we were close to a turning point,” he says. “And it did turn.”

Now, five years later, with prices at a paltry $3.62/Mcf, Pendill is, again, taking a contrarian view. It may take a few years, he says, but the price of natural gas will rise.

Despite Pendill’s optimism, many investors think the price of gas will stay low for a long time, so they’ve abandoned it for higher-priced oil. That’s made natural gas—the commodity and the companies—the black sheep of the energy sector. And that’s a good thing. “The natural gas industry is a value play,” says Pendill. “Near-term, natural gas producers will lag their oil-based peers, but down the road the market will balance itself.” The natural gas industry is also going through some major changes, which presents numerous undervalued opportunities for investors. Find the right stocks today, and you’ll likely be rewarded later.

Natural gas prices have a long history of dramatic rises and falls, but the last time they dropped, in 2008, it was because of a revolutionary change in the industry. Advances in drilling technology made it possible to extract gas from solid rock formations such as shale, vastly increasing the size of the reserves that could be economically recovered. Eric Nuttall, manager of Toronto’s Sprott Asset Management’s Energy Fund, says that eight years ago the average natural gas well would initially produce 250,000 cubic feet of gas per day. That number is over a million cubic feet today. The go-big-or-go-home economics of shale gas mean North American supply is far outstripping demand, even though that is increasing, too, as users switch from more expensive (oil), more polluting (coal) or more dangerous (nuclear) energy sources.

But while North America faces a glut, Asia faces a shortage. China’s natural gas imports have climbed 27% in the first half of 2011, and Indian demand for gas is expected to double by 2015. Currently, North American companies can’t tap into that demand; there’s currently no way to transport gas produced domestically overseas. So, while a Canadian utility might pay $3.62/Mcf for gas, Chinese customers are coughing up $11/Mcf. To move gas from Canada to China, it needs to be liquefied and shipped over the ocean. Scott Vali, a vice-president and portfolio manager with Toronto’s Signature Global Advisors, says North America has been slow to adopt the technology needed to convert natural gas to liquefied natural gas (LNG). With so much supply here, though, companies are now working hard to build LNG conversion plants. Canadian companies should be ready to begin shipping gas to Asia by 2015, says Vali. When that happens, North American operations with export contracts will start earning a higher price for gas, while domestic supplies may finally get drawn down.

To get into this market, investors could buy an exchange-traded fund, but Steffen Torres, a portfolio manager with Kalmar Investments, based in Wilmington, Del., advises against it. Some gas ETFs hold futures contacts that are purchased at a certain price. When it comes time to sell, if the contract is lower than the purchase price, the ETF’s value drops. With gas prices so low, Torres thinks there’s potential to lose a lot of money. If you invested US$10,000 in the United States Natural Gas Fund ETF in March 2007, for example, you’d have about $900 today. ETFs that hold an undifferentiated basket of stocks are likewise inadvisable since some of the companies will have a cost of production above current prices.

It’s a better idea, says Torres, to buy company stock directly. With gas prices so low, though, investors have to look hard for the best buys. The first thing to consider, from a stock valuation perspective, is how much it costs a company to produce gas. The lower the cost, the better. The current price of a basket of natural gas companies, says Torres, assumes gas can be produced at $4.50/Mcf. With gas likely to bounce around between the $3.75 and $5 range, he wants to buy companies where the stock assumes that gas could be produced for $3.50/Mcf or less.

Investors should also look at companies that drill “liquid-rich gas,” which contains some dry gas (methane) and several other liquid forms such as ethane, propane, butane and condensate. “All those different products have a different sales price,” says Nuttall. Companies that can sell all these wet gases often make more than operations that only produce methane. Calgary-based Painted Pony Petroleum, for example, makes 62% more in revenues with those gases than if it only produced dry gas, Nuttall explains.

It’s also important to look at reserve potential and proven reserves. Vali wants to know if a resource base can be grown. “Based on what we know today, how can that resource be developed?” he asks. “What is the value you can assume for that resource base?” It’s risky to place a bet on something unknown, which is why companies on unproven reserves are often cheaper, but if an investor concludes that there is potential, and that pays off, the returns could be huge. Pendill likes to look at proven reserves—reserves that people know will yield gas, but the land hasn’t yet been drilled. The price of proven reserves is based on today’s economics with today’s technology. If technology improves, or gas prices rise, the economics will be that much better.

Looking at the usual metrics, like price-to-earnings, doesn’t work with natural gas companies, but investors still want to see healthy free cash flow and nearly no debt. Look for under one times debt to cash flow, says Nuttall. If prices fall further and a company does have to cut back on growth, a large debt load could force it into bankruptcy. Also look for dividend-paying companies. “You’re basically getting paid to wait for the recovery in the gas markets,” says Pendill.

It may still take years before the benefits of investing in the sector appear, but don’t wait until stock prices rise to get into the market. Pendill was correct when he warned investors in 2007 that the price was too high, and he may be right again that prices are too low. “It will turn,” he says now. “When we get those export facilities, things could really change.”

Bryan’s Picks

Encana (TSX: ECA) Lanny Pendill, an Edward Jones portfolio manager, can’t say enough good things about Calgary-based EnCana. It’s a low-cost producer, it’s in four of the five most attractive natural gas basins in North America and it pays a 3.56% yield. He also says the company is sitting on a lot of acreage in emerging gas fields, and its investment-grade credit rating of BBB+ means it’s a low-risk play.

Range Resources (NYSE: RRC) Range Resources, based in Fort Worth, Texas, is a big player in the Marcellus Formation, a large area in New York, Pennsylvania and other neighbouring states that’s expected to produce vast amounts of liquid-rich gas. Scott Vali, a portfolio manager with Signature Global Advisors, says the company owns a lot of land, and because it’s so close to a consuming market—the northeastern U.S.—it doesn’t have to pay heavy tolls to ship it to its final destination.

Painted Pony Petroleum (TSXV: PPY.A) Calgary’s Painted Pony Petroleum, a junior oil and gas company, has been a “huge winner,” says Sprott fund manager Eric Nuttall. It recently flowed the highest volume of natural gas ever from a well in the Montney shale formation in B.C. and Alberta. “It’s extremely prolific,” he says. It’s also producing natural gas liquids, which means it makes more money than it would if it just mined methane. It trades at $12, but Nuttall thinks it could soon reach $18 to $20 a share.

Magnum Hunter Resources (NYSE: MHR) Houston-based Magnum Hunter has three operations in “the United States’ most enviable formations,” says Steffen Torres, a portfolio manager with Kalmar Investments, including five “strong” wells in the Marcellus Formation. It’s trading at about US$4, but Torres thinks it’ll rise to $7. Its capital expenditures have outpaced cash flow, but the company has the ability to grow production by 80% over the next few years, he says.

Chicago Bridge & Iron Co. (NYSE: CBI) It’s not a gas producer, but buying this Amsterdam-based engineering and construction company is another way to play the natural gas market. CB&I has designed numerous liquefied natural gas plants around the world, and with demand for LNG conversion facilities rising in North America, Torres thinks it’s poised to make huge profits. “Their backlog is increasing,” he says. It seems others agree with Torres; the firm’s stock price has risen by 10% year-to-date.

• This story was originally published in Canadian Business.