The natural-gas stocks are hard to love these days, but there are still angles to be played.
Long-term investors point to optimism about the importance of U.S. natural gas supply in a global context in the years ahead, while short-term natural gas pricing weakness is also a way to identify contrarian bets.
The important thing is that an investor doesn’t have to know whether natural gas pricing sinks below its January low before going higher again, or if production cuts made by some of the biggest drillers, such as Chesapeake Energy, have a positive impact on pricing.
Here are ways to build a natural gas portfolio that doesn’t require a bet on a short-term pricing rebound.
1. Cheniere Energy
One-year return: 84 percent; 200-day moving average: $8.80; current share price: $15.17; 52-week high: $15.44
An investor can think of Cheniere Energy as part of a long-term secular narrative that is being supported by long-only investors.
Think of natural gas engine maker Westport Innovations, one of the few pure-plays on the buildout of natural-gas transportation infrastructure.
Cheniere, building the first government-approved natural gas export terminal in Louisiana, is the only pure play on the development of a U.S. natural gas export market. Weakness in natural gas pricing is actually a tailwind for Cheniere, as it continues to add support to the idea of exporting U.S. natural gas.
There is a difference between a trade that works and an earnings model that is still difficult to project.
William Frohnhoefer, analyst at BTIG Investments and one of the only analysts to cover Cheniere Energy, thinks that, even at a 52-week high, the company’s first-mover advantage hasn’t been fully priced into shares. The BTIG analyst has a $19 price target against Monday’s close at $15.08.
Frohnhoefer said that if an investor thinks of the company like a midstream master limited partnership (MLP) — Cheniere’s subsidiary, Cheniere Energy Partners , is an MLP — then a trading multiple of 11 times to 14 times projected EBITDAis fair. BTIG bases its $19 price target on a 10-year terminal multiple.
“Institutional investors with a view on natural gas prices are attracted to this thesis,” Frohnhoefer said.
The news flow for Cheniere Energy continues to be positive.
Last week, BG Group, which has a deal with Cheniere Energy, said the U.S. will be able to supply about 9 percent of global liquefied natural-gas (LNG) output by the end of the decade, or 45 metric million tons of LNG versus global supply of 480 million tons a year by 2020. Cheniere shares are up 17 percent since that BG commentary.
There are many risks to the Cheniere story, though. Here are a few:
Shares have simply run up too much already to continue to be supported by investors with its earnings years still far out on the horizon. It loses key financing support from larger partners in the energy market. The U.S. natural gas export market never takes off. Overseas demand for U.S. natural gas doesn’t materialize because of the explosion of shale gas finds in Asian markets like China.
While all of these risks are reasonable, and Cheniere has a complicated balance sheet, BTIG’s Frohnhoefer said worrying about the U.S. natural gas market never taking off or Chinese shale finds supplying its own needs is an argument for another day.
All Cheniere needs now is to sign up enough long-term contract partners for the export terminal so that its cash flow from running the facility is a certainty, regardless of short-term fluctuations in natural gas pricing, and that supports trading.
2. Golar LNG
One-year return: 136 percent; 200-day moving average: $38.07; current share price: $44.07; 52-week high: $47.82
Golar LNG recently had to retrofit three-decade-old vessels to meet demand for its natural-gas shipping services.
Golar is another case of where investors can bet on the long-term secular trend: If the U.S. natural gas export market takes off that could be a huge driver for the LNG shipping companies.
There is an important caveat here:The shipping sector does tend to attract a lot of hot money, and investors often chase short-term trends in the market, such as an increase in day rates and exogenous events that throw expected supply and demand out of balance.
That has happened in Golar’s market, where day rates have more than doubled since the beginning of 2011 and Japan’s need for increased natural gas imports in the wake of the Fukushima disaster created an unexpected opportunity.
Previous to the January move to retrofit 35-year-old vessels because demand was higher than expected, Golar and its peers had been laying up ships. That’s still the case for dry bulk shippers, many of which have just started to rally from the 52-week lows at which they started 2012, while Golar tested new highs.
Golar has been on such a nice run that investors recently took some profits, and shares are flat year-to-date. There is still some upside potential in day rates, but ultimately there will be a new ship building cycle in 2013 and 2014 and that could bring an end to the trend.
Golar doesn’t have the opportunity to increase its ship capacity in the near-term — unless through acquisition.
That’s why an increase natural gas export market from the U.S. could be a wildcard in keeping the LNG shipping sector trade from rolling over.
3. Ultra Petroleum
One year return: -49 percent; 200-day moving average: $31.93; current share price: $23.77; 52-week high: $51.20
What about playing the long-term trend in natural gas pricing? Some of the most forgotten natural gas E&Ps, like Ultra Petroleum, are getting some attention.
Mark Hanson, analyst at Morningstar — which tends to have a longer-term focus than Wall Street — likes Ultra Petroleum as its shares reside at a 52-week low.
“The fact the the most economic natural gas drillers can make money at $2 to $2.50 prices tells me we are at or near a bottom,” Hanson said.
In fact, Hanson thinks that it’s probably wiser at this point to bet on upside in Ultra Petroleum rather than continue to ride shares of the independent oil stocks higher, which have already seen shares benefit greatly from $100 oil prices.
“The market seems short-sighted here. From my point of view the contrarian trade here is natural gas. In 12 months I’d be surprised if natural gas was still at $2.50,” Hanson said.
He added that while Cabot Oil & Gas is even more economic at drilling than Ultra in a low natural gas pricing environment, Cabot’s shares are still up 68 percent in the past year, even after declining by 10 percent since the beginning of the year.
“If I look at Ultra and look out 15 years, they are still drilling new Marcellus wells, yet the stock price is reflecting prolonged low gas prices. Ultra may not be a screaming buy, but if you’ve got 15 years worth of drilling and can make money at $2.50, to me that says there is more upside than downside at this point and it’s a reasonable entry point,” Hanson said.
There’s a good chance that Ultra won’t generate too much excitement from analysts or investors, though, even if it makes a good value play.
“I’ve been getting more calls from people looking at gas names and wondering if it’s time to play the contrarian position,” said Raymond James analyst Andrew Coleman.
Coleman said if natural gas moved from $2.50 to $3.25 it would represent meaningful upside for companies like Ultra. However, Coleman added that if the turn is a couple of years out then it’s harder to recommend stocks like Ultra to investors.
“What the market assesses isn’t Ultra’s current asset mix but expectations over the next six to 12 months,” Coleman said.
Ultra has one story to leverage asset-wise through its position within the Niobrara shale, one of the hotter regions for liquids exploration in the U.S. Overall, though, it remains heavily weighted to natural gas.
Coleman thinks the best way to think about these heavily weighted natural gas stocks is like an option, or safe haven, if oil prices soften.
Broadly speaking, it’s unlikely they will look very compelling to investors compared with the oil-levered E&Ps. So far, this analysis has focused on individual stocks that are tied to long-term natural gas narratives finding favor among investors.
4. Basket Trades
There are basket trades that relate to the natural gas story, as well.
On Tuesday, Stifel recommended a basket of natural gas-weighted independent exploration and production companies that have more oil per dollar invested in their shares than other dry gas counterparts.
In other words, as Stifel analyst Amir Arif wrote, it’s “poor man’s oil exposure.” These stocks include Comstock Resources, Penn Virginia, Crimson Exploration, andSandRidge Energy.
Stifel notes that investors have gravitated towards oil weighted equities and shunned the gas names, creating some trading opportunities for the next few months in some of these gas-weighted names that have sufficient oil exposure to turn operations around if gas hits a seasonal bottom.
In its recent 2012 outlook, Comstock — which is roughly 95 percent natural-gas weighted — said it will be spending 97 percent of its 2012 budget on the hunt for oil.
“Given the crowded nature of the oil weighted names, some of these gas weighted names, which have some liquids exposure, are today providing better oil production exposure per dollar invested than most of the oily names do,” Stifel says.
The firm argues that these gas E&Ps provide more liquids production exposure per dollar invested than Gulfport Energy andContinental Resources, specifically.
It’s one more trade that finds a way to capitalize on the low natural gas prices, as opposed to shunning the entire natural gas stock sector, but without having to make a call on whether pricing bottoms at an even lower point.
“The real lows might not happen until the fall if storage capacity gets tested which would force gas to move closer to its marginal cash operating costs of approximately $1.75/mcf. As a result, we believe the pure dry gas drillers will have a more difficult time turning around operations until gas prices improve, which currently looks like a 2013 event at the earliest,” Stifel wrote.
Longer-term (two to three years), Stifel says it does make sense to stick with the names with the better asset quality, strong liquids drilling inventory, and no funding issues.
However, if funding issues are manageable (Comstock is always on bankruptcy watch) and gas approaches a seasonal bottom (the drag from natural gas moving lower is alleviated), then “these names become attractive trading opportunities since they provide more attractive liquids production exposure for each dollar invested,” Stifel wrote. Even if natural gas prices are near a historic low, the logistics of having to move energy to where the demand is have favor midstream energy infrastructure master limited partnerships, and this is one more long-term story about the importance of natural gas.
Deutsche Bank is continuing to support this story even though it’s one of the better known investment theses in the energy sector and has resulted in some of the best returning stocks and biggest M&A takeouts in the past year, namely Kinder Morgan Energy Partners’ takeout of El Paso. Deutsche Bank estimates that these midstream MLPs will generate total returns above 10 percent on an annualized basis for the next several years.
MLPs also show an average yield of 6.3 percent, distributino growth of 6 percent to 8 percent, and 5 percent to 10 percent growth in earnings and cash flows.
Deutsche placed “buy” ratings on Enterprise Products Partners, Energy Transfer Partners, Rose Rock Midstream, Western Gas Partners, and Kinder Morgan Energy Partners.
Deutsche projects that all of these midstream MLPs will generate in excess of 18 percent total returns.
These stocks have three ways to grow: Organic, drop-downs, and third-party acquisitions.
In conceding that MLPs are far from an undiscovered story at this point, Deutsche noted that the group showed a 13 percent total return in 2011 against a 2 percent rise in the Standard & Poor's 500 (including dividends).
However, it sees the MLPs as one more “unique secular growth story” related to natural gas and the larger shale drilling boom in the U.S.
“The need for infrastructure construction in North America to match rising natural gas, oil, and natural gas liquids (NGLs) volumes is unprecedented. We estimate North American infrastructure spending of $20 billion per year through 2015 for pipelines, gathering and processing, terminals, and storage. The relative security and stability of fee based business and contracts support the ability of the industry to raise the equity and debt capital needed to build its growth,” Deustche analysts wrote on Tuesday.
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