In a business as complicated as energy, it still comes down to the simple relationship between supply and demand.
This is true right now for natural gas: Producer inventories badly lag consumption levels. That makes the services of exploration and production companies, as well as the drilling outfits that own and lease on- and off-shore rigs, in high demand.
“You have a situation in North America where demand continues to steadily rise while we’re still having trouble increasing or maintaining production,” said Judson Bailey, a Houston-based energy analyst for Jefferies & Co. “Going into 2006, drillers are going to have all the pricing leverage.”
Even though companies heavily exposed to gas have seen their shares rise considerably this year, Bailey said that as long as commodity prices remain high, stocks will continue to rise.
Since the start of the year the Amex natural gas index of leading companies has risen 39 percent.
The disconnect between supply and demand is largely due to the rapid construction over the past five years of gas-fired power plants.
Today nearly one-quarter of the country’s gas supplies are purchased to generate electricity.
Because gas, unlike crude oil, can’t be easily imported, North American production is the only real option for satisfying domestic needs.
The upshot of rising demand and flat supplies, of course, is higher prices. Natural gas is trading at historic highs–more than $14 per 1,000 cubic feet. That’s stunningly high compared with the $2 to $3 levels common for natural gas from the mid-1990s through 2001. Meanwhile, crude oil prices have dropped since Hurricane Katrina–from $70 a barrel to around $60.
With roughly 20 percent to 30 percent of natural gas infrastructure in and along the Gulf of Mexico still out of service, natural gas prices are likely to stay high through the winter.
Under these economics, it’s no wonder that gas exploration and production companies such as Apache Corp. and Burlington Resources Inc. are scrambling to find enough rigs to put in the ground while prices remain high.
Exploration and production companies, though, must contend with the higher leasing costs being charged by drillers. For that reason Bailey favors the drillers, particularly Pioneer Drilling Co., Nabors Industries Ltd., and two small-cap companies, Patterson-UTI Energy Inc. and Bronco Drilling Co. All are benefiting, he said, from increased orders from companies such as Exxon Mobil Corp., BP PLC and Shell Oil Co.
The great fear of any energy investor, however, is that if national demand weakens it will cause the price of natural gas to turn south. Such a scenario would relieve homeowners along with large industries like steel and chemicals that use huge amounts of natural gas. But it would likely punish most gas stocks.
To David Spika, investment strategist at Westwood Holdings Group Inc. in Dallas, such speculation is overblown, if not plain wrong.
Spika, whose firm manages $4.5 billion, bases his portfolio’s selections on gas priced at no lower than $8.50 per 1,000 cubic feet. (By comparison, Jefferies is forecasting a 2006 average of $7.)
Spika’s strategy calls for picking companies with high cash-flow-to-price ratios, low debt and solid earnings growth.
Though he agrees drillers are well suited for the current supply shortfall, Spika says he prefers the fundamentals for Burlington Resources and Apache. Not only are both companies growing production at a high single-digit percentage rate, they’re trading at 5 to 6 times cash flow, a cheap valuation when compared with the early 1980s, when both stocks traded at 10 to 11 times cash flow.
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“If you believe, as we do, that the price of the commodity is going to remain high, you want to own companies that are most leveraged to natural gas,” Spika said.
In Canada, similar supply-and-demand ratios have boosted the attractiveness of a handful of gas exploration and drilling companies, said Glenn MacNeill, vice president of investments at Toronto-based Sentry Select Capital Corp.
MacNeill, whose firm manages about$7 billion, likes Canadian Natural Resources Ltd., which he says is growing production in the high single-digits.
Another favorite is Precision Drilling Trust, the largest company of its kind in Canada.
Operating like a real estate investment trust, Precision returns 60 to 80 percent of its earnings to investors in a cash distribution.
The stock’s valuation is attractively inexpensive: currently trading at 8.5 times estimated 2006 earnings, whereas most drillers trade between 12.5 and 14 times next year’s earnings.
“Canada has a younger geological basin, which means many more drilling opportunities,” MacNeill said.
“At these price levels,” he said, “it’s good to put money back into the ground.”
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