News Analysis date published New: 
Tuesday, July 24, 2012 - 14:30
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Wednesday, August 22, 2012 - 11:42
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Tuesday, July 24, 2012 - 14:30

The Best Stock to Play the Natural Gas Rebound

Tuesday, July 24, 2012 2:30 PM

Back in April, when natural gas prices jumped from a multi-year low of $1.98 per MMBtu to May's high of $2.82, a lot of traders chalked the 42% gain up as a temporary dead-cat bounce. Sure enough, natural gas prices fell back to $2.23 per MMBtu by mid-June.

Since then, natural gas has made a sharp rebound without moving on to even-lower lows, but it's finally managed to punch through the multi-week price ceiling at $2.83 and move on to higher highs for the first time since the first half of 2011.

While it's too soon to say natural gas is on course to reclaim prices of greater than $13 per MMBtu like we saw back in 2008, I think natural gas has indeed hit its long-awaited bottom.

And to reap the greatest benefits from this rebound, it's time to start thinking strategically...

A little goes a long way
Think about this -- when it comes to natural gas, production cost is fixed, no matter the market price. So when production cost is $3 per MMBtu and the market price is $3, producers don't profit. But if natural gas costs $5 per MMBtu and the cost to produce it is still $3 per MMBtu, then producers can enjoy a 40% net profit margin on each MMBtu. Better yet, a 100% increase in natural gas prices could make producers much more than 100% profitable.

That's why so many explorers shuttered gas operations last year -- it cost them more to produce it than for what they could sell it.

But if you think natural gas has bottomed like I do, then it's time to start picking some stocks. And I found what I think is the best way to tap into the trend. Here's how…

Though natural gas is the same no matter how it's extracted, production costs of natural gas can vary widely. Shale gas can cost considerably more to produce than conventional natural gas wells, and if the gas mine is part of an oil exploration, then higher crude prices can offset higher-cost gas operations. Know-how and geology of the mining operation can be a big factors too.

Point being, not all natural gas operations are the same; expense control separates the men from the boys. And Ultra Petroleum Corp. (NYSE: UPL) is one of the proverbial men.

Ultra Petroleum's production costs are among the lowest in the industry, while its selling prices are far above July's market price. For instance, the gas-mining company only spends between $3.06 and $3.29 to extract a million cubic feet of gas, but through some savvy hedging, Ultra Petroleum realized an average selling price of $5.13 per Bcf in the first quarter, for a 55% profit margin. (Depending on the quality of the gas, one Bcf equals one MMBtu, give or take.)

Those hedges can be a two-edged sword, sometimes. If the going market price to exceeds the average hedged price, Ultra Petroleum could end up leaving good money on the table. As of July, however, its average selling price far exceeds the current market's price for natural gas of about $2.83 per MMBtu.

Of course, Ultra Petroleum can have its cake and eat it too.

While it's enjoying higher-than-average sales prices, only about two-thirds of its 2011 production were hedged at those rates for 2012. The remainder of any current and future production is being sold at market rates. Though that's $2.83 per MMBtu, as was noted above, the price has been in a strong uptrend through July. If prices continue to rise and ultimately exceed the company's average cost of somewhere around $3.18 per MMBtu, then Ultra Petroleum's two key properties could crank up their output, since it would be profitable to do so.

It's one of those rare cases where a company has abnormally low costs and a certain degree of guaranteed income, but doesn't have an income cap.

Risks to Consider: The recent heat wave has gotten the bulk of the credit for the resurgence in natural gas prices. Air conditioners are running longer, which means power companies are burning more of it. If that's the only reason gas is on the mend, then the rebound may be short-lived.

Action to Take --> This is admittedly a higher-risk investment idea, in that it relies on the continued strength and rebound of natural gas prices. That's not a bad bet, however, given the commodity's momentum. Though Ultra Petroleum isn't hedged quite as well for 2013 as it is for 2012, it may not need to be, since gas prices are rising.

Natural gas in the $4 range may seem impossible now, but that was actually the going rate for the better part of 2010 and 2011, which were stunningly profitable years for the company. I think natural gas could reach these levels again by 2013, giving this stock has a justifiable upside potential of 25% to 30%.Another option is to dive into the United States Natural Gas Fund, LP (NYSE: UNG) and just ride the rally in natural gas prices. Or, you could fish for big-name natural gas stocks like SandRidge Energy Inc. (NYSE: SD) or Range Resources Corp. (NYSE: RRC).

P.S. Natural gas isn't the only commodity in an uptrend. Demand is skyrocketing for one the most unusual metals in the world so much that some are saying it could be "the oil of the 21st century.” My colleague Nathan Slaughter picked this metal as "the best commodity play for 2012 and beyond." He tells you all about it, and several other little-known scarce resource profit opportunities, in this free presentation.

James Brumley does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.