"Good things come to those who wait" is an adage I've always subscribed to as an investor, although it may be hard to believe if you're heavily invested in natural gas right now. The stocks of natural gas firms have seen their share of woe in 2012, with many already dropping 10%, 15% or even more year to date.
But I'm certain investors with significant natural gas exposure will reap big rewards if they stay patient.
A key factor in future profits for the natural gas industry will be rising natural gas prices, something we haven't seen for more than a year. In fact, it has been just the opposite. Natural gas is currently around $2.40 per thousand cubic feet, or roughly 50% lower in price than it was last summer.
As you may know, a weak economy combined with dramatic production increases during the past few years contributed to a massive oversupply of natural gas. This, in turn, caused the price of natural gas to drop so much that many producers have had to shut down some of their operations because they're no longer profitable.
One of the best signs of this is natural gas futures, which are exchange-traded contracts requiring the delivery of natural gas for specific prices on specified dates in the future. These contracts foretell increases in natural gas prices to about $3.25 per thousand cubic feet by the end of 2012, $3.90 per thousand cubic feet by the end of 2013 and $4.20 per thousand cubic feet by the end of 2014. Based on this, we're looking at a75% price increase during the coming 34 months, and a 35% spike in price this year alone.
This is good news for natural gas producers, especially those with the lowest production costs. As natural gas prices recover, these low-cost producers will be the first to see their profits and stock prices bounce back. And barring any unforeseen management gaffes or costly accidents, they should also have the best long-term growth potential, since they're profitable even when natural gas is priced so low that other producers are losing money.
There's one well-known natural gas producer in particular that fits this description very nicely and, in my opinion, it could be the best way to play a natural gas rebound. The company is Ultra Petroleum Corp. (NYSE: UPL), which generates 90% of its $1.2 billion in annual revenue from natural gas and currently produces about 250 billion cubic feet of the fuel per year.
As a low-cost producer, Ultra Petroleum is difficult, if not impossible, to beat. Indeed, analysts estimate the company breaks even when natural gas is $2.70 per thousand cubic feet. At this price, the typical producer has long since packed up and gone home, since most are in the red when natural gas falls below $3.00 per thousand cubic feet.
Of course, this means Ultra Petroleum is losing money now, too, and analysts see earnings per share (EPS) declining 15% in 2012 to $2.20, from $2.60 in 2011. However, assuming natural gas prices behave as futures suggest they will, analysts forecast annual growth rates of 17% for revenue and 16% for earnings during the next three to five years. At these rates, revenue would more than double to $2.6 billion in 2016, from $1.2 billion in 2011. Earnings would more than double, too, to $5.68 per share in 2016, from $2.60 last year.
In terms of valuation, Ultra Petroleum is an absolute steal.
For example, the stock has a price-to-book (P/B) ratio of only 2.2, though historically investors have been willing to pay as much as 7.7 times book value. This suggests the stock could trade as high as $80 a share (7.7 X $10.45 a share in book value = $80.47 a share) once natural gas prices pick up, implying explosive upside potential of as much as 250% from the current share price of about $23.
Risks to Consider: Although natural gas futures can be very good indicators of where natural gas prices are headed, they're by no means set in stone. If the global economy stagnates or weakens, then natural gas prices probably won't rise as much as futures suggest they will. If that occurs, don't expect Ultra Petroleum to perform as I've described.
Action to Take --> It could be at least another six months before natural gas prices return to levels that enable Ultra Petroleum to begin showing rapid profit growth, so expect the stock to continue doing poorly in the short-term. It's down about 20% year-to-date, and could fall further. I won't be surprised at all if it finishes 2012 with a loss, just like it did the prior two years.
That being said, I think short-term losses make Ultra Petroleum that much more attractive for the long haul, setting up the stock for what could be a mind boggling rebound, with some of the best returns the stock market will have to offer in the coming four or five years. And there's really only one thing investors need to enjoy those returns -- patience.