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Wednesday, December 31, 1969 - 18:00

What The Brutal Winter Means For Natural Gas Stocks

Wednesday, December 31, 1969 - 6:00pm

Millions of Americans suffered through a brutal heating season, and the bills are now coming due.

Yet a quick glance at the natural gas futures market suggests the most brutal winter in recent history will soon be a distant memory. Gas for delivery in the summer 2015 and 2016 remains around $4 per thousand cubic feet (Mcf). Futures traders figure that our nation's drillers will simply pump enough gas out of wells to rebuild depleted inventories, and the market will soon be well supplied.

But is such a rosy view justified? After all, the number of domestic gas drilling rigs in service is far lower than a year ago, and this industry is no longer hell-bent for growth like it once was. According to Baker Hughes, the number of domestic gas rigs in service fell from more than 400 a year ago to a recent 318.

The conventional wisdom holds that drillers have kept only the most productive rigs in service, idling less productive rigs, which means that industry output would be fairly constant despite the smaller rig count. Yet that logic ignores the depletion rigs being experienced at our nation's best shale plays.

Many of the wells that have been tapped over the past two to three years are at their peak of production right now but will likely start to deliver diminished output soon. This is known in the industry as the Red Queen syndrome, as discussed in this Businessweek article.

To be sure, the rig count can be boosted to offset depletion rates, but the notion that natural gas production can be sharply boosted at the flip of a switch ignores decades of history regarding depletion rates.

Yet it is the demand side of the equation that is also being overlooked. Even ignoring the fact that natural gas is increasingly being used as a transportation fuel source, and may eventually be exported in vast quantities in liquefied form; demand from power plants is likely to keep growing rapidly.

In recent years, a number of electric utilities have switched from dirty coal to cleaner gas in their power plants in a process known as C2G (coal-to-gas). In response to the recent rebound in gas prices, some suggest that the trend will reverse. That ignores the fact that 8% of our nation's coal plants are set to close in the next few years, according to U.S. Energy Information Administration (EIA), and another 16% may be mothballed as well.

Meanwhile, gas producers not only need to meet rising demand from existing powerplants, but they also need to replenish badly-depleted storage supplies. At this time of year, there are typically 1.8 billion cubic feet of gas in storage, though the EIA says supplies are currently at half that total.

The futures market, anticipating a move back to $4 natural gas, simply shrugs off that concern. But it's looking less likely that gas inventories will be rebuilt before next winter, unless drillers go on an all-out pumping spree, which as noted by the Baker Hughes rig count, simply isn't in evidence.

$5 Gas
This means that it's time to start think about how gas drillers would be affected if natural gas prices settled later this year closer to that $5 mark. Analysts at BMO Capital have already done the exercise with driller Southwestern Energy (NYSE: SWN). The analysts noted that SWN would generate $90 million in quarterly free cash flow (FCF) if gas prices were at $5 per Mcf, compared to just $20 million in FCF if gas was $4 per Mcf.

The analysts rate SWN as "outperform" simply based on expected output growth. Higher prices only help. "Not only do we view the shares as inexpensively priced in the context of what is a growth profile that's more visible (and predictable) than what most other producers can possibly generate, but we believe the risk/reward is especially attractive when put in the context of potentially greater free cash flow."

Analysts at Citigroup are bullish on Cabot Oil & Gas (NYSE: COG), which has lost more than $2.5 billion in market value since a fourth-quarter report highlighted a lack of distribution capabilities for gas transport in its key regions.

Still, as key pipelines come online, Cabot's gas production will have an easier time getting to market, and the company will realize better prices by being connected to the national distribution grid. These analysts also see a surge in output, which should take Cabot's revenue from $1.75 billion in 2013 to more than $4 billion by 2016, by which time the company should be generating more than $2 billion in operating profits. The scenario of firming oil prices, as outlined earlier, would simply boost those figures. Citigroup's current $45 target price would likely also get a boost.

Risks to Consider: Weather remains a big wild card for this energy source. If we get an unusually cool summer, then air-conditioning demand may be so weak that gas storage levels can rebuild at a faster than expected pace.

Action to Take --> Natural gas producers, especially those that haven't locked in all of their output at current prices, have a huge amount of operating leverage to higher gas prices. Southwestern Energy, for example, would see free cash flow rise more than 300% on just a 25% jump in gas price assumptions. This is a good time to re-visit other gas producers, to see which ones have similar operating leverage to higher prices. If gas storage levels don't start to rapidly rebuild in the next few months, then many on Wall Street will be talking about $5 gas for next winter.

P.S. StreetAuthority's resident commodities expert, Dave Forest, just got back from a resource-rich region dripping with oil and natural gas -- and he's convinced it could be the next trillion-dollar boomtown. Best of all, Dave found the three small companies best positioned to profit from the coming boom. To get his report with the names of these three companies, click here now.

David Sterman 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.