Two of our Natural Gas Picks were up More Than 20% in One Day. Which Stock is Next?

It’s no coincidence El Paso (NYSE: EP) and Brigham Exploration (Nasdaq: BEXP) would receive massive buyout offers on the same day. Both of these companies are exposed to a fuel source — natural gas — that has seemingly been out of favor since 2008. But major investors know that the future for natural gas looks a lot brighter than a flagging commodity price may indicate.

For a whole host of reasons, natural gas will be playing a bigger part of our energy future. And gas prices, which have been stuck in neutral, could make a solid upward move in coming years. That’s why it pays to have exposure to this sector, as a perfect backdrop begins to unfold.

Here are the details…

Deal #1
At first glance, Kinder Morgan (NYSE: KMP)’s $21 billion deal to acquire El Paso is a bit curious. Kinder Morgan operates natural-gas pipelines and really has little interest in owning acreage and drilling for gas. El Paso has exposure to pipelines and production. Kinder Morgan is likely to shed the production assets and focus on being the country’s largest gas pipeline operator. It’s a great “rain or shine” business, because the company simply makes a fixed mark-up on the gas it transports and isn’t subject to fluctuating prices. Kinder Morgan is well aware of the fact that the volume of gas flowing through the pipeline grid is bound to keep growing.

We already know that supply is no problem. Drillers tap even more wells in the major shale plays around the country with each passing month. But the demand picture looks equally impressive. An increasing number of freight trucks are being retrofitted to run on natural gas (which explains why engine conversion firm Westport Innovations (Nasdaq: WPRT) recently saw its stock run to an all-time high).

It’s not just trucks, though. Congress had been looking at providing subsidies to businesses that convert their fleets to run on natural gas (known as the NAT GAS Act), though passage is unlikely in these tough fiscal times. No matter, many companies are looking at making the switch to gas anyway — a move likely to be augmented by the addition of more natural gas-fueled cars expected to hit the market in 2012 and 2013 (Honda’s Civic is the only one currently on the market).

Beyond transportation, power generation is likely to be a key driver for gas in coming years as nuclear’s star dims and no new coal plants are being built. Meanwhile, supply is likely to remain robust but not grow much higher as current wells start to deplete and newer wells simply replace lost supply. As demand finally catches up to supply, prices should finally respond and shoot up. Gas contracts for current delivery run about $3.69 per thousand cubic feet (MCF). That figure rises to $4.32 for gas contracts slated for delivery in November 2012, $4.82 for November 2013 delivery, and $5.12 for November 2014 delivery. The $1.50 change between now and that last contract is crucial. Producers can sell into future contracts at that forward rate, which typically means about double the profit (compared to $3.69 per MCF currently), after costs are accounted.

Some suspect spot prices will rise even higher. Note that in the past, the industry had an equilibrium between supply and demand in the $6 to $8 range. Sure, supply is now higher, but demand will be steadily catching up in 2012 and 2013.

Deal #2
Let’s assume the price moves back to $5 within a few years. If that’s the case, what are the best ways to play the trend? Well, Norway’s Statoil (NYSE: STO) has just decided to acquire Brigham Exploration for a whopping $4.4 billion. [Tony Daltorio also recently wrote about Statoil’s huge new oil finds in the North Sea.]

Curiously, multi-national energy firms typically buy U.S. companies for their oil, not gas, because oil is a much more fungible global commodity. Statoil is clearly focused on U.S. energy market opportunities because natural gas produced in the North America invariably stays here. By acquiring Brigham (along with a $3.4 billion purchase of assets from Chesapeake Energy (NYSE: CHK) in 2008 and a $225 million purchase of shale acreage from Talisman Energy (NYSE: TLM) in June), Statoil is tacitly expressing the belief that the U.S. natural gas market offers some of the strongest potential returns in the global energy industry.

How you can profit going forward…
So what other companies should attract your interest? Perhaps the most obvious play is Chesapeake Energy, which my colleague Nathan Slaughter has been recommending in his Scarcity & Real Wealth newsletter. Nathan thinks Chesapeake’s stock is sharply undervalued, trading at less than 50% of the value of its assets. [See Nathan’s presentation, “The 9 Best Stocks to Own for the Next Decade,”]

Also, check out GeoResources (Nasdaq: GEOI), which is in the process of developing gas fields in the Bakken (35,000 acres) and Eagle Ford (25,000 acres) shale regions. This stock should also perk up in a rising gas price environment. Recent transactions in the space imply that the market is severely undervaluing GeoResources’ real estate.

Many energy plays have exposure to both oil and gas. If you’re particularly bullish on the outlook for natural gas, Citigroup notes that Range Resources (NYSE: RRC) and Southwestern Energy (NYSE: SWN) have a decided tilt toward gas production. In fact, Southwestern is the eight-largest gas producer in the country, with 1.347 million MCF of production in the second quarter. It’s the only one in the top eight (besides Chesapeake Energy) that gets the bulk of its sales from gas and not oil. Merrill Lynch notes Southwestern has chosen to avoid hedging, meaning it hasn’t locked up its output at moderately higher prices, as many producers have. “We think this could be an indication of the industry’s view on natural gas prices trudging at near floor levels.” Said another way, Southwestern’s stock has more upside than most if gas prices start to rebound in coming quarters.

Risks to Consider: These stocks are economically sensitive. Any further weakness in the U.S. economy could push gas prices to fresh lows, but it’s hard to see prices going much lower from here. The upside definitely outweighs the downside.

Action to Take –> Natural gas prices have been under pressure for several years now, long enough for many investors to stop focusing on the sector. But as Monday’s major acquisitions show, there’s significant industry interest from strategic buyers that likely spot an eventual rebound.

Chesapeake Energy remains Nathan’s top pick for investors who anticipate an uptick in gas demand that boosts prices and profits. I think he’s right. Two of his picks, El Paso (up 25%) and Brigham (up 21%), were two of the biggest gainers on the market on Monday. Chesapeake could be his next big winner… [If you haven’t seen Nathan’s special presentation on natural resource stocks, “The 9 Best Stocks to Own for the Next Decade,” I urge you to check it out, click here to watch Nathan’s video.]