There is blood in the streets in the energy sector.
Oil- and gas-related stocks have been pummeled for the better part of the past year and a half. Yet, economists and analysts continue to lower their forecasts for energy prices and downgrade stocks in the group.
The latest rout came this week on bankruptcy rumors surrounding Chesapeake Energy (NYSE: CHK) -- once one of the world's largest natural gas producers -- which seemed to call into question the survival of some companies in the space.
However, there is little question regarding long-term demand in the sector. Natural gas accounted for 35% of U.S. power generation last year, up from just 20% in 2010. And BP (NYSE: BP) estimates natural gas consumption will grow 13.4% through 2020.
Energy companies that can survive the current storm could thrive when the clouds clear. In the current market, though, one natural gas heavyweight could offer traders a chance to book a 174% annualized return.
Why I'm Bullish On A Sector The Market Loves To Hate
With oil and gas producers burdened by huge debt loads thanks to years of heavy capital investment and falling energy prices, it's not surprising that four of the five most-shorted companies in the S&P 500 are energy stocks.
After perennially shorted GameStop (NYSE: GME), Chesapeake and Transocean (NYSE: RIG) top the list with short interest of about 35%, while Southwestern Energy (NYSE: SWN) and Consol Energy (NYSE: CNX) each have just over 20% of shares sold short.
Right now, survival is indeed the big question, but there's no question that some players will not only make it out alive, but enjoy a nice rebound once they do.
For starters, the supply of natural gas is falling as demand continues to grow. Drilling rigs for natural gas have fallen 62% over the past year, leaving fewer rigs producing than at any time since Baker Hughes (NYSE: BKH) started compiling the data in 1987.
As a result, the U.S. Energy Information Administration (EIA) forecasts production growth will slow to just 0.7% in 2016, a significant drop from the 5.7% growth in 2015. At the same time, the EIA predicts domestic natural gas consumption will increase 1.3% this year, and adds that strong demand from the industrial sector could propel consumption even higher.
Natural gas prices are expected to rise slightly this year, with an average price of $2.64 per MMBtu, followed by a significant rebound to $3.22 per MMBtu in 2017.
When it comes to picking the best natural gas producers to profit from a rebound in prices, Chesapeake's decimation is a testament to the importance of a strong balance sheet. And looking through debt maturities and available credit, one company stands out.
My Energy Apocalypse Survivor Pick
Southwestern Energy is the third largest producer of natural gas in the United States after Exxon Mobil (NYSE: XOM) and Chesapeake. For 2015, Southwestern expects production of 978 billion cubic feet equivalent, up 27% from 2014, with proven reserves of 10.7 trillion cubic feet equivalent.
In November, the company announced it had entered into a three-year, $750 million loan agreement to pay down balances on its existing credit facility, improving liquidity for 2016. Southwestern has 51% of its capital structure financed with debt but no maturities until late 2017 -- and those tally just $40 million.
Chesapeake, on the other hand, has 73% of its capital structure in debt, a $476 million bond payment due in March and $1.38 billion in debt maturities by the end of 2017.
Fitch also recently affirmed Southwestern's BBB- credit rating, which is the lowest investment grade rating. For comparison, Fitch downgraded Chesapeake to a B rating in December, indicating material default risk and a limited margin of safety.
Fitch also estimates Southwestern has $1.95 billion of its credit line available over the next two years.
Plus, Southwestern's cash operating costs of $1.25 per thousand cubic feet equivalent (Mcfe) for the nine months ending September 2015 is well below the current price of natural gas at $2.05 per Mcfe. Even better, the company had 27% of its gas production hedged through the fourth quarter at an average price of $4.40 per MMBtu.
So while the road for natural gas producers will likely remain rocky through 2016, Southwestern has the liquidity and balance sheet health to survive. Shares could even turn up sooner than most think if natural gas prices rebound faster than anticipated thanks to weaker producers like Chesapeake falling out of the market or harsh winter weather conditions.
Alternative Strategy Capitalizes On Volatility In SWN
Southwestern Energy is scheduled to report fourth-quarter and full-year results on Feb. 25. While management will likely cut capital spending further to protect cash flow, it has been open with investors, releasing an update in December. Therefore, I do not expect any surprises and believe investor sentiment should improve with a detailed look into the balance sheet and available credit.
In a show of strength, shares of Southwestern closed flat Monday, while Chesapeake's 33% plunge dragged most of the energy sector down with it. SWN did fall more than 10% on Tuesday before recapturing a chunk of those losses on Wednesday, as it bounced around with oil prices.
Volatility like this can be tough for traditional investors to stomach, but there are alternative strategies that can be used to take advantage of it. For instance, the high volatility in the current market has pushed option premiums into the stratosphere. This makes one of my favorite strategies even more attractive: selling put options to generate income and potentially buy shares at a discount.
If you're not familiar with this strategy or selling puts is simply out of your comfort zone, this eight-minute training video will show you exactly how it's done.
With SWN trading for $8.58 at the time of this writing, we can sell the SWN Mar 8 Puts for around $1.20 each ($120 per contract). If SWN closes below the $8 strike price at expiration on March 18, we will be assigned 100 shares per contract at that price. Since we received $1.20 in options premium, our actual cost is $6.80 per share, a 21% discount to the current price.
We want to make sure we have enough money in our account to cover this potential obligation. This means setting aside $680 for every put contract we sell -- $800 for 100 shares minus the $120 we collected from selling the puts.
If SWN is above $8 at expiration, we keep the premium for a gain of 17.6% on the $680 we set aside in just 37 days. That works out to an annualized return of 174%. And all we need is for shares to fall less than 6.7% over the next month.
I like the long-term outlook for Southwestern Energy and wouldn't mind taking a position, but selling puts offers an opportunity to buy shares at a discount. Plus, in the meantime, I benefit from the high levels of volatility by collecting even more income.
Note: A former military intelligence analyst has been selling puts on her favorite stocks for years and recently closed her 122nd winning trade in a row. If you want to learn about how she selects her trades or sign up to receive the next one, click here.
This article was originally published on ProfitableTrading.com: This Leading Energy Producer Can Weather The Storm