Playing the Rise in Natural Gas Prices

 | Oct 12, 2012 | 1:30 PM EDT  | Comments
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Stock quotes in this article:

xec

,

dvn

Natural gas prices have hit a year-to-date high this week and stand at just over $3.60/MMBtu. This is a more-than-60% move since the fuel hit its lows in the second quarter. Morgan Stanley now believes natural gas prices could hit $5/MMBtu by the first quarter of 2013. FBR Capital also just upped its forecast for natural gas prices to be $4.50/MMBtu in 2013, up from its previous forecast of $3.50/MMBtu.

The supply/demand equation has changed significantly, as production has shifted to more of an oil-and-liquids focus and large industrial users and utilities continue to switch to natural gas vs. coal. Interestingly, coal stocks were huge winners on Thursday, as investors bet than the rising price of natural gas will slow or possibly start to reverse this conversion. They might remain a decent speculative play but the uncertainty about coal as a fuel domestically and the fast-approaching presidential election is undermining their case as long-term investments right now. I would also be wary of fertilizer stocks right now, as natural gas is a primary component in their manufacturing process.

Obviously, production companies that have large natural gas reserves and production should benefit if natural gas prices continue to rise. Here are two that seem like good plays right now.

Cimarex Energy (XEC) is as an independent oil and gas exploration and production company primarily in Texas, Oklahoma, New Mexico, and Kansas. Its proven reserves consist of over 1.2 trillion cubic feet of gas and 138 million barrels of oil and natural gas liquids.

Four reasons XEC has significant upside from $60 a share:

  1. Although net income growth over the past few years has been lumpy, the company has been consistent in growing operating cash flow (OCF) and has increased OCF some 80% over the past three years.
  2. The stock is going for 11.5x forward earnings and under 5x operating cash flow.
  3. The 16 analysts who cover the stock have a median price target of $78.50 a share on XEC, implying 30% upside over the current stock price.
  4. Although about 60% of the company's proven reserves are natural gas, Cimarex has done a good job of growing its oil-and-liquid production over the past few years. It has had an 18% compound annual growth rate (CAGR) for oil production since 2008.

Devon Energy (DVN) is an independent energy company that has interests in various properties located in Rocky Mountains, Mid-Continent, the Permian Basin and the Gulf Coast regions of the U.S. as well as energy properties in Canada. It is the largest producer in the Barnett Shale area.

Four reasons to buy Devon at $61 a share:

  1. The company divested itself of some $10 billion of offshore assets as well as its properties in the Gulf of Mexico in 2010 to become a pure play onshore North American energy producer. It also has executed well on its strategy to grow the oil-and-liquids ratio of overall production and should be at a 60% natural gas/40% oils-and-liquids ratio by end of this fiscal year.
  2. The company has received some love from analysts recently. Both FBR Capital and Credit Suisse have upgraded their views on the stock in the last few weeks. The median price target by the 24 analysts who cover the stock is $74.50 a share.
  3. This is another stock where an investor is served well by looking at the growth in operating cash flow which Devon has grown consistently over the past few years. The stock is cheap, trading at just above 4x trailing OCF.
  4. Revenue growth should resume next year with analysts calling for increases in the low double digits. The stock also sells near the bottom of its five-year valuation range based on P/B, P/S and P/CF.

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