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  1. Home
  2. / Investing
  3. / Energy

Natural Gas Gets Interesting

Despite today's pop, nat gas prices are still at their lowest levels in years, but should improve.
By TIM MELVIN Jan 23, 2012 | 03:30 PM EST
Stocks quotes in this article: RBS, AEG, XCO, SWN

As I put football season behind me, thanks to a dropped touchdown pass and missed field goal last night, I forced myself to turn my attention back to the markets this morning. So far this year, the market has rallied nicely with the S&P 500 up around 5% and the Nasdaq markets rising a bit more than 7%. I didn't anticipate this, but I'm pretty happy about the nice bounce to begin 2012.

My European financial positions have soared with Royal Bank of Scotland (RBS) up 34% and Aegon (AEG) up 21% so far this year. Once again, having the discipline ignore market opinions -- especially my own -- and buy a little of what is cheap, has paid off, as has selling cash-secured puts on cheap stocks when the market is selling off and volatility is rising.

I'll be scouring around for some cheap stocks with expensive options later this week, but this morning I want to focus on what has not been working so far this year. Clearly, in spite of the morning bounce, the answer to that question, so far, has been natural gas and related equities. Many production companies and gas utilities have hit new lows with double-digit percentage drops already this year. With plenty of supply and weak demand for gas, as a result of mild temperatures so far this winter, natural gas prices have dropped like a rock. As a consequence of the price declines, some major gas producers announced production cuts this morning, and I expect we will see some more in the near future.

I am not an energy expert or a great chart reader, so I have a tough time predicting when this particular commodity may find a bottom, allowing the equities to recover some lost ground. However, I checked in with Bob Bryne this morning for a look at the technical side of the natural gas picture. Once he finished his 20-minute rave about skiing conditions in Utah, he said that he thought natural gas looked like it might be putting in something of a bottom here. The colder weather in the Northeast may help correct the pessimistic picture on the demand side of the equation and allow for some price firmness. Also, I am hoping that Glenn Williams might chime in on Real Money for the fundamental side of the natural gas equation.

At this level, the stock of Exco Resources (XCO) looks interesting. The company is focused on oil and gas production from onshore shale fields and it has seen its stock price decline about 25% since the first of the year. In July, the company turned down a buyout offer from the CEO at almost 3x the current prices and suspended their strategic review process. The stock is cheap on the numbers here trading at about 4x cash flow and just about 1.2x tangible book value. The F-score for the stock is a solid 6, indicating a strong possibility of continued financial improvement and a higher stock price during the next year.

Two of my favorite long-term value and distressed managers, OakTree Capital and Wilbur Ross, are major shareholders of the company. Mr. Ross has been adding to his 12% position in recent months. The board seems to feel that the company is worth more than the $20 buyout offer, and I agree. The stock opened up sharply this morning, but it still trades for about 20% of the 2008 highs.

Another energy stock with exposure to the natural gas markets is Southwestern Energy (SWN). Although the shares are bouncing higher this morning, the stock is down almost 8% year to date and has shed 25% of its market value in the past three months. Although the stock is not cheap on a price-to-book basis, the EV/Ebitda ratio is less than 4 and the F-Score is a solid 6. Production at the company's Fayetteville Shale field have grown by about 40% a year since the discovery in 2004, and the company has also expanded its drilling presence in the Marcellus shale gas fields. When natural gas prices stage a long-term recovery this stock could easily find its way to the year ago highs around $50.

Early this morning, natural gas prices staged an impressive rally and announced production cuts. After reviewing the potential for natural gas prices over the next several years and the low valuations of the sector, I decided that the one-day spike in commodity and stock prices did not spoil the thesis that these stocks were excellent long-term opportunities. Even though we saw a nice price pop in natural gas futures this morning prices are still at the lowest level in years. Not only should natural gas prices improve as the economy does, but eventually gas will become a much bigger part of the discussion about our energy future in the U.S.

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At the time of publication, Melvin held no positions in any securities mentioned.

TAGS: Investing | Global Equity | Energy

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