Natural gas stocks defy gravity

Prices should continue to stay low in the short term, but shares of producers are climbing anyway.

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NEW YORK (Fortune) -- Something strange has happened to natural gas stocks: They've gone up.

Despite the fact that gas prices are dirt-cheap and energy demand has fallen off a cliff, shares of gas producers Chesapeake Energy (CHK, Fortune 500), Anadarko Petroleum (APC, Fortune 500), and Southwestern Energy (SWN) have climbed an average of 37% so far this year, compared with the S&P 500's 10% gain.

The upswing in stocks seems illogical given the state of the natural gas market. Prices are the lowest they've been in years, in large part because the supply of gas -- unlike that of oil -- is visibly growing. The Energy Information Administration (EIA) estimates that working gas in storage had climbed to 3,152 billion cubic feet as of August 7, a 2% increase over the previous week. The five-year average is 2,635 Bcf.

Why has supply swelled? Over the last few years, domestic energy producers have unearthed a bounty of natural gas beneath shales in states like Louisiana and Pennsylvania. "There seems to be a new shale discovery every couple of months," says Chris Armbruster, an analyst at Al Frank Asset Management. "It's amazing how many drillable places there are in the U.S." The boom in supply has coincided with a drop in demand. The EIA predicts that natural gas consumption will decline by 2.3% in 2009 and stay flat next year.

Cutting back, boosting production

Gas producers have responded to the imbalance by cutting back on the number of rigs they operate. Oil-services company Baker Hughes (BHI, Fortune 500) recently reported that 688 gas rigs were active in the U.S., down about 56% from one year ago.

Ultimately, the cutback ought to reduce production enough to hamper supply, which would boost prices, says Rich Howard, manager of the Prospector Capital Appreciation fund. "We think the decline curve for production will be fairly steep because of the big drop in drilling," he says.

But while fewer rigs are running, some companies have actually boosted production. The CEOs of Chesapeake, Devon Energy (DVN, Fortune 500), and XTO Energy (XTO, Fortune 500) all announced in recent earnings calls that their output had gone up, but Nick Pope, vice president of equity research at Dahlman Rose & Co., says these producers are the exception, not the rule.

According to Pope, cutbacks are coming from private operators, who are constrained by their cash flow, and integrated oil companies like ConocoPhillips (COP, Fortune 500), which is decreasing natural gas production. "A lot of rigs have come offline -- before, growth was more aggressive," he says.

David Tameron, an analyst at Wells Fargo Securities, says companies like XTO and Devon are hanging on in part to please shareholders. "To an extent, they're continuing to drill because they're public companies," he says. "If their production growth declines, the Street will beat them up." Indeed, the market is responsive to hikes in production: Since Chesapeake announced on August 3 that it intended to boost output this year, gas prices have dropped 12%, but the company's shares have climbed 14%.

Riding on oil

Armbruster points to another factor in the stocks' rise. "A lot of [natural gas producers] belong to indices that move when the price of oil moves, so they get taken for a ride in the rally," he says. While natural gas is dirt-cheap, oil recently topped $70 a barrel, up from $30 last winter.

Eventually, some analysts believe that gas stocks will decouple from their integrated oil brethren, responding more to commodity prices. But speculators are betting that those prices will improve: Gas futures for August 2010 are trading at about $6, which is low compared to 2008, when they topped $10, but nearly twice as high as where they are now.

If prices recover, the companies best equipped to take advantage of the bump will be the ones operating in areas with abundant reserves. John Freeman, an analyst at Raymond James, likes Chesapeake, which is known for its aggressive exploration strategy, for that reason. "There's significant upside to their price because they're in Marcellus and Haynesville," he says, referring to shales in Pennsylvania and Louisiana. Freeman thinks that if gas prices hit $6, Chesapeake's stock will be worth $50, compared with $24 now.

While Wells Fargo's Tameron is skeptical about the likelihood of a spike in gas prices next year, he also likes Chesapeake's stock. Tameron says he initially thought investors would shy away from the company's high debt level, but he changed his mind last week when Chesapeake announced it would receive an early payment on a joint venture.

"Chesapeake has a number of joint ventures -- with Statoil, BP, and Plains. They go out and find the prospects, make the plays commercial, and recover their investment by bringing a partner in," Tameron says. "The model has worked."

Many analysts prefer companies with assets in North American shales, which experts believe have the potential to yield hundreds of trillions of cubic feet of natural gas. But getting natural gas from the rocks is a difficult feat, requiring a complicated and expensive drilling process called hydraulic fracturing.

As a result, says Dahlman Rose's Pope, technological ability is extremely important right now. "You're seeing a shift in structure of these companies," he says. "It's become more of a manufacturing game -- they know the gas is there, and the challenge is getting it out." Pope likes gas producer Southwestern because he admires their its focus on drilling in the Arkansas' Fayetteville Shale.

Tameron says gas producers with concentrated portfolios are better off than those with a string of properties. "Devon is too scattered," he says. "They have a great asset in Barnett, but they don't have a core niche. A good stock in this environment needs to have a niche." To top of page

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