Christopher Edmonds

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A Second Chance on Gas

Christopher Edmonds

The recent decline in the price of natural gas has depressed investors in natural gas stocks. After a tremendous 2000 -- the Amex Natural Gas Equity Index, or XNG, gained nearly 80% -- the new year began with a decline of about 10%.

And the depression intensifies when you open your December natural gas bill, likely more than double last year's postholiday gift from your local gas utility. I know what you're thinking: With natural gas bills soaring, these gas companies are making a killing.

They are, with fourth-quarter earnings zooming past expectations. But that was then, this is now and the market looks ahead. And recently, the stocks have, predictably, followed the price of gas. After flirting with $10 (per million British Thermal Units), gas prices have settled around $7.50, still a far cry above the $2.54 on spot markets this time last year.

That decline has many investors concerned about the future of natural gas stocks. In fact, in a very prescient call, my colleague James J. Cramer suggested the run in natural gas stocks was over. He was right, then.

But, one longtime energy pundit thinks the recent slump is overdone, giving investors a "second chance" to jump into a market with tremendous potential. "I think [the recent declines] are just noise in the system," says John Olson of Sanders Morris Harris, a Houston investment firm specializing in energy. "For the first time in years the producers are making a ton of money. With $7.50 gas, it's hard to miss."

And, for Olson, who has followed the sector for more than 30 years, including multiple stints as an Institutional Investor all-star, the recent pullback in energy stock prices is exactly the opportunity a value player wants. "What's more interesting is that the price-to-earnings ratios of these companies have fallen like stones."

We first caught up with Olson in September, just as natural gas prices were heating up, ahead of strong winter demand. Then, he was bullish.

He still is, explaining that newfound summer demand for gas will push prices higher in traditionally weak months. "When we move into May and June, you will be looking at a short squeeze in supply, caused by all the start-up natural gas-fired peaking plants producing electricity," he says. "That should lead to the next leg up in gas prices."

Pit Stop: Just Waiting for Gas to Rise

In September, Olson suggested investors consider three natural gas plays: Mitchell Energy & Development (MND - Cramer's Take - Stockpickr), Oneok (OKE - Cramer's Take - Stockpickr), and CMS Energy (CMS - Cramer's Take - Stockpickr). Since then, those stocks have really moved -- up and then back down. While only Oneok has held on to gains, Olson thinks that gives investors another chance. "I'd add to these positions," he says. "I'm very happy with these three companies."

Mitchell Is BIG Gas

If everything is bigger in Texas, Mitchell fits right in as one of the largest natural gas producers in the U.S. Yet, 2001 is off to a slow start. "Mitchell is down 23% year to date. It hit an old-fashioned air pocket," he says. "The company is trading at less than eight times this year's earnings estimates. You have to add to positions here."

Olson continues to rate Mitchell a strong buy and has a 12-month price target of $83 a share. And, with the stock trading at such depressed multiples, he sees Mitchell as one of very few energy value plays. "Compare Mitchell to the natural gas group at 9.6 times 2001 and 12.1 times 2002 estimates," he says. "That's value."

What's ironic, Olson suggests, is that Mitchell's profile looks more like a growth company: He estimates the company's natural gas production will grow 20% annually over the next several years and its profits will lead the industry. "It's about the most profitable energy company out there," he says. "Last year, it had a 49% return on equity."

And, he says, George Mitchell, the spry 80-year-young chairman, may be looking to get out. "George will entertain offers," says Olson. In that case, Olson thinks fair value may well be north of $100 a share.

Oneok Is OK

Oneok, with a name only an Oklahoman might understand, is a diversified energy company that produces, gathers, processes, markets, transports, stores and distributes natural gas. The company also has begun, on a limited scale, the wholesale marketing of electricity. In short, it works from the wellhead to the furnace.

The integrated nature of the business is what attracts Olson to Oneok. He likes the fact that the company has become a "massive player" across the gas spectrum, with an interest in nearly 20% of the nation's gas supply.

And its production business is poised to take advantage of increases in gas prices as it expands its E&P business. "Oneok has tremendous asset density in the Anadarko Basin in Oklahoma and the Hugoton Basin in Kansas," Olson says, noting the region's rich natural gas reserves.

He also notes Oneok owns 21% of Magnum Hunter (MHR - Cramer's Take - Stockpickr), a growing E&P company. In addition, he thinks the company may have a chance to purchase a large chunk of its own equity back from Western Resources (WR - Cramer's Take - Stockpickr), a Kansas utility, if its merger with Public Service of New Mexico (PNM - Cramer's Take - Stockpickr) is completed. It's possible that purchase could occur "well below book value," says Olson.

Olson thinks the stock remains cheap. He expects the company to earn $3.60 in 2001 and more than $4 in 2002. He has a 12-month price target of $57.

CMS: Turning Around and Spinning Off

When we spoke in September, Olson acknowledged the CMS story might take longer to develop. Progress is being made and Olson's rewards may come soon.

"The turnaround is progressing nicely," he says. "They have proposed an IPO of their energy E&P company, CMS Oil and Gas. We should learn more about that in [Wednesday's] conference call."

If Wednesday's earnings announcement is an indication, Olson is right. Before one-time charges, the company's fourth-quarter earnings grew 30%. Investors cheered the news; in midmorning trading Wednesday, CMS stock gained nearly 2.5%, or 69 cents, to $28.81.

Olson believes the growth will continue. From $2.53 last year, he thinks CMS will earn $2.75 in 2001 and $3.10 in 2001. And, if the company completes its housecleaning, it should trade at around 15 times earnings, giving Olson a price target of $41 by the end of the year.

There are other options. "Plan A is still to turn the company around. However, if Plan A doesn't work, Plan B is to split the company up. There you get about $35 in value for the utility and $8-$10 a share for the rest of the company," he says.

However, he thinks Plan A is more likely. "They have their problem assets behind them. They should be a clean growth story going forward."

Coming next: The longtime energy pundit's view of the crisis in California, one gas play for California and a surprisingly overvalued energy leader.