How Your Portfolio Can Cook With Gas

For investors interested in speculation seasoned with a dash of geopolitical gaming, it may be time to step on the gas.

The broad-brush reasons for taking positions in small-cap North American energy exploration companies have been in place for some time, as China has emerged as a voracious consumer of energy, Saudi Arabian turmoil has intensified, U.S. state governments have demanded wider use of clean-burning fuels by power plants, and environmental laws have tightened supplies.

Early-bird speculators have therefore pushed up prices of some of the best little explorers, such as Ultra Petroleum (UPL Quote) and Callon Petroleum (CPE Quote), by as much as 100% over the past 10 months. But most of these stocks have cooled recently, providing a new entry point for a second wave of investors and traders seeking a hedge against overseas uncertainty.

Increasing Value

First, the big picture: Back in the 1940s, natural gas was worth virtually nothing. Drillers burned it off in the process of exploring for petroleum. As new uses were discovered, it became increasingly valuable, rising from $2 per 1,000 cubic feet on average during the 1990s to $10 in 2000. The price collapsed back to $2 in 2001, but it has steadily risen since -- spiking above $10 at the start of last year's war in Iraq before settling back to around $5.25, where it is now.

The price of natural gas always jumps during winter cold snaps, and that accounted for its most recent foray above $5.75, but it's unlikely to collapse below its current trading range again, because there's not enough drilling being done to satisfy demand, because of tough environment laws. Federal Reserve Chairman Alan Greenspan told Congress in June 2003 that tight supply threatened the U.S. economy.

All gas drillers are not equal, and it pays to understand the industry's superstructure, risks and leverage points. Just as technology investors are accustomed to learning about the varied makers of semiconductors, disk drives and switches that make components for popular consumer electronics devices and determining which ones offer the most oomph at various points in the economic cycle, energy investors must learn about the complex, high-risk way gas is discovered and distributed.

Lesson No. 1, though, is how truly speculative some of these names are. The companies are usually run by cagey industry veterans -- some with checkered pasts -- who suspect they can use new high-tech 3-D seismic imaging tools to find gas formations in properties abandoned by much larger drillers such as ExxonMobil or ChevronTexaco.

At the start of new projects, observers are skeptical that the driller will even find financing to start the project. Then they're skeptical they'll persuade an oil-services company to lease them a drilling rig. Then they're skeptical that drilling will ever actually start. Then they're skeptical that the project will ever be completed. Finally, they wait anxiously to learn whether gas is discovered or not.