A Rough Patch in Oil Gives Way

Finally, we have a week of good news from the oil patch and natural gas fields.

• Devon Energy (DVN) refocuses investors on the importance of future natural gas production by purchasing Mitchell Energy (MND) at prices just below Mitchell's early year highs, when natural gas prices were pushing $10 per thousand cubic feet (Mcf).

• The American Gas Association reported gas storage of only 3 billion cubic feet (Bcf), which was below estimates that had projected nearly 70 Bcf. The five-year average for the week is 63 Bcf.

• Morgan Stanley's upgrade of the oil-service sector: "Our more aggressive stance on the sector is based on a deep-value approach to investing," Morgan analyst Ole Slorer wrote. "Drillers are ripe for bottom fishing."

While this troika of good news may not be enough to call a bottom in the sector, it has provided a buzz that has directed attention back to the oil patch.

Devon, Mitchell, Next?

As with other mergers, the Mitchell-Devon deal has sparked speculation about the next big energy deal and renewed interest in natural gas stocks. But it pays to review recent history.

There was talk after the battle for Barrett Resources -- finally won by Williams -- about the beginning of the next natural gas merger and acquisition wave. However, there has been little action since then.

A combination of sagging natural gas prices, drooping stock prices and a whole host of logistical issues associated with public company mergers likely contributed to the lack of new deals.

Yet, Devon's play for Mitchell highlights one important fact: Gas exploration and production companies have to find new drilling territory and new production to replace quickly depleting wells. Devon cherry-picked the best prospect in Mitchell.

While Mitchell was the gem, other large exploration and production (E&P) companies, including Apache (APA), Anadarko (APC), Burlington Resources (BR) and EOG Resources (EOG), are sure to be looking for opportunities.

That should lead to acquisitions similar to the Devon-Mitchell combination. Companies that continue to be mentioned as possible candidates for purchase include Ocean Energy (OEI), Tom Brown (TMBR), Pioneer (PXD), Cross Timbers Oil (XTO), Forest Oil (FST), Louis Dreyfus Natural Gas (LD) and Newfield Exploration (NFX).

There are possible candidates north of the border as well. While companies like Alberta Energy (AOG) and Talisman (TLM) have been growing through acquisition, both could be ripe for the right suitor. If power generation continues to push natural gas demand in the coming years, Canadian gas will become a much more important part of the U.S. natural gas picture.

While Mitchell was clearly the gem among natural gas companies, the deal may well spark additional interest in similar companies. "Our bottom line is that there will be more consolidations," notes Merrill Lynch natural gas analyst John Herrlin. "In the last eight years we've lost 25 companies [to M&A]. ... There will be more."

Gas Storage: Pent-Up Demand or Anomaly?

Wednesday's natural gas storage data from the AGA caught everyone by surprise, especially those short natural gas. The September New York Mercantile Exchange (NYMEX) natural gas contract soared nearly 12% on the news, and now gas prices for the rest of the year are above $3.80.

While most pundits expected a lower-than-normal AGA report -- a combination of the scorching temperatures in the Northeast and Midwest, the impact of Hurricane Barry and some pipeline maintenance in the Gulf of Mexico -- the data were so far outside the normal band that many are discounting its validity.

"We would not rule out a revision or at least an informal reversal of this week's lumpiness in future reports," UBS Warburg natural gas analyst Ron Barone told clients Thursday morning. However, the AGA says its data are accurate and aren't likely to be revised.

However, Merrill's Herrlin says lower natural gas prices combined with higher oil prices may be pushing some users to switch to natural gas. If that trend continues, support for higher natural gas prices may be near. Apparent "strong oil and products demand could help support natural gas pricing," he notes.

While the AGA number clearly provided a reason for despondent natural gas traders to celebrate, it needs to be viewed in context. As Barone notes: "One week's data does not make a trend."

Morgan's Value Call

Morgan Stanley's bullish stance on the drillers and oil-service companies Thursday morning may not have provided the spark many bulls were hoping it would provide, but its thesis is worth considering.

Ole Slorer, Morgan's oil-services analyst, has a deep-value bent and a very disciplined approach.

"We should emphasize that our call on the sector is being driven first and foremost by valuation," he notes in his report. "The stocks are simply discounting a much bleaker future than we can see play out over the next 12 to 18 months."

Slorer acknowledges that the near-term news could be mixed, but suggests current values are very compelling for longer-term investors. "We believe that a disciplined value approach is the only style of investing that will consistently provide a decent return in the sector over the long run," he writes. "We also recognize that such a value approach carries the inherent risk of being early on the stocks -- both in and out."

That said, among his best ideas are BJ Services (BJS), Schlumberger (SLB), Global Marine (GLM), Noble Drilling (NE) and Nabors Industries (NBR). He rates all a strong buy, and his firm has provided banking services for Nabors.

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