These Natural Gas Stocks Are Big-Time Bargains - TheStreet

These Natural Gas Stocks Are Big-Time Bargains

They're undervalued just as pipeline capacity is about to open.
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What's the hottest energy play in the lower 48 states?

It's not Louisiana. And it's not Texas.

Try the Rocky Mountains.

The fastest-growing supply of onshore natural gas in the lower 48 states comes from the Rocky Mountains. Proved reserves of natural gas in the region have tripled since 1977, according to industry consultant Wood Mackenzie. The three key Rocky Mountain basins -- the Green River Basin in Wyoming, the Uinta-Piceance Basin in Utah and the Powder River Basin in Wyoming -- will see natural gas production climb by 22%, 56% and 10%, respectively, from 2007 through 2011.

Bet you'd like to own some stock in the companies with the biggest stakes in that region. But you're afraid they're too pricey. Have I got a buying opportunity for you.

Thanks to a lack of pipeline capacity in the region, natural gas companies are going to have to rein in growth in the second half of 2007 and into 2008. A local glut of natural gas has already driven the price of Rocky Mountain natural gas to a deep discount vs. the commonly quoted Henry Hub benchmark price.

Know what that means? The best producers in the fastest-growing production area in the lower U.S. are going to turn in comparatively lousy earnings growth over the next quarter or two. And that will be your chance to swoop -- in September or October or so -- and pick up these stocks before new pipeline segments set to open in 2008 and 2009 start to eliminate the glut and wipe out much of that discount in regional natural-gas prices.

Rock-Solid

I'm going to start with the big picture and then zoom in on three stocks that have the most potential to profit from continued growth in natural gas production from the Rocky Mountains.

First, a quick geology lesson. The Rocky Mountain natural gas reserves are the result of a huge sea that stretched from Louisiana into Canada and that divided North America in half for 25 million years. For year after year, plants and tiny sea animals lived and died in this ocean, building up huge deposits of organic material that under pressure turned into natural gas and bitumen (a kind of very heavy oil).

As the region folded, eroded and refolded, those deposits wound up buried in rock layers resting at oftentimes crazy angles. Much of those reserves existed as smaller pools of oil, or as oil and natural gas "trapped" in finely grained sedimentary rock.

Getting the natural gas out is extremely difficult because of that geology. Getting oil out is even harder -- so tough that no one has yet really solved the problem.

On the natural gas side, Mitchell Energy drilled the first discovery well for natural gas in the Barnett shale formations of Texas and Oklahoma in 1982. Over the next decade, natural gas companies developed new drilling technologies and new methods for fracturing the shale formations so the natural gas could escape from the rock.

Flow rates gradually climbed; horizontal wells in the Barnett region now produce 2.1 million to 3.5 million cubic feet of gas a day. Higher flow rates meant that wells became more profitable more quickly. That sent natural gas companies searching over a wider region that now stretches from the Barnett wells of Texas into the Canadian Rockies.

What's called "unconventional" natural gas -- gas from tight sands, gas shale and coal-bed methane -- now accounts for about 30% of all gas produced in the U.S. And this production couldn't be arriving at a better time, since production of conventional natural gas has peaked in the U.S. (This isn't coincidence: It's the higher prices for natural gas that come from a production peak that have made it profitable to develop unconventional sources of natural gas.)

Oil and Water

The story on the oil side isn't nearly as positive. While it's possible to release natural gas from these formations by fracturing the rock underground by injecting nitrogen or other gases or sand into the formation, you have to cook the rock to get the oil out.

Exxon Mobil

(XOM) - Get Report

spent $5 billion on its Colony Oil Shale Plant in Colorado in the aftermath of the Arab oil boycott in the 1970s before pulling the plug. That plant mined the rock and then cooked it above ground to release the oil. The current round of research plants try to cook the oil underground by injecting steam or inserting giant electrodes into the ground.

No one yet knows how much energy one of these plants, running at full scale, would require to produce a barrel of oil. And no one knows exactly how much water these plants would consume in oil production. (For example, one technology, mine and retort, would use 2.1 to 5.2 barrels of water to produce every barrel of oil.)

And no one knows if it's possible to design a production process that doesn't pollute local ground and surface water. (The Natural Resources Defense Council has produced a report on the environmental effects of oil production from shale and tar sands. Here's a

link for a summary that will take you to the full report.)

While the pilot projects go on, we're still a long way away from producing oil from Rocky Mountain shale in any quantity. But with the Green River Basin alone promising total reserves of 800 billion barrels of oil -- about three times the reserves of Saudi Arabia -- I doubt the oil companies will simply walk away this time.

A Buying Opportunity

The biggest obstacle in the way of expanded natural gas production from the Rockies is the lack of enough pipeline capacity to get gas out of the region to consumers in the Midwest and East. This lack of transport has produced a local glut of natural gas that has left the price in the region at $5 per million BTUs, below the Louisiana Henry Hub price in June. Growing production has just made the problem worse: In 2004 the discount averaged just 89 cents, but it had climbed to $1.55 by 2005.

According to Wood Mackenzie, natural gas export capacity from the region is now maxed out, and supply growth will stabilize. In June, for example, supply from the region is likely to grow by just 600 million cubic feet per day, a drop from the 1 billion cubic feet a day added to supply in June 2006. By September, Wood Mackenzie projects, growth is likely to drop to just 350 million cubic feet a day.

Rocky Mountain natural gas producers will be caught in a tight spot, with both lower natural gas prices and lower supply growth squeezing earnings. That's likely to lead to analyst downgrades and earnings disappointments that will punish stock prices for regional producers.

Relief, however, is on the way. The Rockies Express pipeline will link producers in the region to Cheyenne, Wyo., this year, to Mexico, Mo., in 2008 and to Clinton, Ohio, by 2009. And since this new pipeline uses higher pressures to move higher volumes of gas, transportation costs for Rocky Mountain natural gas will be lower than for competing gas from Texas and Louisiana.

That should result in a complete reversal of the 2007 squeeze on earnings, as natural gas volumes climb and the price discount to the Henry Hub benchmark price narrows or vanishes.

If you want a lower-risk way to play this turnaround, go for the shares of a bigger producer such as

Anadarko

(APC) - Get Report

or

Encana

(ECA) - Get Report

. A big company like this can still get a considerable part of its natural-gas revenue from the Rockies -- 50% of Anadarko's natural gas comes from the Rockies, for example -- but the same large portfolio of other energy assets that lowers the risk of these stocks also limits the upside from a turnaround in Rocky Mountain gas prices.

My Picks

So I prefer smaller producers with more of their eggs in the Rocky Mountain basket. My three favorites, in order of preference:

XTO Energy

(XTO)

placed a huge bet on Rocky Mountain natural gas in early June when it acquired 1 trillion cubic feet of proved reserves in Texas and the Rockies from

Dominion Resources

(D) - Get Report

for $2.6 billion.

In addition to the proved reserves (95% natural gas), XTO Energy also picked up 542,000 acres of leasehold, of which 235,000 are undeveloped. The bulk of the reserves are in the Uinta, San Juan and Green River basins. In June, XTO Energy boosted its production guidance for 2008 by 15%, to 580 billion cubic feet of natural gas. That would be roughly a 35% increase from 2006 production.

Ultra Petroleum

(UPL)

is the leading producer of natural gas on the Pinedale and Jonah formations in the Green River Basin. The company expects to see production climb to 135 billion cubic feet in 2008 (from 114 billion cubic feet in 2007) and to 160 billion cubic feet in 2009. As of the end of the first quarter of 2007, the company had price hedges in place for about 15% of its 2008 production. Ultra Petroleum's other big exploration effort is in the waters of China's Bohai Bay.

Cabot Oil and Gas

(COG) - Get Report

owns unconventional natural-gas reserves in the Rockies, in Canada, in Texas and in the Appalachian Mountains. About 57% of Cabot's Rocky Mountain natural-gas production is hedged for 2007 with a $7 floor so that Cabot is likely to sell off relatively less in the tough period before the Rockies Express pipeline kicks in.

But despite this "handicap," I recommend Cabot on any dip. The company has one of the highest returns on equity among similarly sized natural-gas producers at 16.2%. (That trails only XTO Energy at 23.4% and

Chesapeake Energy

(CHK) - Get Report

at 17%.) The company's very clean balance sheet, with a 16% debt-to-capitalization ratio, gives Cabot plenty of room for a strategic acquisition or two if it wants to increase the efficiency of existing fields.

If you do manage to pick up any of these three on weakness over the next few months, I believe you can safely put them away for five years or more.

At the time of publication, Jim Jubak owned or controlled shares of XTO Energy. He did not own short positions in any stock mentioned in this column.

Jim Jubak is senior markets editor for MSN Money. He is a former senior financial editor at Worth magazine and editor of Venture magazine. Jubak was a Bagehot Business Journalism Fellow at Columbia University and has written two books: "The Worth Guide to Electronic Investing" and "In the Image of the Brain: Breaking the Barrier Between the Human Mind and Intelligent Machines." As an investor, he says he believes the conventional wisdom is always wrong -- but that he will nonetheless go with the herd if he believes there's a profit to be made. He lives in New York. While Jubak cannot provide personalized investment advice or recommendations, he appreciates your feedback;

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