Natural-Gas Producers Are on Sale

For the second straight year, we have seen natural-gas producers' stocks sell off over the course of the summer as natural-gas storage levels reach record highs. Mild weather, which has limited heating and cooling demand over the past two years, is the root of the problem. As a result, natural-gas spot prices have recently been hovering around $5 per mcf (thousand cubic feet). We think that this is a pretty low level given strong domestic demand, the declining nature of natural-gas wells, and the cost to find new reserves. In our opinion, natural-gas prices will have to average more than $7 per mcf over the next five years to encourage investment in new supply.

Natural-gas prices of $5 per mcf put tremendous strain on some domestic producers, especially those with significant Rockies operations. Currently, a lack of pipeline infrastructure is causing natural gas in the region to sell at a steep discount to Henry Hub, the industry benchmark. Natural gas in the Rockies has been selling at less than $4 per mcf for most of the summer, and in recent weeks has occasionally dropped below $0.50 per mcf. There's a strong possibility that some high-cost regional producers could be in the red for the third quarter if they are not significantly hedged.

We believe that natural-gas prices will average more than $7 per mcf over the next five years, but what are natural-gas prices and natural-gas producers' stocks going to do in the short run?

Worst-Case Scenario
As we see it, the worst-case scenario for gas producers would be if we finish September with only moderate temperatures, escape the hurricane season without a major disruption of offshore production, and experience a slowdown in economic activity. In this scenario, we wouldn't be surprised if benchmark spot prices fell to around $4 per mcf like last year. But we doubt that prices would stay at that level long because drilling activity would slow. This would in turn cause production to decline temporarily, boosting prices.  Chesapeake Energy  last week and  Questar  have already announced they were voluntarily cutting back production this year, and we wouldn't be surprised if more producers follow suit.

Best-Case Scenario
The best-case scenario for gas producers includes above-average temperatures throughout September, one or more hurricanes that disrupt Gulf Coast infrastructure, and an extremely cold winter. Although it seems unlikely that all three factors in the scenario will favor gas producers, it is definitely not outside the realm of possibility. If that happened, prices would probably spike temporarily (like they did in 2005), and then moderate through the end of the year and into January as the increase in prices would encourage imports and drilling activity. Even if only one of the aforementioned factors swing in favor of gas producers, natural-gas prices could rise.

Investment Opportunities
At Morningstar, our approach is simple: We recommend stocks that are trading at an appropriate discount to out estimate of their intrinsic value. The market is notoriously fickle and will sour on stocks when their near-term outlook is bleak. This creates buying opportunities for folks who are willing to look out longer than a couple of quarters and have a solid grasp on the long-run fundamentals of the business. Natural gas might fluctuate between $4 and $5 per mcf in the short-run, but in our opinion there is very little chance it will stay there for a significant length of time. A large installed base of gas-fired power plants and the cost of new supply should help keep prices above this level.

As of Sept. 5, we had 34 exploration and production stocks trading at a discount to our fair value estimates, but we've narrowed this list to firms whose current production mix is at least 70% natural gas and that are currently trading at a minimum 20% discount to their respective fair value estimates.

Natural-Gas-Weighted Exploration and Production Firms on Sale
	Morningstar     Rating	Fair Value Estimate	Price/ Fair Value	% of Firm's Prod. that Is  Natural Gas
XTO Engery		$70	80%	78%
EOG Resources (EOG)		$97	72%	87%
Cimarex Energy		$63	59%	76%
Compton Petroleum		$16	58%	85%
Newfield Exploration		$64	72%	82%
Chesapeake Energy		$52	65%	92%
Ultra Petroleum		$80	68%	86%
Quicksilver Resources		$56	73%	85%
Data as of 09-06-2007

When considering your options, it may make sense to buy a handful of the above stocks rather than only one. Not only are the expected future returns on each stock relatively similar, but buying a basket would also help reduce company-specific risk. Potential investors should note that these stocks tend to be volatile, so even if some of the them have increased in price since this article was written, it is still worth keeping them on your watch list.

For more on natural-gas stock opportunities, click to see Pat Dorsey's recent video report.