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Stock Strategist

Is a Natural Gas Supply Bubble Forming?

Will a tsunami of new natural gas production wash up our 5-star natural gas producers?

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Natural gas prices have fallen sharply from where they stood earlier this year, and so have gas producers' stocks. During the swift market action, many of the Morningstar Ratings went to 5 stars for exploration and production (E&P) company stocks we cover. We've kept our attention focused on the ever-dynamic fundamentals underpinning our valuations for the E&P companies during this turbulent two-month period, updating our forecasts for lower near-term oil and gas prices.

Short-Term Fundamentals
Although we speculate that much of the magnitude of the recent drop in E&P stock prices can be attributed more to the financial health of large hedge fund players in the space (or lack of financial health), we have seen the short-term fundamental picture for natural gas producers erode in recent months. When we kicked off 2008, a relatively cold winter helped push natural gas prices much higher (above $12 per mcf) and plentiful drilling rig and services capacity--combined with more efficient development programs--kept well drilling and completion costs low. These factors contributed to margin expansion and lower reinvestment risk for the E&Ps (and higher stock prices). But these factors have changed over the summer. The rig market has recently tightened, especially in regions with particularly active drilling (like the midcontinent and North Texas). More visible to everyone, natural gas prices have come way down in recent months. So margins and incremental returns on new investment look set to contract for the near term.

Eric Chenoweth has a position in the following securities mentioned above: RRC. Find out about Morningstar’s editorial policies.