Natural Gas Rally’s Winners and Losers

Over the past two years the spot price of natural gas fell from nearly $5 per million British thermal units (MMBtu) in June 2011 to less than $2 per MMBtu in April 2012, and then began a steady climb back to the current level of about $4 per MMBtu.

We previewed the long-term trends favoring natural gas back in March in The Coming Natural Gas Explosion. Prices have been supported by resilient demand as well as diminishing supply from some of the more mature shale formations and the depleted wells offshore.

Stronger natural gas prices are good news for some and bad news for others. Natural gas producers like Chesapeake Energy (NYSE:CHK) were hit especially hard as gas prices fell. Between June 2011 and April 2012, CHK’s share price declined 25 percent. But over the past 12 months, CHK has rallied 36 percent as gas prices recovered.

Since Chesapeake is the nation’s second-largest producer of natural gas, it’s not surprising that its shares track the price of the commodity. The company isn’t diversified, so it is nearly a pure play on natural gas.

However, Chesapeake isn’t the nation’s largest producer of natural gas. That distinction belongs to ExxonMobil (NYSE:XOM). ExxonMobil shares have underperformed in recent years because of the company’s ill-timed $41 billion buyout of natural gas producer XTO Energy in 2009. The week the deal was announced natural gas fetched close to $6 per MMBtu. The acquisition of XTO made Exxon the largest US natural gas producer just as prices began a long decline. By June 2012 CEO Rex Tillerson was admitting that “We are losing our shirts” on natural gas production because of low prices.

As a result, ExxonMobil’s share price has lagged that of competitors like Chevron (NYSE: CVX), whose natural gas production is a much smaller part of its business. Over the last five years CVX is up 23 percent, the S&P 500 17 percent, and XOM a mere 1 percent. (Keep in mind that this time period includes the oil price crash of 2008.) Over the past 10 years CVX is up 265 percent and XOM 154 percent, but CVX only began to seriously outpace XOM in 2009 — the year the XTO acquisition took place.

ExxonMobil wasn’t the only oil producer to have made an ill-timed foray into natural gas. The timing was even worse for ConocoPhillips (NYSE: COP), which acquired Burlington Resources for $35.6 billion in 2005. At the time natural gas prices were hovering near $15 per MMBtu and many were predicting that they might stay that high for years. As with ExxonMobil, ConocoPhillips shares fell behind those of competitors as natural gas prices declined, a trend that only reversed once the company spun off its refining business in April 2012.

Given their heavy investments in natural gas, ExxonMobil and ConocoPhillips, along with Chesapeake,  stand to benefit from rising natural gas prices.

But overall production volume and the extent of a company’s reliance on natural gas extraction are hardly the only variables that determine its sensitivity to higher prices. The quantity and quality of its proven and unproven reserves, and its capacity to turn those reserves into higher production at an attractive margin in the coming years are other key factors that must be considered.

Those factors have led The Energy Strategist to recommend the shares of two Marcellus Shale gas producers that we consider to be most profitably leveraged to higher prices in the future, despite near-term hedging.

So while Chesapeake’s shares remain down nearly a third over the last two years, these stocks are up 50 percent and 150 percent over that span, and have also handily outperformed Chesapeake (as well as ExxonMobil and ConocoPhillips) to the upside both for the last year and so far in 2013.

In natural gas as in so much else, size isn’t everything.

Who Loses?

As for the losers, natural gas is an important feedstock for the chemicals and fertilizer industries, so higher prices could pressure those sectors. Oil companies with significant chemicals operations could also see this business segment take a hit, but based on ExxonMobil’s advocacy of liquified natural gas (LNG) exports, it clearly believes the net effect of rising natural gas prices on the company would be positive. Dow Chemical (NYSE: DOW), on the other hand, has come out strongly against LNG exports because of the potential cost hit to its own business and that of other heavy users of natural gas.

Less well understood is the risk from higher natural gas prices to the biofuels sector. This may be counterintuitive, since renewables like wind and solar power become more attractive options as natural gas prices increase.

The difference (underappreciated by many biofuels investors) is that many biofuel technologies rely heavily on natural gas. Corn ethanol, for instance, produces the process steam required to purify ethanol largely from natural gas. And since natural gas is also a key component in fertilizer, higher natural gas prices tend to drive up fertilizer prices and eventually corn prices, subjecting ethanol producers to a double whammy.

But the advanced biofuel industry may be at an even greater risk, since it hasn’t yet become economically competitive.

Take KiOR (Nasdaq: KIOR), for instance. KiOR’s technology starts with a fast pyrolysis process that heats up biomass rapidly to break it down into a bio-oil. KiOR uses a common oil refining process called Fluid Catalytic Cracking (FCC) technology for the pyrolysis step in a process they call Biomass Fluid Catalytic Cracking (BFCC). The end product is partially upgraded pyrolysis oil (still very different from crude oil), which is further upgraded to gasoline and diesel blendstocks via another common oil refining process called hydrotreating.

The entire process is heavily dependent on hydrogen from natural gas. Based on my calculations from KiOR’s published statements on wood feedstock inputs (500 bone dry tons) and gasoline, diesel, and fuel oil outputs (13 million gallons per year), as much as half of the energy content of the produced fuel is derived from natural gas. I asked the company to comment on my calculations, and based on the evasive nature of the answers I received, I believe I am correct. Thus KiOR — and certain other advanced biofuel producers — have a very high sensitivity to natural gas prices.

This is just another reason to shy away from investing in this company, which I have been advising investors to do since 2011. This has proven to be good advice, as the company’s share price has fallen 70 percent since mid-2011.

So if you are of the opinion that natural gas prices will retain strength in the coming months, the companies to target for superior performance are obviously the natural gas producers, especially those with the greatest potential to profitably grow their output. (And The Energy Strategist can help you identify these winners.)

Conversely, exercise caution with chemical companies (including fertilizer manufacturers) and biofuel companies — particularly advanced biofuel companies engaged in hydrotreating.

Around the Portfolios

Dresser-Rand (NYSE: DRC)

It’s been a tough spring in many ways for the energy sector, with oil prices sliding well off recent highs in recognition of subpar global growth and capital markets no longer cheering debt-fueled expansion plans as was the case a couple of years ago.

As you would expect, the caution has filtered into the industry’s capital spending plans. Notably, Growth Portfolio holding Dresser-Rand disappointed investors for the second straight quarter with a cautious outlook, as enthusiasm for large-scale energy investments wanes, leaving Dresser-Rand more dependent on the (recently strong) aftermarket bookings of replacement parts.

But even though the stock slumped 6 percent in response to the results, it recouped much of that loss the next day and hasn’t looked back. Perhaps investors found solace in rising operating margins, or in the earnings leverage the company expects starting next year as new equipment designs are rolled out and the heavy investment of recent years is scaled back.

Possibly, the market took its cues from a CEO who bought $1 million of the company stock in March at just above $57. Certainly, investors will have had the recent $3.3 billion buyout of Dresser rival Lufkin Industries (Nasdaq: LUFK) by General Electric (NYSE: GE) fresh on their minds. Like Lufkin, Dresser-Rand benefits from a large installed base of equipment that will need to be maintained and upgraded for years.

Sure enough, Bloomberg News reported last week that Germany’s Siemens (NYSE: SI) has been eyeing Dresser-Rand as an acquisition target for as long as two years, though it’s also reportedly wary of overpaying. GE, National Oilwell Varco (NYSE: NOV) and Growth Portfolio holding Cameron International (NYSE: CAM) were also mentioned as potential bidders.

To snare Dresser-Rand, a corporate suitor would likely have to offer a nice premium over the current market valuation of not quite 13 times trailing cash flow. After GE’s offer of a 38 percent premium for Lufkin, which is growing more slowly than Dresser-Rand, Lukfin’s shares now trade for nearly 17 times trailing cash flow. That suggests the best days for DRC still lie ahead. Buy it on a dip below $55.

– Igor Greenwald

Stock Talk

David Daub

David Daub

This is a query not a reply. From all that’s going on with energy, it appears that LNG export is an opportunity to realize a fair return for an investor. But how and where should a guy invest? I’ve asked this of ES previously but received no comment. How about a bit of guidance this time? Thanks.

Igor Greenwald

Igor Greenwald

David, thanks for reading. Your request is my command. See story in the latest issue:

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