In last week’s installment of The Energy Letter, my colleague Elliott Gue shared his dour near-term outlook for North American natural gas prices. The crux of his argument should be familiar to our regular readers.

Rising production from the nation’s prolific unconventional fields has led to a supply overhang that was exacerbated by the unusually warm winter, historically a period of elevated demand.

With gas storage levels about 46 percent above the seasonal average at the end of April, there’s a distinct possibility that inventories could max out available capacity, a scenario that would send the price of the commodity spiraling even lower.

The Energy Information Administration (EIA) once again lowered its price outlook for domestic natural gas in its most recent Short-Term Energy Outlook. The EIA now expects the fuel to fetch an average of $2.45 per million British thermal units (mmBtu) in 2012, down from $2.51 per mmBtu in April and $3.17 in March.

First-quarter results and management’s comments in recent conference calls indicate that exploration and production firms with the flexibility to do so plan to scale back drilling activity in gas-focused plays.

For example, energy giant Chevron Corp (NYSE: CVX) hasn’t shut-in any wells in dry-gas plays but has made a concerted effort to minimize activity in these regions, though its output in the Marcellus Shale will likely increase because of drilling obligations that it inherited from its acquisition of Atlas Energy. The company’s first-quarter US gas production declined by 10 percent from a year ago.

ConocoPhillips (NYSE: COP), which earlier this year announced plans to curtail natural gas output in the US, stated that production of the fuel decline by 18,000 barrels of oil equivalent per day in the first quarter. Management indicated that the firm continues to shut-in about 9,000 barrels of oil equivalent per day of production and will contemplate additional measures to limit production in dry-gas plays.

Independent operators also unveiled stepped-up plans to reduce drilling activity in gas-focused shale fields. EnCana Corp (TSX: ECA, NYSE: ECA), one of North America’s leading producers of natural gas, is on track to reduce its gross production capacity by about 600 million cubic feet per day in 2012, primarily through reduced capital investment and shut-ins or volume curtailments.

Meanwhile, drilling activity outside the liquids-rich fairway in the Marcellus Shale continues to dwindle, as Talisman Energy (TSX: TLM, NYSE: TLM) announced that it would cut its capital expenditures to $200 million and run only one rig in the area. At the end of 2011, the company had 10 rigs drilling in the Marcellus Shale.

Quarterly conference calls in the contract drilling space corroborated the great migration from dry-gas plays to shale fields that are rich in crude oil and natural gas liquids (NGL). Mark Siegel, chairman of Patterson-UTI Energy (NSDQ: PTEN), acknowledged the slowdown in activity in the Northeast:

In the current natural gas pricing environment, our customers in the Northeast seemed to be delaying well completions, which accentuated the problems arising from the oversupply of equipment in this market. The lower utilization, combined with some pricing erosion in the Northeast, negatively impacted our margins.  

Meanwhile, the company’s CEO Douglas Wall noted that work in the Marcellus had become “far more spotty” and told analysts, “We do expect to see frack [hydraulic fracturing] crews leave this market for oilier pastures over the course of the next few quarters.”

Mergers and acquisitions activity in the North American oil patch likewise reflect the shift toward liquids-rich plays. For example, BreitBurn Energy Partners LP (NSDQ: BBEP), an upstream master limited partnership (MLP) that has a natural gas-weighted acreage portfolio, on May 10 announced the acquisition of 160 drilling locations in the Wolfberry Trend portion of the Permian Basin for $220 million.

But a new trend has emerged: We’ve seen a number of well-capitalized operators scoop up gas-focused acreage at bargain prices that guarantee solid returns even in the current environment. These canny investments should generate even more compelling returns once natural gas prices recover.

Linn Energy LLC (NSDQ: LINE), a limited liability company with an oil-weighted production profile, in February announced an agreement to acquire conventional gas fields in Kansas’ Hugoton Basin from BP (LSE: BP, NYSE: BP) for $1.2 billion. NGLs account for about 37 percent of output from these properties, with natural gas making up the remaining 63 percent.

Although natural gas prices remain depressed in North America, Linn Energy has purchased these properties at a price that makes the transaction immediately accretive to distributable cash flow. Moreover, the limited liability company disclosed that it has hedged 100 percent of the acreage’s expected natural gas production and 68 percent of its NGL output over the next five years. This move limits the firm’s exposure to unfavorable swings in commodity prices.

Meanwhile, ExxonMobil Corp (NYSE: XOM) on April 10 acquired about 58,000 net acres in the TexArkoma Woodford Shale from Chesapeake Energy Corp (NYSE: CHK) for $590 million in cash. Wells on the leasehold flowed the equivalent of roughly 25 million cubic feet of natural gas in 2011.

KKR Natural Resources, a joint venture between private-equity firm Kohlberg Kravis Roberts and Premier Natural Resources, paid $306 million to WPX Energy (NYSE: WPX) for 27,000 net acres in Texas’ Barnett Shale and 66,000 net acres in Oklahoma’s Arkoma basin. Existing wells in the Barnett Shale acreage flowed about 67 million cubic feet per day in 2011, while the leasehold in Oklahoma yield about 9 million cubic feet per day.

More recently, Atlas Resource Partners LP (NYSE: ARP) on April 30 announced the purchase of 277 million cubic feet of natural gas equivalent reserves in the Barnett Shale from Carrizo Oil & Gas (NSDQ: CRZO) for about $190 million. The MLP, which went public in February 2012, today followed up this deal by announcing an agreement to acquire privately held Titan Operating LLC for $184 million in stock. This transaction will net the purchaser 250 billion cubic feet of natural gas equivalent reserves in the Barnett Shale.

We expect this fire sale of gas-focused acreage to continue apace in coming months; acquisitive companies with strong balance sheets and oil-weighted production profiled remain our favorite way to bet on an eventual recovery in North American natural gas prices. In the meantime, we remain short First Trust ISE Natural Gas (NYSE: FCG), as we expect further pain for gas-leveraged producers.

Around the Portfolios

Our Portfolio recommendations haven’t been immune to the recent correction; many have pulled back significantly from the highs hit in March and April 2012. Although investors should be prepared to endure some more short-term pain, this selloff should prove an outstanding buying opportunity.  

Among the hardest-hit recommendations in the model Portfolios are our high-yielding oil and gas trusts and master limited partnerships (MLP). Many of these stocks traded above our buy targets during the rally but have declined to prices that represent a solid value. Here’s my outlook for a handful of Portfolio holdings whose market values have tumbled in recent trading sessions.

Units of Chesapeake Granite Wash Trust (NYSE: CHKR) have sold off for two reasons. First, the trust’s sponsor and parent, Chesapeake Energy Corp (NYSE: CHK), has been besieged by a litany of negative headlines over the past few months, including allegations that the CEO Aubrey McClendon hasn’t acted in shareholder’s best interests. These allegations have been accompanied by more pressing concerns about Chesapeake Energy’s ability to fund its planned $12 billion 2012 drilling program.

But investors’ fear about Chesapeake Energy is overblown. Since most of its 2012 capital spending budget is discretionary, the company could delay some projects until it’s able to raise funds through planned asset sales. Any news on these divestments would be a strong upside catalyst for the stock.

If the stock were to trade at a depressed valuation for some time, don’t be surprised if a larger integrated oil company steps in with a takeover bid.

Bottom line: Chesapeake Energy shouldn’t have any trouble funding the wells it’s scheduled to drill on Chesapeake Granite Wash Trust’s behalf over the next few years.

Chesapeake Granite Wash Trust’s recently announced quarterly distribution of $0.6588–about 11 percent below the target–also contributed to the selloff. Lower-than-expected price realizations on natural gas liquids (NGL), which account for about one-third of the trust’s production, were the culprit.

Weaker oil and NGL prices may mean lead to another disappointing distribution in the second quarter, though we expect these commodity prices to recover in the back half of 2012.

I stress-tested my valuation model for Chesapeake Granite Wash Trust by assuming that the quarterly distribution will be 15 percent below the targeted level throughout the trust’s life. I also factored in a 7.5 percent discount rate when calculating the present value of the units.

Even with these conservative assumptions, the model yields a valuation of more than $18 per unit. For more details on my valuation process for oil and gas trusts, consult Trust Exercise from the Feb. 23, 2012, issue. Chesapeake Granite Wash Trust rates a buy under 25.

Although investors should steer clear of Chesapeake Energy’s common stock, Chesapeake Energy Corp 4.5% Preferred D (NYSE: CHK D) yield 7 percent and offer potential upside when the common stock rallies or in the event of a takeover. Buy Chesapeake Energy Corp 4.5% Preferred D under 105.

SandRidge Permian Trust (NYSE: PER) has also sold off because of the pullback in oil prices; crude accounts for more than 80 percent of the trust’s total production. At current oil prices, the trust’s quarterly distributions should be close to targeted levels. The quarterly payout should exceed this threshold if oil prices increase in the back half of the year. Over the next four quarters, SandRidge Permian Trust will likely disburse between $2.40 and $2.75 per unit, equivalent to a yield of between 12.5 and 14 percent.

The recent selloff has been exacerbated by the fact the stock’s average daily trading volume of less than 500,000 units. Buy SandRidge Permian Trust under 26, a price that represents my base case valuation for the trust.

SandRidge Mississippian Trust II (NYSE: SDR) has also sold off because of concerns about commodity prices. In fact, the stock now trades below its initial public offering price.

Oil accounts for about half the trust’s production and almost three-quarters of total revenue. When the trust went public, the targeted distributions assumed that natural gas prices would remain depressed.

The trust’s first distribution of $0.27 per unit exceeded the targeted distribution of $0.26 per quarter, and I expect the trust’s disbursements to approximate or surpass management’s estimates over the next few quarters. SandRidge Mississippian II will likely distribute between $2.25 and $2.50 per unit over the next 12 months, equivalent to a yield of about 12.5 percent at current prices. SandRidge Mississippian II rates a buy under 23.

Linn Energy LLC (NSDQ: LINE) produces oil, NGLs and natural gas, which explains why the stock price sometimes fluctuates with commodity prices. However, Linn Energy has hedged all its natural gas production through 2017 and all its oil production through 2015. The limited liability company has no exposure to near-term changes in commodity prices.

Moreover, a string of recent acquisitions should enable Linn Energy to grow its distribution at an average annual rate of about 10 percent in coming years. Take advantage of the recent selloff and buy Linn Energy LLC under 40.

Shares of US Silica (NYSE:  SLCA) tumbled after the firm issued its first quarterly results since going public. Although the firm’s earnings trumped analysts’ consensus estimate, investors sold the stock after management indicated that the selling price of its fracturing sand would decline in the second quarter.

Some of the projected decline in selling prices reflects a higher proportion of contract sales in the second quarter; many of these agreements were signed years ago at lower prices.

We expect drilling activity in shale oil prices to remain robust despite the near-term dip in the price of crude.

Demand for US Silica’s white sand–the kind used in fracturing oil wells–should outstrip supply for the foreseeable future. Buy US Silica under 19.50.