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Natural Gas Is up 40%... Time to Buy?

Posted
7/3/2012 1:00:00 PM
By: David Sterman
Referenced Stocks:CHK;MCF;MRO;UPL

Natural gas prices have been depressed for just a few years, but it feels like a lot longer. Numerous analysts (myself included) have tried to spot the bottom for this clean, abundant energy source, angling for the moment when supply comes down to -- and below -- the level of demand.

Back in January, I noted that this commodity might finally buck up once the domestic natural gas rig count slipped below 725.

By then, natural gas prices had slid from $6 per thousand cubic feet ( MCF ) to about $2.50, but the bottom wasn't in yet. The rig count kept falling, piercing the 700 mark and then the 600 mark, and still, gas prices couldn't find a floor. (The rig count now stands at 534 if you're keeping score.)

Yet just as most investors have thrown in the towel, they may have missed an important turn. Look at this two-week chart for natural gas.

Since late April, natural gas is up more than 40%. 

It's safe to say that almost no one saw this coming.

Why the spike?
Gas has been in an uptrend for precisely the reason you'd expect. Demand is steadily rising (thanks in large part to the ongoing switch at power plants from coal to gas), and supply, if not shrinking, at least is no longer surging. The most recent price gains, which began on June 14, came from a U.S. Energy Information Administration report that highlighted a 67 billion cubic feet build in gas inventories, which is unusually low (compared with the more normal 88 BCF) for a period that is typically characterized by weaker demand ahead of the peak July and August summer season.

The fact that it has been unusually hot in much of the United States in recent days (and expected to stay that way for awhile) is leading gas traders to expect a faster-than-normal drawdown in inventories in the weeks ahead. 

Short-covering also gets some of the credit. Bearish gas traders have been unwinding their positions, whichmeans that further near-term gains are likely to be more muted -- if the short-covering process is nearly complete.

Still, natural gas producers must be downright giddy. The difference between $2 and $3 gas is the difference between losses (and funding pressures) and robust profits. If gas is able to hold its own in the $3 range and move toward $3.50 a year from now, as futures contracts imply, then the entire tone of media coverage and Wall Street analysis will pivot back to bullishness -- and smart investors will cash in. 

With this in mind, here's a look at some of the top natural gas ideas from my esteemed colleagues here at StreetAuthority. To be honest, the timing on some of our calls have been off (as I mentioned before, few have been able to correctly time natural gas price movements), but these views look much more timely now.

Our best ideas
Despite its name, Ultra Petroleum (NYSE: UPL ) derives more than 90% of its revenue from natural gas. Roughly four months ago, Tim Begany spelled out why he thinks this company's profits could double by 2016. Shares have moved up from $18 to $23 over the past three weeks, and according to Tim, have ample further upside ahead.

Perhaps the most controversial stock in the natural gas sector also happens to be a favorite of my colleague Nathan Slaughter, editor of our Scarcity & Real Wealth newsletter. In a recent article, Nathan laid out the case for how Chesapeake Energy's (NYSE: CHK ) impressive base of assets will eventually override the current concerns over debt loads. Rising gas prices surely strengthen Nathan's case.

Firmer gas prices should eventually lead drillers to tap more wells. To gain access to gas buried deep in shale formations, these drillers will need to hydraulically fracture (or "frack") the shale to access the gas beds. In a separate article , Nathan looked at the companies providing the tools and services to make that happen. Those companies -- and the stocks behind them -- look to benefit in a major way.

My favorite pick
My favorite stock pick in this space is still Marathon Oil (NYSE: MRO ) , which has thus far been a losing pick in my $100,000 Real-Money Portfolio due in large part to its legacy exposure to crude oil. Yet as I noted back in February, Marathon's $3.5 billion 2010 purchase of Hilcorp will make it a major player in the highly-productive Eagle Ford Shale.

Risks to Consider: As short covering is one of the reasons behind the  upward move, long-oriented traders may now look to book profits, which could cause these stocks to pull back somewhat.

Action to Take --> Forecasts for continued hotter-than-normal temperatures across much of the United States for the next few weeks could push natural gas prices even higher. Any hurricane activity in the Gulf of Mexico would be an additional potential catalyst . On the upcoming round of quarterly conference calls, look for companies to revise their cash flow outlooks. Last quarter, they were bracing for a world of $2 gas. But $3 gas changes everything. And if prices indeed remain firm, then you'll want to position yourself to profit from stocks in this space.


-- David Sterman

David Sterman does not personally hold positions in any securities mentioned in this article. StreetAuthority LLC owns shares of CHK, MRO in one or more if its "real money" portfolios.