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The Natural Gas Conundrum

September 01, 2009 | Filed Under »
Tickers in this Article » CHK, UNG, COG, PETD
With oil at $74 a barrel and natural gas at $2.75 per tcf (thousand cubic feet), the price divergence between the two commodities is near a 20-year high. These prices represent a near 27-to-one natural gas-to-oil ratio, compared with nearly a 13-to-one average this past year.

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What China Wants, China Gets
The widening price gap is a result of several factors. China's stimulus efforts have increased the country's demand for more oil. The opposite is happening with natural gas. Supplies continue to increase, and storage capacity for natural is nearing capacity - or so the data tell us. However, gas producers have responded and, over the past year, the number of drilling rigs has declined. The market has priced natural gas for extinction. Sure it can go lower, but with the onslaught of winter in the U.S. coming up, the commodity, at a multi-years low, looks like a good bet to make. (For further reading, check out Oil And Gas Industry Primer.)

Good Long-Term Bet
While this is completely arbitrary at this point, at the 13-to-one ratio this year, natural gas would be trading for $5.61 per tcf. That's nearly 100% up from today's level. But as you can see, at the recent price of $2.90, the cheapness of natural gas relative to oil can lead it higher this winter. If heating the home is cheap this year, more consumers will turn on the heaters, thus using up existing supply.

The big daddy in natural gas is Chesapeake Energy (NYSE:CHK) and it's selling at an attractive valuation for long-term investors. With 12 trillion cubic feet of proved gas, simply valuing the company at $2 per 1,000 cubic feet values the company at $24 billion. This is against a market cap of $15 billion and an enterprise value of $29 billion. Obviously, the back of the envelope valuation is rough: you have to discount the value of production that occurs in the future. At the same time, if natural gas is selling at $9 a tcf four years from now, Chesapeake is an even better buy.

A smaller, less leveraged player is Cabot Oil and Gas (NYSE:COG), but the stronger balance sheet means Mr. Market likes it more than Chesapeake. And what Mr. Market likes usually comes with a premium price tag. Investors may also want to dig into the financials of Petroleum Development Corp (Nasdaq:PETD). The market cap is $200 million, but the enterprise value is $600 million. However, shares trade at half of book value and there is no goodwill or intangibles on the balance sheet. The trailing twelve month operating and profit margins are 64% and 34%, respectively.

United States Natural Gas (NYSE:UNG) is a pure play ETF on the commodity itself. Not surprisingly, it trades at a near 52-week low. However at current levels, investors should be aware that it trades at a premium to the NAV of the ETF. This premium to NAV continues to narrow however. (For more, check out Commodities That Move The Market.)

The Bottom Line
Periods of pessimism can often spell wonderful opportunity for patient value investors. It looks like natural gas is going through such a moment.

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by

Sham Gad

Sham Gad
Sham Gad is the Managing Partner of Gad Partners Fund's, value inspired investment partnerships modeled after the Buffett Partnerships of the 1950's. Previously, Gad ran the Gad Investment Group and delivered annualized returns of 22% from 2002 to 2005. Gad is also the author of "The Business of Value Investing" which will be out in the fall of 2009. Gad earned his MBA at the University of Georgia in May of 2007. Gad runs a value investing blog. He can also be reached by visiting the Gad Partners Funds site. When not writing or analyzing businesses, Gad enjoys hanging out with his wife Maggie, reading, golf, and yoga
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