Natural Gas Producers Are A Bargain

By Aaron Levitt | March 22, 2012 AAA

What a difference a few years makes. After experiencing a virtual drought of natural gas and $15 per million BTUs pricing, the United States is awash in a sea of the fuel. New advances in drilling techniques have allowed a variety of E&P firms to tap into the nation's shale formations and finally access the trapped hydrocarbons. However, retrieving this abundance has had some unintended consequences. Now faced with a glut, natural gas prices have fallen to their lowest levels within a decade and many producers have begun ending production. Given these historically low prices, now could be the best time for investors to add the sector to a long-term portfolio.

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A Glut of Gas
The growth in hydraulic fracturing is causing a major headache for natural gas producers, as the drilling technique is causing a dearth of fuel. Without a real source of domestic demand, storage levels within the U.S. have risen rapidly and currently sit at 2.7 trillion cubic feet. That's more than 45% higher than a year ago and nearly 52% higher than five-year averages. This has resulted in a price slide not seen in decades. Overall, prices for natural gas futures have fallen about 80% since 2005, when the fuel was trading as high $15. Since the beginning of the year, prices have continued their slide downward and now have reached a decade low of $2.27 per million BTUs.

These decreasing prices have caused a variety of E&P firms to cut production in the face of unprofitable conditions. According to oil service firm Baker Hughes (NYSE:BHI), the number of rigs looking for natural gas have dropped by 212 versus a year ago. Likewise, share prices for many firms associated with the sector have decreased as well.

However, there may be signs that things are turning around for the industry. First, many analysts believe that prices for natural gas will have to rise, as they are currently below the marginal cost of production for many drillers. As various hedges begin to expire, you'll see more E&P firms cut production and drive-up prices. Secondly, while storage levels continue to be high, they have been dropping. According to the EIA's latest storage report, inventories have fallen for the 17th consecutive week and represent a 38% reduction in storage during the past four months. (For related reading, see A Natural Gas Primer.)

Playing The Turn Around
Overall, the International Energy Agency (IEA) estimates that global consumption of natural gas will rise by more than 50% over the next 25 years. That's certainly a bullish long-term prediction and many analysts estimate that current natural gas pricing can't get much lower. Now could be the best time for investors to strike. Featuring exposure to a who's who of natural gas firms, including like Chesapeake (NYSE:CHK) and Ultra Petroleum (NYSE:UPL), the First Trust ISE-Revere Natural Gas ETF (NYSE:FCG) is still the easiest way to gain access to the producers of the fuel. The fund tracks and equal-weights 29 of the largest E&P firms that derive the majority of their revenue from natural gas. The ETF charges 0.60% in expenses and has been roughly flat since its inception.

Recently receiving attention from a variety of foreign sources has been producer Devon Energy (NYSE:DVN). The firm recently cut a $2.2 billion deal with China's Sinopec (NYSE:SNP) for a piece of its production from five different fields. The deal provides Devon with a large cash infusion to continue carrying out expensive unconventional drilling. Shares of Devon currently can be had for a dirt cheap P/E of less than seven and currently yield 1.1%. Similarly, Quicksilver Resources (NYSE:KWK) can be had for a P/E of about 10.

The Bottom Line
Given the advances in drilling techniques, natural gas prices have continued to fall by the wayside. However, production cuts at a variety of firms may be finally working. The sector's turnaround could be at hand. For investors, now could be the best time to pounce. The previous picks, along with Forest Oil (NYSE:FST), make ideal selections to play the rebound.

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At the time of writing, Aaron Levitt did not own shares in any of the companies mentioned in this article.

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