Here's How To Profit From The Disconnect In Natural Gas

By: Street Authority

A rising tide doesn't always lift all boats. The major stock indexes are up 10% or more this year, but as I recently noted, it has been a brutal few months for commodities. But at the time, I saw a small silver lining.

"These are the kinds of commodities you need to keep tracking, because lower prices counterintuitively set the stage for the next bull market in commodities," I wrote, citing iron ore as an example. However, I overlooked an even more glaring example of how slumping commodity prices can impair production, which leads to an eventual pricing rebound.

I'm talking about natural gas, which has been on fire in the past year.

Simply put, in the spring of 2012, few people saw this kind of move coming.

Yet the rebound in natural gas shouldn't have come as a total shock. After all, the number of rigs drilling for natural gas had fallen sharply throughout the end of 2011 and the first half last year, as I noted, and we're now seeing the benefits of reduced supply.

The question is: Can the good times last? Yes, they can.

Natural gas prices are likely to consolidate back toward the $4 per thousand cubic feet (Mcf) level during the seasonally weaker spring season (when it's neither too hot nor too cold to generate much demand from utilities). Still, at that price, it's like manna from heaven for energy drillers.

At $2 per Mcf, most drillers lose money, and some would be at risk of defaulting on their debt. At $4 per Mcf, these same drillers can make enough money to generate solid cash flow. Better still, $4 natural gas still isn't high enough for drillers to get carried away and sharply boost their production plans.

The key to this rebound is to be sure that output remains restrained, right at or below the levels of demand. How does the output picture look? The weekly tally of domestic gas rigs in service paints a good picture.

A Healthy Rig Count

Source: Baker Hughes

The fact that the rig count is now below 400 is quite impressive. (I unwisely suggested more than a year ago that the rig count needed to fall to 725 for the industry to find equilibrium between supply and demand, which was clearly off the mark.)

You know that the falling rig count is having an impact by one key measure: For several years, the amount of natural gas in storage depots remained above the five-year average (adjusted for seasonality). Well, the figure is now below average, and Goldman Sachs expects "a further reduction in gas storage vs. the five-year average over the next six months."

The key takeaway: Barring a sudden spike in the number of rigs, $4 gas is here to stay.

Sticking With Ultra
Even as natural gas prices have rebounded, industry share prices haven't moved much. In effect, the crowd still thinks this rebound is a head fake, so people are waiting for gas prices to plunge anew.

Yet that looks unlikely with the drop in output that has resulted from the plunging rig count. In a minute, I'll note some of the current favorite ideas being bandied about by Wall Street analysts.

But first, I'd like to remind investors about one of my colleague Nathan Slaughter's favorite gas plays. Nathan is our in-house natural resources expert, and when he talks, I listen. He's written extensively about his favorite investment opportunities in natural gas, including America's coming natural gas highway and the timely revival of a decades-old technology.

Back in October, Nathan told StreetAuthority Managing Editor Bob Bogda that Ultra Petroleum (NYSE: UPL) was one of his top picks. "Ultra is extremely efficient with an "all-in" production cost of $2.88 per Mcf ... (and will) pocket more cash per Mcf than almost any other producer as prices rebound."

Despite his bullish outlook, shares of "Ultra Pete" are actually lower than they were when Bob and Nathan chatted about the company seven months ago. Yet his assessment of the company still appears to be on the mark.

Assuming that gas prices stay at $4 per Mcf, then Ultra appears to be on the cusp of a solid upturn in operating cash flow. Citigroup's analysts see operating cash flow rising nearly 96% to $900 million by 2015.

If gas prices remain stable or even rise, then Ultra will have a chance to sell its prodigious projected output at locked-in prices, ensuring those cash flow targets will be met.

Wall Street's Favorite Plays
It seems as if every Wall Street firm has its own favorite way to play the rebound in natural gas.

• Goldman Sachs is partial to Bill Barrett Resources (NYSE: BBG), citing a new management team that is focusing on much better cost controls and higher cash flow.

• Goldman also is high on Southwestern Energy (NYSE: SWN), which is sitting on some of the most productive areas of the Marcellus Shale.

• Cabot Oil Gas (NYSE: COG) is a favorite of both Merrill Lynch (due to sharply rising estimates of proven recoverable reserves) and Citigroup (thanks to projected cumulative free cash flow of $1.5 billion from now through 2015).

Risks to Consider: If the subpar temperatures last winter lead to a cooler-than-normal early summer, then gas demand might slump, so keep an eye on long-term weather forecasts if you own any names in this sector.

Action to Take -- Any commodity that doubles in value in just a year would seem to be ripe for a pullback. But the supply and demand fundamentals in the gas patch are markedly better than they were a year ago. More importantly, so many industry players were burned over the past few years by drilling for too much gas that they now understand the importance of restraining their capital budgets.

While gas prices may not move up sharply from here, they are unlikely to fall back, and at current levels, that creates much more favorable economics for gas producers. If you fret that you missed that rally in gas prices, know that there are still ample opportunities with gas producers, as their shares have yet to respond to the commodity's price recovery.

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