Bad News in the Gulf Spells Higher Profits for These Stocks

By: David Sterman
Staff Writer
StreetAuthority

Published: June 7, 2010

As the Obama administration gets set to spell out the restrictions placed on offshore drilling, one thing is clear: The domestic supply of oil and natural gas is bound to be cut -- at least in the near-term. This should have little impact on oil prices, as the commodity is global in nature, and the Gulf contributes only a tiny fraction of the world's output.

Natural gas -- that's a different story. It's not a fungible commodity. Natural gas costs more to transport from distant lands and the Gulf accounts for about 12% of all domestic gas production. That means the market for natural gas, which has recently had greater supply than demand, could come into balance.

If that happens, the folks digging for gas on dry land would finally have a reason to cheer. Land-based drillers were euphoric a few years ago when they discovered that the United States was sitting on massive pockets of underground gas that could now be tapped thanks to new technology. The euphoria was short-lived as it quickly became apparent there was perhaps too much gas yet to be tapped. Prices fell off a cliff, and have remained at multi-year lows ever since. Share prices of most land-based drillers now sit well off of their highs from a few years ago. But all that's about to change.

Since last Wednesday, natural gas prices have risen from $4.25 per MCF (thousand cubic feet of gas) to $4.86. Once prices breach the $5 mark, analysts expect prices to move toward the $6 level as demand for natural gas is set to rise when power plants crank out more juice to satisfy air-conditioning needs. At that price, we'll start to see sharp upward revisions to profit forecasts for many firms in this sector.

Three Ways to Play

The potential earnings power of Chesapeake Energy (NYSE: CHK) highlights the extreme impact that natural gas prices can have. Analysts at Morningstar believe if natural gas prices were stuck around $5 per MCF, then its stock is worth just $7, well below the current price. But if prices rose up to $15 per MCF (they hit almost $14 two summers ago), then shares would be worth a whopping $80. More than likely, natural gas prices will fall between those two poles.

Action to Take --> For Chesapeake, which carries a lot of debt and has had to bring in myriad partners to help fund all of its operations, this level of volatility is especially pronounced. If you are bullish on natural gas prices and believe that an eventual economic rebound will push energy prices sharply higher, then Chesapeake likely has the greatest price appreciation potential of any of the natural gas exploration firms.

Less Risk but Still Has Rewards

If you don't want to swing for the fences with a stock like Chesapeake Energy, you may want to check out Range Resources (NYSE: RRC), which owns prime real estate in a newly-developed region in Appalachia known as the Marcellus Shale. Range Resources is tapping this shale with more than 100 wells, and output is expected to climb steadily in coming quarters.

The key is tying that output to expected natural gas prices. Roughly speaking, every $1 move in natural gas would impact Range's value by around $10 a share. Assuming natural gas prices rise to $6 per MCF during the next year (as futures contracts indicate), Range's gas fields are likely worth about $65 a share. If gas fell back to around $4, then shares are likely worth about $45, roughly -10% below current levels. But in the event that natural gas prices rise to $9 -- halfway between the low and high prices seen in the last two years -- shares would be worth about $95 a share, nearly double the current price.

Action to Take --> It would take robust global economic growth to push energy prices back up by a healthy margin, and few are expecting that in the next 12 to 18 months. But with share prices reflecting the worst case scenario on natural gas, the reward here looks quite good for the risk investors are being asked to assume.

Nabors Provides the Tools

If natural gas prices only moderately rise, it might limit the upside of these gas producers, but should be sufficient to push the number of working gas rigs ever higher. The natural gas rig count bottomed out less than a year ago, and is now rising virtually every week. Trouble is, the industry built too many rigs when business was booming and many are sitting idle. This is pushing down the lease rates that major vendors can procure.

The good news is rig suppliers aren't building new ones, and as more rigs get put back into service, lease rates are rising. This should help boost results for Nabors Industries (NYSE: NBR), the industry's largest player.

Shares have recently held appeal for value investors, as the company's $18 a share book value provided value for bottom-fishers. Now, growth investors are rotating into the shareholder base. Sales should be roughly flat this year, but could rise about +15% next year, thanks to a combination of rising lease rates and more rigs in service. This should propel earnings growth of more than +50% in 2011 to about $1.65.

Action to Take --> As a point of reference, Nabors earned about $3 a share in both 2006 and 2007. Assuming this drilling cycle is not as robust as the last, figure per share profits rise to about $2.50 by 2013. If shares trade at roughly 12 times that figure, they'd rise to about $30 -- or more than +50% above current levels.

-- David Sterman
Staff Writer
StreetAuthority

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