As I laid out in my deep look at the changing dynamics in the natural gas sector (click here for Part 1), the entire industry may soon start to rebound as a falling rig count eventually leads to falling output, which in turn should help bring supply down to a level where natural gas prices firm up.
What kind of snapback can investors expect?
Well, a return to the glory days of 2008, when natural gas briefly touched $13 per thousand cubic feet (MCF) seems nigh on impossible. It's simply hard to envision a scenario where natural gas is once again scarce -- at least in terms of any reasonable investing time horizon. Still, a clear case can be made that supply and demand will be in rough equilibrium, perhaps as soon as a few quarters from now if the falling rig count finally starts to curtail output.
Natural gas currently trades for around $2.70 per MCF.
As a rough framework:
• A sharp drop in temperatures in the U.S. Northeast in the second half of this winter would quickly push gas above $3.
• A drop in the rig count to around 725 or even 700 is probably good for another $0.50 move.
• Further conversions in multi-fuel power plants from coal to natural gas is another clear, but hard-to-quantify catalyst.
• And legislation that advances the opportunity for natural-gas powered vehicles could add $1 to natural gas prices.
Add it all up, and natural gas prices could be trading between $3.50 per MCF and $4.50 per MCF a year from now. Goldman Sachs believes an inflection point is at hand and sees a slow rebound in natural gas prices to $3.75 by the end of this year, $4.25 next year, and $5.50 by 2014 as supply finally drops to appropriate levels.
In case you're wondering where the downside exists, industry-wide cash costs average about $2.30 per MCF. Any price below that and production would HAVE to fall. In any event, prices appear to have already bottomed in the current $2.60 to $2.70 range.
If the upside scenario plays out according to plan, here are three stocks that would surely benefit...
1. Chesapeake Energy (NYSE: CHK)
No one would be happier to see gas prices rebound than Aubrey McClendon, CEO of this beleaguered industry giant. McClendon pushed this company to the edge in 2008, believing high gas prices would provide the cash flow to pay for a massive buying spree on key shale formations. McClendon spent the next two years walking that strategy back, ling up partners to provide cash in exchange for a share of many of the company's energy fields.
The decision to lighten the company's debt burdens initially appeared brilliant, and shares rallied in 2011 as it increasingly appeared as if Chesapeake retained the most prized assets and had the cash flow to fully exploit them. But plunging natural gas prices have raised fresh liquidity concerns, and McClendon is again scrambling to raise cash to be able to meet current development plans.
Rising natural gas prices would be a sure-fire panacea. Not only do firmer prices enable Chesapeake to generate more cash flow from existing wells, but they remove the risk that the company hits a liquidity crunch in coming quarters.
At this point, Chesapeake is the poster child for "high-risk/high reward." If the chips fall the right way and firmer gas prices remove the risk concerns, then this stock would likely quickly move to $35 or $40, simply because the company's real estate acreage is so valuable (the stock is currently around $21). In a best case scenario, my colleague Nathan Slaughter, chief strategist of Scarcity & Real Wealth, sees shares moving closer to $60, nearly 200% above current levels.
Chesapeake may be too risky for some investors. After all, the company's funding gap may cause it to scramble to raise funds, which is never a pleasant event to watch. Instead other investments options to consider include...
2. Southwestern Energy (NYSE: SWN)
Although this company has exposure to both oil and gas production, it has considerable upside if natural gas prices rise because it would boost the company's cash flow and fund development of many areas in the Marcellus shale (Pennsylvania) that remain untapped. In effect, the company is doing a nice job of restraining spending in an era of weak gas pricing, which is leading to respectable cash flow. This means Southwestern won't need to scramble to raise funds if gas prices remain weak. Reflecting the current sobering pricing environment, shares have fallen by roughly a third in the last six months to a recent $31. A move back to the 52-week high of $49 would be the likely outcome if gas prices started to percolate.
3. Apache Corp. (NYSE: APA)
This company also has exposure to both oil and gas, and it's the oil end of the business that is fueling big profits right now. But Apache has assembled a very impressive slate of gas-oriented properties that would prove quite valuable in an era of firming gas prices.
Even with gas prices in a funk, the company's assets appear quite undervalued. Citigroup estimates Apache's energy holdings are worth around $177 a share. That's far above the current $99 share price. (Citigroup's actual $150 price target takes a more conservative approach to Apache's ability to monetize its holdings.)
Risks to Consider: A rising tide would surely lift all boats, but if you look to purchase selective stocks now, it may be wise to assume that industry conditions remain weak and be wary of other firms that have funding gaps to meet their 2012 capital spending plans. Besides Chesapeake Energy, companies like Devon Energy (NYSE: DVN), EOG Resources (NYSE: EOG), and Noble Energy (NYSE: NE) will all need to raise at least $1 billion this year -- or curtail current plans if gas prices don't pick up.
Action to Take --> Firms with the greatest exposure to natural gas would surely see the biggest gains from a rebound in the commodity's price. Beyond Chesapeake Energy and Southwestern Energy, each of which have greater than 80% of their revenue from natural gas (as opposed to crude oil), other gas-focused firms include Anadarko Petroleum (NYSE: APC) (57%), Devon Energy (66%), Endeavour International (NYSE: END) (66%), Newfield Exploraiton (NYSE: NFX) (61%), Range Resources (NYSE: RRC) (77%) and Canada's Encana (NYSE: ECA) (96%).
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David Sterman does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC owns shares of CHK, ECA, DVN in one or more if its “real money” portfolios.
This article originally appeared at www.streetauthority.com.