2 Energy Stocks on My Radar

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As things stand, oil is now almost $100 per barrel after its recent strength. Consumers cannot get enough oil, which cannot be said about natural gas. With oil hitting highs and natural gas continuing to stagnate, it's no surprise that companies have been increasing liquids production while decreasing gas production.

Looking at the top 20 U.S. natural gas producers as of Oct. 28, 2011, 406 rigs were drilling, down from 452 on Jan. 1, 2010. That's not surprising, given that they're not receiving very much in revenue from that gas sold. Here's what the top four of them were doing:

Company

U.S. Gas Rigs Drilling on Jan. 1, 2010

U.S. Gas Rigs Drilling on Oct. 28, 2011

% Change

ExxonMobil (NYS: XOM) 5247(10%)
Chesapeake Energy (NYS: CHK) 11066(40%)
Anadarko (NYS: APC) 243338%
Devon Energy (NYS: DVN) 344018%

Source: Company's investor presentation.

By itself, the above table does not say much. Chesapeake dropped its natural gas rig count mightily over those 23 months, but the third and fourth most prolific producers of natural gas actually increased their natural gas production. With that in mind, let's take a look at the same four companies and see how their liquids drilling programs have fared:

Company

U.S. Liquids Rigs Drilling on Jan. 1, 2010

U.S. Liquids Rigs Drilling on Oct. 28, 2011

% Change

ExxonMobil414250%
Chesapeake Energy15105600%
Anadarko513160%
Devon Energy718157%

Source: Company's investor presentation.

The percent change in the number of gas rigs showed mix results, but the percent change in the number of liquids drilling rigs sends a clear message. Every one of the top four natural gas producers increased their liquids drilling rigs by anywhere from 157% to 600% since the beginning of 2010. That's a clear sign from oil and gas producers that they will react to low natural gas prices by looking for more oil instead.

Not for everyone
Capital naturally flows to the highest rate of return projects, and for now, that is oil. However, there are two companies that are bucking the trend:

Ultra Petroleum (NYS: UPL) , producing out of the Pinedale Anticline in Wyoming and the Marcellus shale in Pennsylvania, managed to produce a record 63.4 billion cubic feet of oil equivalent in the third quarter, a 14% increase year over year. Despite producing mostly natural gas, Ultra managed a 74% cash flow margin, 32% net income margin, 32% return on equity, and 14% return on capital in its most recent quarter.

Southwestern Energy (NYS: SWN) is another low-cost natural gas leader and commands a huge position in the Fayetteville shale play. Southwestern managed total oil and gas production of 128.9 BCFE in the third quarter, up 23% from 105.0 BCFE in 2010. Much of that increase came from its increased Fayetteville shale production, which was up to 111.9 BCF from 92.3 BCF a year earlier. Despite producing mostly natural gas, Southwestern continues to increase its production and produce strong cash flow. The reason is simple -- Southwestern makes solid profits in natural gas where many others do not.

But wait, there's more
Despite these low-cost natural gas leaders doing so well, they have also caught the oil bug as they ponder the benefits of an oilier product mix.

In August, after evaluating more than 125 different projects, Ultra announced it had acquired nearly 100,000 net acres in the Niobrara shale, which is known to be liquids prone. The company plans to drill and complete several exploratory wells this winter to evaluate the play's prospects. Favorable results would then lead to a big ramp-up in oil volumes.

Not to be outdone, Southwestern also acquired its own acreage in recent months, acquiring 487,000 net acres targeting the Lower Smackover/Brown Dense formation, a new unconventional horizontal oil play. The company spud its first well in this play in September and plans to spud its second well this month. Going into 2012, eight additional wells have been planned to test the play's prospects. Success here could introduce a nice, oilier mix into the company's Fayetteville-dominated natural gas production.

Natural gas will one day work its way up, but not without further pain for the industry's laggards. As the highly leveraged companies with unproductive assets fizzle out one by one, companies like Ultra and Southwestern continue to mint money with their low operating costs. What's more, they now plan on cultivating oil exploration projects on the side.

Foolish bottom line
My favorite type of natural gas company is one with some oil exposure that can wait out the low natural gas prices, which may be here awhile. Now that two of the industry's low-cost leaders have themselves gotten oiler, they have planted themselves solidly on my radar. Until now, my reservation with these two companies was that they lacked strong liquids acreage. However, that may have just changed for the better.

At the time this article was published Paul Chi owns shares of Chesapeake Energy. The Motley Fool owns shares of Ultra Petroleum and Devon Energy. Motley Fool newsletter services have recommended buying shares of Southwestern Energy, Chesapeake Energy, and Ultra Petroleum. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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