As Natural Gas Prices Slump, Is It Time to Buy Natural Gas Stocks?

Summertime temperatures may be soaring in many parts of the U.S., but natural gas prices have been anything but hot. To most investors, that would mean natural gas producers are to be avoided, but Paul Mecray, managing director of Tower Bridge Advisors, disagrees.

He sees the slide in gas prices as an opening for patient investors to buy on the cheap into the sector's exploration and production companies -- particularly those now in the early stages of developing new wells in shale gas deposits in Pennsylvania, Arkansas, Texas and Louisiana. Then, it's just a matter of waiting for the sector's significant growth prospects to develop over the next two years.

Patience is the key here, of course, because current gas price trends are going the other way. For instance, the U.S. Energy Information Administration (EIA) reported on July 8 that natural gas inventories increased by 78 billion cubic feet for the week ending July 2, versus expectations for a 70-bcf rise. That large upswing in inventory sent gas prices tumbling. Futures for August delivery fell 17 cents, or 3.6%, to $4.40 per million Btus (prices are given in both million Btus and thousand cubic feet, and are interchangeable) .

Trends That Could Push Prices Higher

While this news sent many investors running, Mecray sees it bolstering the buying opportunity. He believes that starting this year, demand will begin rising by an average of 1.5% per year as the economic recovery builds steam in the U.S. Over the long term, he suggests that the industrial sector, which currently uses about 30% of all gas consumed, will increase that use to keep pace with the economy. And he figures that more natural gas will be sold for use in residential heating and cooling, especially if homeowners switch from costlier and dirtier oil to cheaper and cleaner gas.

Mecray also pinpoints utilities as a source of demand. "A lot of utilities have the ability to switch from using coal as their fuel to natural gas, and I'm looking for some of that switching to occur," he says. All of these trends should help push prices higher.

In a dynamic similar to what the oil industry has experienced repeatedly, when gas prices sink below a certain threshold, exploration and production grind to a halt. That eventually reduces supply, and when demand rises, prices follow suit quickly. Mecray acknowledges the possibility that gas production will fall off sharply unless prices increase enough to justify drilling new wells.

"In my view, the costs to develop additional natural gas reserves are higher than people think," he says. So, he thinks prices need to average about $6 per thousand cubic feet in the 2011 to 2014 time frame for producers to operate profitably. Otherwise, "there won't be enough gas to meet demand," he says.

"Prices are averaging $4 this month," he continues, "but if you look at the next 12 months, the average price is projected at about $4.70 for the next 12 months on average -- that's too low [for profitable production]."

Which Way Will Prices Go?

The EIA calculates volatility for natural gas prices, and its current estimates range from $3.16 per million Btus at the low end to $7.18 at the upper end. The factors it weighs include colder-than-normal winters and the level of expected economic growth.

So, investors interested in investing in the sector need to decide which way they see prices moving in the future.

Even if prices linger at low levels for a while longer, Mecray sees some positive in that as well. He suggests that the long-term approach can still pay off because he believes some exploration and production companies will become takeover targets for the giant energy companies like ExxonMobil (XOM) and Chevron (CVX) as they seek to diversify.

Here are some companies that Mecray says could be worth considering.

Range Resources (RRC) and EQT Corp. (EQT) because both were able to buy into the Pennsylvania Marcellus shale reserves four or five years ago at rock-bottom prices. If natural gas prices rise over the next two years, both companies should benefit. "They have found huge quantities of natural gas, and they got that at a very low cost," he says. "As others come in, the value of their reserves and their acreage position increase."

Chesapeake Energy (CHK) because it has become a major player in shale gas by offering a piece of its reserves to international energy companies that want to get into the U.S. natural gas market. By getting other companies to bid on its gas production, Chesapeak has "set a price for the value of all of their acreage," notes Mecray.

Southwestern Energy (SWN) because it's capitalizing on its Fayetteville, Ark., shale reserves in the same way that Range Resources is benefiting in Pennsylvania: It was the first company in, which lowered its costs tremendously as it ramps up production. "As a result, they are going to be a major beneficiary if my price thesis for gas takes hold," Mecray says.

EOG Resources (EOG) could be a good choice for those who want a more diversified approach to capitalizing on shale gas deposits. EOG is a $28 billion company that's a big shale player in Pennsylvania, Texas and Arkansas. Formerly known as Enron Oil and Gas, EOG also has substantial holdings in the oil industry. Says Mecray: "It's very diversified with outstanding management."