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02/16/2011 11:08 am EST


Paul Goodwin

Emerging Markets Specialist and Analyst, Cabot Wealth Network

Natural gas is on the rebound as the US economy gathers steam, and these two Canadian gas producers are perfectly placed to reap the rewards, writes Tom Slee in the Internet Wealth Builder.

If we are brutally honest, 2010 was a disappointing year for the North American oil and gas group. In Toronto, the energy sub-index ended the year with a gain of 8.7%, underperforming the broad Canadian market, which advanced 14.4%.

The good news, though, is that because they lagged last year, energy stocks now represent relatively good value. They should do well in 2011 as the recovery becomes self-sustaining and demand for energy strengthens. Even cautious analysts expect oil prices to average US$90 or more this year.

As a result, energy-sector results are going to improve—and, given the buoyant market, we could see much higher earnings multiples.

The big question mark is natural gas, which is trading at depressed prices. The consensus is that it is likely to fluctuate and drift sideways for a while. Certainly, there is an abundance of supply and a new export facility on the West Coast to service Asian buyers is still two years away. Demand for lighter gas-focused drilling rigs has fallen off a cliff.

However, I am a little more optimistic, at least as far as investors are concerned. The reason why we have this oddity of energy prices heading in different directions is because oil is driven by world economic activity, while gas reflects the sluggish domestic economy. That bodes well for gas.

The all-important US economy is picking up steam. It is expected to grow at 3% this year, which should bolster demand for all types of energy. Moreover, at these levels gas is cheaper than coal, and many facilities are being converted.

Most important, all the bad news is already out there in the market. It's built into the gas-weighted stock prices.

I am not suggesting that gas prices are going to pick up soon. My point is that we should not avoid the industry or even particular stocks because of their gas exposure.

In fact, my two recommendations are primarily gas producers at this stage in their development. They are also both relatively junior companies; such stocks offer more upside potential.

Trusted Hands at the Helm
My first choice is Tourmaline Oil (Toronto: TOU, OTC: TRMLF), a company that was formed in 2008 and has grown rapidly through acquisitions and farm-ins. Current production is about 23,000 boe/d (barrels of oil equivalent per day), of which 85% is natural gas. Production should exceed 40,000 boe/d by the end of 2012.

What I really like about this company is that the key executives are a successful team with a proven track record. For example, CEO Michael Rose founded, built, and then sold Berkley Petroleum and Duvernay Oil.

More to the point, the management team has invested C$253 million of their own money in Tourmaline, and hold 30% of the outstanding stock. That's a healthy situation.

Tourmaline is already one of the largest landholders in the promising Alberta Deep Basin, an area with significant potential. It is also producing in the Montney Fairway in British Columbia, a low-cost extraction site that is becoming extremely active.

The company has drilled more than 70 wells during the last two years, and there are plans to drill another 55 in 2011. Top-line revenues, however, will be driven by natural gas pricing—which, as I have mentioned, is likely to mark time for a while.

Against this, Tourmaline has one of the lowest cost structures in the industry. Its rich natural gas-drilling inventories have a weighted break-even price of $3.65/Mcf. As a result we should see a cash flow of about C$1.35 a share in 2011, and as much as C$2.25 next year. Production growth in the 35% range is expected.

Tourmaline Oil is a buy with a target of C$32 for investors willing and able to assume some risk. Keep in mind that small energy stocks are volatile.

An Energetic Crew
Another rapidly growing junior producer that I like is Crew Energy (Toronto: CR, OTC: CWEGF). Formed from a restructuring of Baytex Energy in 2003, the company has three core operations: the Princess properties in central and southern Alberta, and the Sierra and the Septimus holdings in British Columbia.

Management is actively bringing oil and gas wells into production and output now exceeds 13,000 boe/d, of which 50% is natural gas.

Crew is dedicating most of its capital expenditures to the Princess operation, where it has 52 wells producing in one of the most economical plays in North America. Analysts now feel that the chance of drilling success at Princess is as high as 90%—and in fact Crew's production there continues to surpass expectations.

As a result, the company should generate cash flow of about C$2 a share in 2011. Consolidated net asset value per share exceeds C$25 and production could reach 18,000 boe/d this year.

Crew Energy is a buy with an initial target of C$27.

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