Coal and Gas: Heating Season

09/16/2005 12:00 am EST

Focus:

Elliott Gue

Editor and Publisher, Energy and Income Advisor and Capitalist Times

"The pundits are focused on oil and gasoline right now due to Katrina-related disruptions and the high retail pump prices of gasoline," notes Elliott Gue. But with the winter heating season soon approaching, he sees more opportunity in natural gas and coal.

"Just as we move out of oil’s peak demand season, the winter heating season starts to pick up, pushing up demand for electricity and gas-fired heat. With significant natural gas production from the Gulf of Mexico shut down due to Katrina, the normal seasonal build in gas stocks has slowed. Gas inventories are now actually below 2004 levels. Suffice it to say that this is bullish for natural gas.

"The most leveraged play in the gas sector is XTO Energy (XTO NYSE). The company’s strategy over the past ten years has been to acquire mature onshore US-based fields and develop them efficiently. Basically, XTO is not out to find major new reserves of natural gas. Instead, the company focuses on reserves that have already been explored and partly depleted. In most cases, these are properties previously owned by one of the major integrated or independent firms. The geology of such properties tends to be already well known, so XTO doesn’t have to spend a great deal on exploration.

"XTO simply invests in advanced technology and productive methods to squeeze more gas out of these mature fields. And XTO also looks for ways to lower the operating costs of recovering smaller pockets of gas from mature fields. Simply put, the company tries to recover the gas left behind by prior producers. And XTO owns properties all over the country. Its exposure to the domestic US market is very attractive right now. The company has consistently delivered low production costs, high margins, and very good cash flow growth. With one of the best reserve replacement rates and production growth in the industry, XTO is a good way to play the trend and should be a member of a well-diversified portfolio. XTO is a buy."

"The other major fuel for power plants that’s in high demand during the winter months is coal. Just as the winter heating season means a drawdown in gas inventories, it spells higher demand from utilities for coal to fire their power plants. With Hurricane Katrina disrupting gas supplies this season and sending gas-fired power costs sky-high, you can bet that America’s fleet of coal-fired plants will be working flat-out this winter to meet demand.

"Given the extraordinarily low inventories of coal currently being held at the nation’s utilities, the utilities will be scrambling to secure coal supplies and restock their dwindling coal yards. Penn-Virginia (PVR NYSE) and Natural Resource Partners (NRP NYSE), are two great ways to play this supply crunch. Both are structured as master limited partnerships. Other recommended plays are coal-mining companies Peabody Energy (BTU NYSE) and Arch Coal (ACI NYSE).

"In addition, there’s another back-door play on the coal market that’s getting less attention the railroads. Substantially all the coal consumed in US power plants is transported by rail. For many years, railroads suffered from consistently declining and depressed rates. This meant the group generated very low returns on capital because to keep operating they still had to shell out for track repairs and maintenance on railroad cars. But this is no longer the case. In recent years rising demand for electricity has spelled greater demand for coal; to haul that coal, railroads have been able to consistently boost their rates.

"With roughly one-quarter of its revenues coming from hauling coal, the railroad most leveraged to the coal story is Burlington Northern Santa Fe (BNI NYSE). Its route network serves the heart of the Powder River Basin in Wyoming and Montana. This region is the ‘Saudi Arabia of coal’. An alternative pick is Norfolk Southern (NSC NYSE), which garners about 20% of revenues from coal; much of that coal comes from East Coast (Appalachia) reserves. Norfolk has seen solid returns from its coal business and has a solid record of quality service."

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