...But Natural Gas Producers Still Look Good

05/19/2010 12:30 pm EST

Focus: COMMODITIES

Richard Young

Editor, Young's Intelligence Report

Richard C. Young, editor of Intelligence Report, says natural gas prices are far too depressed, and growing demand will eventually spur further exploration.

The iShares Dow Jones US Oil & Gas Exploration & Production Index Fund (NYSEArca: IEO) owns domestic oil and gas companies with a median market capitalization of about $2.6 billion. The sheer quantity of new natural gas supplies from unconventional plays and lower demand caused by the recession have served to depress the price of natural gas.

But on a BTU basis, the price of natural gas is much too low. Natural gas [recently traded around $4] per million BTUs; meanwhile, spot WTI crude oil [recently traded around $14] per million BTUs. That means for every BTU purchased in the form of oil, you could buy 3.5 BTUs in the form of natural gas. That's a relationship that simply can't sustain itself for long.

Another relationship that can't last is that between the prices of natural gas and coal. Gas is cleaner and easier to transport than coal, so it demands a premium per BTU. That premium has historically been 2.6x the price of coal per BTU. [Recently] the premium was around 1.5x] the price of coal only 57% of the historic premium.

This unsustainable condition is already beginning to show signs of adjusting. Big power producers like Xcel Energy (NYSE: XEL) and Calpine (NYSE: CPN) have announced plans to convert coal plants to natural gas to exploit the cheap gas supplies. There is also anecdotal evidence that homeowners are buying natural gas boilers and furnaces for their homes instead of oil. The supply glut and demand slide for natural gas are already beginning to show potential signs of easing.

After hitting a peak in October 2008 at 3,360, the number of natural gas wells drilled each month fell to a low of 1,299 in May of 2009. Since then, drilling has rallied and the number of wells drilled each month is up 39%. 

Many of the companies owned by IEO are participating in the drilling rally, including its seventh-largest holding, Chesapeake Energy (NYSE: CHK).

Chesapeake owns interests in over 44,000 productive oil and gas wells and is America's most active well driller. [It] drilled over 2,200 gross wells in 2009, and achieved success rates of 99% on its own wells and 98% on wells it drilled for other companies. Chesapeake is also the country's largest unconventional natural gas player, with leasehold rights to 13.7 million net acres of land for exploration and production.

IEO also owns Range Resources (NYSE: RRC) and Petrohawk (NYSE: HK). Both are leading natural gas exploration companies, and each owns over 2.7 trillion cubic feet equivalent of natural gas resources.

Both are expert in extracting the shale gas resources that have transformed the natural gas industry in America. As America's energy infrastructure adjusts to domestic natural gas, the companies owned by IEO will benefit from their expertise in exploiting the unconventional shale gas resources at the heart of the natural gas revolution. (The Index Fund closed above $52 Tuesday—Editor.)

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