2 Deepwater Gas Winners

06/11/2012 10:30 am EST

Focus: STOCKS

Elliott Gue

Editor and Publisher, Energy and Income Advisor and Capitalist Times

There's nothing better than to have a growth stock in the energy patch combined with a solid dividend yield, and below we feature two of them, observes Elliott Gue of Personal Finance.

Gas production in the US from unconventional shale fields has soared, reaching record levels in early 2012. Although a slowdown in gas-directed drilling this year may dampen production, accelerating activity in oil and liquids-rich plays such as the Eagle Ford Shale in South Texas will offset any decline.

Rising demand for natural gas in the power sector won’t be sufficient to absorb excess supply. The equation won’t change meaningfully until the latter half of this decade, when the nation should begin to export liquefied natural gas in earnest.

The outlook for crude oil and natural-gas liquids (NGL), a group of heavier hydrocarbons that includes ethane, propane, and butane, is far more sanguine.

Global oil demand in 2012 should eclipse 90 million barrels per day, a record high. US oil demand has remained fairly steady after recovering from the financial crisis and Great Recession; emerging markets such as China continue to drive global oil consumption. At the same time, non-OPEC supply is growing at a far slower pace, forcing Saudi Arabia to dip into its precious spare capacity.

The ongoing shale oil and gas revolution has led to a surge in NGL production. Nevertheless, this market has avoided the supply overhang that will continue to plague natural gas. US propane exports have reached record levels, while the abundance of ethane- a critical component in many plastics-has prompted domestic petrochemical operations to add capacity.

These developments on the demand side have ensured that NGL prices have remained relatively resilient.

Exploration and production in deepwater and other harsh environments—the final frontier for major oil finds—has continued apace. Between 2008 and 2010, operators announced an annual average of 23 discoveries in water depths of at least 4,500 feet, compared to 16 in 2002-2004 and four in 1996-1998.

The three main areas of deepwater development—the Deepwater Golden Triangle—are offshore Brazil, the Gulf of Mexico, and West Africa. Producers have announced a number of significant discoveries over the past 12 months, including major finds offshore Africa’s east coast. For example, Income Portfolio holding Eni (E) has made major oil and gas discoveries offshore Mozambique.

In late April 2012, SeaDrill (SDRL) announced that it secured a three-year fixture for one of its deepwater semi-submersible rigs for a potential day-rate of almost $650,000. The contract begins in the second quarter of 2013, and the rig will operate offshore West Africa.

Day rates earned by deepwater rigs last eclipsed $600,000 when deepwater exploration peaked in 2008. The willingness of producers to pay up to secure rigs in 2013 suggests that the supply-demand balance remains tight and the existing fleet can’t handle all of the impending deepwater work.

With one of the highest-quality fleets in the business and a dividend yield of almost 9%, SeaDrill rates a buy under $45.

Growth Portfolio holding Linn Energy (LINE) recently announced a 5% hike in its quarterly distribution to 72.5 cents per unit. The company has been on an acquisitions spree in recent months, paying BP (BP) $1.2 billion for gas-producing properties, including the Hugoton Basin. It also bought acreage in East Texas for $175 million and added acreage in the Granite Wash from Plains Exploration & Production (PXP) for $600 million in late 2011.

Although Linn Energy’s production mix and reserves are heavily weighted toward oil and NGLs, gas-focused acquisitions represent the firm’s best growth opportunities. Chesapeake Energy (CHK) and other US independents continue to monetize gas-focused acreage at bargain prices to support the migration toward liquids-rich plays.

Bottom line: Linn Energy can scoop up high-quality, gas-focused acreage at valuations that guarantee a solid rate of return even in the current environment. The long-term returns on these assets are even more compelling.

Linn Energy has fully hedged its natural gas exposure through 2017 and its oil exposure through 2015. Buy Linn Energy under $40.

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