Playing the Rise in Natural Gas

06/12/2008 12:00 am EST

Focus: COMMODITIES

Jon Markman

Editor, Trader's Advantage

Jon Markman, editor of Strategic Advantage, sees natural gas prices continuing to rise and he recommends one stock that should move up as well.

What's behind the latest advance [in natural gas]? Well, I heard a rumor that one reason for the continued gains is that the earthquake in southern China knocked out a lot of that country's gas production and transmission capacity.

I haven't seen any mainstream news reports to this effect, but I was told that a lot of liquefied natural gas (LNG) that would have normally gone to Europe or the United States has been diverted to southern China instead. These sources also suggest that natural gas has the potential to go to $22 over the next year, as there is some belief among traders that it has the potential to trade at 17% of the value of crude oil. (Crude closed above $136 a barrel Wednesday—Editor.)

The most important issue now for natural gas prices is the upcoming hurricane season in the Gulf of Mexico, as supply disruptions tend to have a powerful upward effect on prices. We can put just about zero credence in multi-month forecasting, but the last two summers have been much quieter than normal in the Gulf, so it would make some sense from a mean-reversion point of view that a meaner season may be due.

GeoMet (Nasdaq: GMET), based in Houston, is focused on the development and production of "unconventional" gas. GeoMet focuses on the gas found in coal seams, which usually goes by the term coalbed methane. Most of its properties are in the Cahaba Basin of Alabama and in the Central Appalachian Basin area of West Virginia and Virginia. It also controls coalbed methane property rights in British Columbia, Louisiana and Colorado, with proved reserves somewhere north of 350 billion cubic feet.

The company points out that its technical staff has extensive expertise on five major large-scale coalbed projects over the past two decades. And coalbed methane production is considered to be much lower risk than other methods of exploration, since it follows in the well-established footsteps of coal miners, and can use all of their geological data. As a result even a small company like this has hundreds of drilling opportunities in places where they are extremely likely to have positive results.

Insiders at GeoMet have been buying the stock repeatedly over the past two years as it has moved up at prices ranging from $5 to $7. With shares now [above $9.00], I think they're still fairly characterized as cheap. If the company earns 35 cents per share in 2008 and 45 cents in 2009, as I suspect, then its forward price/earnings multiple is just 19x despite growth north of 25%.

My guess is that shares should move back toward the $11 level over the next nine months so long as commodity price and company production levels stay on track.

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