Two Natural Gas Bargains

09/08/2008 12:00 am EST

Focus: STOCKS

Richard Band

Editor, Profitable Investing

Richard Band, editor of Profitable Investing, says falling energy prices have made some gas stocks attractive. 

It seemed unstoppable. But then, in a flash, on July 11th, the irresistible force met the immovable object. With rumors flying about an impending Israeli attack on Iran, West Texas light crude oil topped at an excruciating $147 a barrel, having doubled in the space of a year.

Since then, black gold has plunged 27%. Natural gas, which peaked a few days earlier, has plummeted even further, down [more than 40%] from its high.

What’s happening here? A shift in both supply and demand. On the supply side, oil companies have announced several large new discoveries in recent months.

Demand has also fallen off. America’s drivers have curtailed their consumption of gasoline for more than a year now. However, the real hit to global demand came from June onward, when China boosted retail prices for gasoline and diesel fuel by up to 18%.

[But] oil and natural gas prices won’t stay down indefinitely. Year after year, petroleum is becoming harder to find and more costly to extract. Investors will eventually stream back into companies with access to large and growing resources of this critical material.

Shares of natural gas producers have tumbled considerably more in recent weeks than
companies whose production consists mainly of oil. Thanks to the plunge, selected gas stocks now offer more potential than their oily rivals for capital gains. Two of my favorites are Chesapeake Energy (NYSE: CHK) and Questar (NYSE: STR).

Of the pair, CHK is the more aggressive pick. Chief executive officer Aubrey McLendon actively manages the company’s property portfolio, acquiring and divesting big chunks of acreage. He also locks in prices for much of CHK’s production by hedging in the futures market—a tactic that has generally worked well, but occasionally produces losses (as in the second quarter of 2008).

All in all, he’s building one of the fastest-growing gas producers in North America, at a rock-bottom multiple of only 10x estimated earnings for the next 12 months. Buy at $45 or less. (It closed above $44 Friday—Editor.)

Utah-based STR adheres to a more conservative business model. Besides drilling for gas, Questar operates a pipeline system and distributes the fuel to retail customers. These businesses steady the ship when gas prices are slumping. At better than a 30% discount off the July peak, the shares deliver exceptionally good value. Buy at $55 or less. (It closed below $48 Friday—Editor.)

I recommend limiting your overall oil and gas exposure to no more than 10% of your equity portfolio until we get a clear-cut bottom in energy prices.

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