Profit from the Commodity That Hasn't Surged...Yet

David Sterman's picture

Wednesday, April 28, 2010 - 5:32pm

by David Sterman

The natural gas industry seems to only know extremes. A few years ago, supply trailed demand, leading to a sharp spikes in prices. But then geologists realized that we’re sitting on a lot more of the energy source than we could ever have imagined. Suddenly new wells were being dug at a furious pace, and with supply ramping up, natural gas prices plunged. And that’s where they stand today.

A case can be made that the period of extremes will soon end. Low prices have led many producers to throttle back production. And as the U.S. economy rebounds, demand should resume, creating a nice balance between supply and consumption. That could create the Goldilocks scenario that the industry has long pined for. Prices high enough to make money, but not so high that they force power plants to switch back to cheaper coal.

As natural gas moves into favor, investors should gravitate towards Southwestern Energy (NYSE: SWN). Unlike most natural gas producers, the company has largely declined to hedge its business by selling off future output at agreed-upon above-market prices. This mostly unhedged position (14% of 2010 output is spoken for) would enable Southwestern to capture the full price increase in natural gas that some investors expect.

This may seem to be a curious time to be talking about natural gas. The winter season has just ended, and demand is at a seasonal low. But we’re also only months away from the peak summer season, when electricity usage sharply climbs to support all of those air conditioners. And as noted above, economic growth is starting to build again, which should stimulate demand for natural gas from the moribund industrial sector. A third potential catalyst: hurricane season begins in about a month. Every few years, a hurricane knocks out some industry production capacity, sending natural gas prices northward.

Make no mistake, Southwestern Energy will need to see at least a moderate rise in prices to fulfill its potential. If prices stay flat or fall, management will likely need to throttle back production plans to make sure that capital spending doesn’t exceed cash flow. Right now, the market anticipates that pricing will indeed firm up. Natural gas prices for current delivery trade at $4.22 per thousand cubic feet. But futures contracts indicate a price rise to $5.48 by year-end, and to $6.17 by the end of 2011.

If that forward price curve stays in place, Southwestern Energy looks set to generate considerable cash flow in 2011 and 2012. The company has been digging hundreds of new wells in the Fayetteville, Ark., region, known as the Fayetteville Shale. That should lead to a +39% jump in production this year, and another +33% spike in output next year. (Southwestern Energy is expected to release quarterly results on Friday, so those numbers may be modestly adjusted).

Analysts tend to multiply projected gas prices by projected output, and then subtract projected expenses to arrive at a forecast for cash flow. Based on the current price curve and Southwestern’s stated output plans, the company is expected to generate around $1.7 billion in cash flow this year, $2.5 billion in 2011 and $3.1 billion in 2012. Against that backdrop, shares trade at a sharp discount to their historical average. During the past ten years, which has seen all phases of the boom-and-bust cycle, shares have typically traded for 8.6 times next year’s cash flow. Now, they trade for just 6.1 times projected 2011 cash flow. If shares can climb back to that average multiple, then they possess +45% upside from current levels.

Of course, if natural gas prices remain stuck at depressed levels, the company won’t meet those cash flow targets. Then again, if demand finally catches up with supply and prices rise north of $7 per thousand cubic feet, then Southwestern’s cash flow generation would exceed even the most bullish forecasts. With its relative lack of hedging of output at current lower prices, these shares could quickly become an investor favorite.

David Sterman does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.