Time to Play the Natural Gas Rally?

Natural gas can be the most mercurial of commodities, believe me.  In the 20 years I’ve watched it trade, it can be the most difficult to understand and predict.  Weather always plays a huge role in its pricing, but never when we think it should – sometimes the commodity will rally as it obsesses about a cold winter or hot summer coming, sometimes it ignores it when it actually comes.

But baby, it’s cold outside – right now – and natural gas is ramping.  Is this a rally I should trust and jump onto or is this just another of the many head fakes from a commodity that’s famous for them?  

Or is there another way to play it entirely?  I think there is.  

In the last three years, natural gas producers have obviously had a helluva time – gluts from undisciplined, rampant and frankly stupid fracking leases unleashed an overflow of natural gas that cratered the price.  Prices in fact went lower than $2/mcf in the spring of 2012 and dropped a bomb on the share prices of the dedicated natural gas producers, which caused a whirlwind in their boardrooms.  

What emerged from most of those company CEO’s was a new plan to shift production, shutter down or slow the leases that were producing almost all dry gas (sometimes difficult or impossible to do) and to increase development of leases that had at least 30% or more of liquid gas production (an equally slow process).  In addition, and to the degree it could, many CEO’s chose to sell or enter into JV’s of dry gas assets to raise money to commit to new shale assets producing oil.   Think of Devon (DVN) and Chesapeake (CHK), to name two of the largest who continue to pursue oil and liquids and forsake dry gas – or at least that’s what they planned.  

But what of the natural gas dowagers?  What about the companies that have ‘kept to their knitting’ and instead of refocusing their production towards liquids, used their time to focus on assets that were returning higher rates of dry gas per well, or cost less to frack, or were developing improving rates of scale and consistently dropping margins – what about them?

Some of these ‘dowagers’ were recognized for their consistency and discipline – like Cabot (COG) and EQT Corp (EQT).  Shares of these Marcellus producers shot up in 2013, despite a flat natural gas price for most of the year.  But let me give you one that hasn’t yet – Southwestern (SWN).  

Listen to the conference calls for Southwestern and you can’t help but be as impressed with this massive natural gas producer as with any other – their margins have improved so mightily in the past two years that this is a profitable company at $3 gas, never mind the $5 we’re about to breach.  So why has SWN been mostly dead money in 2013, barely moving out of its $36-40 range?  Is it their notorious and overwhelming presence in the Fayetteville?  While this play has lost much of its ‘heat’ in the past two years, SWN has been continuing to work it, with return rates as impressive as any in the ‘hot’ Marcellus.  And SWN is committed to increase its percentage production in 2014 in the Marcellus, adding $800m of capital for development there.  Production was up 17% in the 4Q of 2013 and projected to increase another 14% in 2014.  

This is a value play that, even with the Stearne Agee upgrade pushing shares higher, I want to be in.  It’s a company that can withstand the fickle natural gas price, certain to test $4 again before it remains sustainable at $5.  It’s sporting a share price that hasn’t yet had it’s 50% run.  But I think it can.

Southwestern:  recommended at $42.