(By Mani) US gas prices have nearly doubled from $1.90/mcf in April, the lowest in 12 years, due to low demand caused by an unusually warm winter and increased production from horizontal drilling and hydraulic fracturing.
These factors depressed US gas prices to unsustainable levels and, despite expectations that prices would rise over time with the usual volatility exacerbated by speculation.
"We expect 2013 Henry Hub spot natural gas prices to remain in the $3-$4/mcf range next year. Prices above $4.50/mcf or below $2.50/mcf are unsustainable, in our view," Oppenheimer analyst Fadel Gheit wrote in a note to clients.
The EIA's most recent forecast suggests the US average annual natural gas price is likely to remain below $5/mcf in the next three years and unlikely to reach $6/mcf before 2018. In addition, the winter weather remains key to gas prices.
Meanwhile, most gas stocks have outperformed oil stocks this year as investors are expecting a pullback in oil prices and continued surge in natural gas prices.
"We believe the current valuations of many gas stocks, based on 2013 consensus estimates, are discounting higher gas prices, which we think unlikely, even with a normal winter. A pullback in gas prices by spring could result in a sharp correction in gas stocks," the analyst noted.
Low gas prices forced the industry to shift drilling activity away from dry gas plays to oil and liquids-rich plays. However, a rise in gas prices could accelerate gas drilling, increase supply and cool off prices.
However, the US gas price discount to oil will remain significantly above historical levels. Oil stocks are discounting lower oil prices and gas stocks are discounting higher gas prices.
"We think the industry should adopt a more realistic conversion ratio for production and reserves than the 6-to-1 energy equivalent, which does not reflect true market values," Gheit said.
"We think, but even assuming a 20% pullback in oil prices and a 40% increase in US natural gas prices in the next 12 months, most oil investments would still be generating superior returns compared with gas investments. A pullback in oil prices could initially sink both oil and gas stocks," Gheit added.
Chesapeake Energy Corp. (NYSE: CHK) and Devon Energy Corp. (NYSE: DVN) are two stocks that are attractively valued in this scenario.
Chesapeake Energy is currently trading at 3.7 times 2013 consensus cash flow estimates, a 20 percent discount to the large-cap E&P average. The stock also has an implied reserve value (adjusted for 15:1 oil-gas ratio) of about $21.25/boe, a 22 percent discount to the group average of $27.35.
"We expect liquids production growth of 45% this year and 33% next year, including oil volume growth of 72% and 26%," the analyst wrote.
Meanwhile, natural gas share of production is expected to decline from 80 percent in 2012 to 74 percent in 2013. Chesapeake maintains the No. 1 or No. 2 leasehold position in ten of the top US unconventional plays (three gas plays and seven liquids plays).
The company is in the process of closing $6.9 billion recently announced asset sales. Year-to-date, it has announced $11.6 billion sales out of a planned $13 billion to $14 billion, more than offsetting an expected funding gap of $10 billion.
Chesapeake should also generate enough cash this year to bring total debt down to $9.5 billion from $14.3 billion as on June 30.
On the other hand, Devon has one of the lowest implied reserve values (adjusted for 15:1 oil-gas ratio) in the industry at approximately $14.25/boe, a 48% discount to the group average. The company trades in line with the large-cap E&P peer group on both P/E (13.1 times) and P/CF (4.5 times), based on 2013 consensus estimates.
"We expect liquids production growth of 31% this year and 34% next year. This growth will largely come from Canadian oil sands (Jackfish) and US liquids-rich plays (Permian, Cana-Woodford).
The company has over $6 billion cash balance overseas, mainly proceeds from its offshore and international operations in the last two years, which are awaiting more certainty around repatriation taxes. That cash could ultimately be used to fund share repurchases, accretive acquisitions, or accelerated spending in the company's liquids-rich plays.
"We believe repatriating the $6B offshore to fund growth investments and a buyback program could significantly boost the stock's performance," Gheit said.
Meanwhile, Devon recently completed two joint ventures ($2.2 billion with Sinopec and $1.4 billion with Sumitomo) in new venture plays, enabling the company to monetize its acreage partially and reduce capital commitments, while still participating in significant upside on prospective liquids-rich plays.