My Best Pick 2013

The long shot

It's time to look beyond Indian shores and invest in US gas stocks, which are quoting cheap

Although Indian stocks account for only 2.5% of global market value of equity, Indians tend to concentrate their holdings in India. This “home bias”, where people prefer to invest nearer home than abroad, is a universal phenomenon: Americans prefer US stocks, Europeans concentrate their portfolios in European stocks, Japanese concentrate in Japanese stocks and so on. In unfamiliar situations, the predominant emotion is fear. Foreign stocks are less familiar than Indian stocks, hence the home bias. Currently, Indians can invest abroad to the tune of $200,000 every year, but this bias keeps them away from investing in good value stocks globally. Once you break the bias, several new opportunities open up. I have a firm conviction in the future of the US natural gas sector and the US companies available at attractive valuations.

It is not a matter of “if” but “when” natural gas prices will spike in the US. Most commodities have rebounded handsomely from the lows seen in 2008. However, the price of natural gas is down significantly since the highs of 2008. Natural gas was trading at a high of $10.79 in July 2008 and since then it has fallen to a low of $1.89 in April 2012. The drop is because demand is yet to catch up with a relatively fast ramp-up in natural gas supplies in the US.

The increase in supply is due to widespread use of fracking (hydraulic fracturing), the procedure of creating fractures in rocks and rock formations by injecting fluid into cracks to force them further open. The larger fissures allow more oil and gas to flow out of the formation and into the wellbore, from where it can be extracted. Fracking as a technology has changed the US’ fortunes. Some years back it used to be a major importer and now it has the potential to become an exporter of natural gas. Shale gas production accounts for 25% of the total natural gas production in the US. 

There is a wide disparity in natural gas prices globally, from $3.5 per mcf in the US to $17 in Japan and $15 in Asia. This variation cannot last forever and natural gas prices in the US is bound to revert and (at least, partially) converge with global prices over a period of time. The reason for the sharp variation in prices across regions is that it is not easy to transport gas between locations, especially when the distances are large and oceans are to be crossed. Gas can be transported by pipelines over land at a reasonable cost. However, to transport gas from, for instance, the US to Asia would be very costly as it would have to be brought to a port, liquefied, transported in LNG carriers and again re-gasified for consumption.

However, this doesn’t mean convergence will not take place. The economics of consuming natural gas in the US versus consuming oil-based energy are compelling. Natural gas at $3.5 per mcf is roughly the equivalent of $21 per barrel of crude oil. So effectively, one can substitute natural gas for oil at 25% of the price in the current scenario. At these prices it is very attractive to produce power, petrochems and fertilisers from natural gas rather than from other alternatives or at other locations. 

There is no doubt that natural gas is the cleanest and most efficient fossil fuel. It emits upto 60% less carbon dioxide than coal, which is used for electricity generation. The US is estimated to have at least 100 years worth of supply, given huge shale gas reserves as well as the new horizontal drilling technology.

But gas production from a shale well decreases dramatically compared with traditional gas reserves. Also, rising environment concerns about the risk posed by hydraulic fracturing, which can pollute air and water, will see regulators introducing strict rules governing shale gas discovery.

Hence, supply will take a downturn while the demand is expected to go up due to more usage of gas for electricity generation, petrochemicals and fertilisers and as a fuel for transportation. With the supply-demand gap decreasing, the price of natural gas will start moving up. Also, energy companies in the US have shifted their focus from gas to oil fields due to low gas prices -- the number of rigs drilling for gas has fallen this year by almost half. Therefore, supply has been decreasing over the past six months and gas prices have almost doubled from $1.89 to around $3.80 currently.

Make it three

So, which stocks in the natural gas space are strong bets? Take a look at these three.

Chesapeake Energy is the second-largest producer of natural gas in the US. It produces around 3,000 Mmcf/day, up by around 20% from last year, and has an output mix comprising 78% natural gas, 6% oil and 16% natural gas liquids. The company is trading around $16, given the relatively lower gas prices and controversies surrounding its CEO Aubrey McClendon. With Chesapeake trading below book value (0.88 times) currently, any reversal in natural gas prices will give good returns to its investors.

Another stock is Devon Energy, which is trading at just about book value. It is a Fortune 500 company with operations concentrated in the US and Canada. Devon Energy produces approximately 2,600 Mmcf/day of natural gas and controls 75% of Barnett Shale’s production, which is the second-largest onshore gas field in the US. Devon Energy could be a very safe company to bet on, considering the low debt levels (D/E ratio of 0.4 times) as well as mix of oil and gas in its reserves. The company also has $7.5 billion in cash.

The third is Cabot Oil & Gas Corporation, which, unlike other energy companies that have shifted focus to oil, has consistently explored and is still exploring reserves for natural gas. When gas prices start rising, it will be among the first companies to benefit and give good returns to investors. Cabot’s huge position in Pennsylvania Marcellus, as well as other assets such as Utica, Eagle Ford, Anadarko and so on, suggests potential production growth over the coming years. The company’s conservative management and cost discipline will also help in achieving profitable production growth.  

Taking a call

It is better to take a diversified investment approach rather than buy just one stock. The other point to note is that it is impossible to predict the direction of dollar-rupee movements. One way to approach this is to look at the dollar exposure as a measure of diversification from India-specific risk and leave it unhedged. If, however, an investor is looking at only rupee-denominated returns, hedging the dollar exposure provides an additional income source (approx 5-6% per annum), apart from the underlying dividends and capital appreciation. This is because the rupee always trades at a discount in the forward and futures market. Hence, as on date, when you buy a dollar for 54.35, you can, at the same time,  sell one-year futures on dollars on the NSE/MCX SX for 56.95, giving an annual return of about 5%. By doing this, an investor can avoid forex risk and generate some income.

Lastly, investors should look to hold these investments for at least three years and expect an approximate annual return in excess of 15% per annum.