Betting on the Boom in Natural Gas

Stan Luxenberg - The Street  JAN 02, 2013 2:05 PM

Some fund managers think these stocks will soar as demand grows.

 


The price of natural gas has collapsed, falling from more than $13 per million British thermal units in 2008 to $3.43 now. The decline sliced the profit margins of gas producers and caused the stocks to languish.

Now some managers of value mutual funds have become intrigued. Funds that have been buying gas shares include Croft Value (MUTF:CLVFX) and Schwartz Value (MUTF:RCMFX).

The bulls say that gas prices have started to rise in recent months and more gains are likely. But even the optimists concede that it will take time for prices to recover fully. "I don't know what prices will be in one year, but five years from now we will be happy that we bought these stocks," says Kent Croft, portfolio manager of Croft Value.

Don't expect to see a crowd of funds rushing to the gas stocks any time soon. Not many fund managers are willing to wait several years for stocks to climb. But Croft is unusually patient, keeping his average holding for more than five years. The low-turnover strategy has worked. During the past ten years, the fund has returned 9.1% annually, outdoing 96% of large blend funds, according to Morningstar.

The gas stocks suit Croft's taste because the industry's long-term future looks so much brighter than the present situation. He says that gas prices sank because of dramatic shifts in supply and demand. During the financial crisis, demand sank as manufacturers and utilities burned less gas. At the same time, supplies spurted as new fracking technologies enabled producers to deliver more gas.

Croft says demand will grow substantially in coming years. Because gas causes less pollution and is cheaper than oil, chemical manufacturers are building new gas-fired plants. Power companies are shifting from coal to gas.

Gas could also become more popular as cheap fuel for vehicles. Already 15% of the country's municipal fleets of buses and trash collection trucks have engines that can run on gas. Commercial vehicles have been slow to shift because few service stations provide natural gas. But now several gas companies have decided to invest hundreds of millions of dollars to provide natural gas fuel stations at truck stops.

Exports could provide a big new source of demand. Up until now, not much gas has been shipped abroad because the supplies must first be converted to liquefied natural gas, a process that requires expensive infrastructure. Now companies are racing to build LNG facilities that could serve growing markets in Japan and Europe. A new plant in Canada should begin shipping supplies to Asian customers in 2015, and eight projects in the US are currently seeking government approvals. Croft's holdings include Ultra Petroleum (NYSE:UPL), which produces gas in the rich Marcellus Shale field of Pennsylvania. The company is a low-cost producer, an important advantage in the current environment. "Natural gas producers are not making a lot of money now, but the most efficient companies can remain profitable at low prices," says Croft.

Croft also likes Williams (NYSEAMEX:WMCO), which operates natural gas pipelines that serve New York City and other areas. Williams charges producers for shipping through the pipelines. Croft says that the volume shipped will increase as demand for gas grows. "The more gas that moves through the pipelines, the more Williams makes," says Croft.

Tim Schwartz, portfolio manager of Schwartz Value, looks for out-of-favor companies with little debt and healthy profits. During the past 10 years, the fund returned 6.8% annually, outdoing 66% of large blend peers.

Schwartz says gas supplies have been declining in recent months as companies cut back unprofitable production. That will help to boost prices. A producer Schwartz likes is Southwestern Energy (NYSE:SWN). "They have a history of profitability and very attractive assets around the country," he says.

A cautious way to bet on a gas revival is Hennessy Gas Utility Index (MUTF:GASFX). The fund holds mostly regulated utilities that deliver gas to customers. While the companies can record higher revenues as demand for gas grows, profits are limited by regulators.

During the past three years, the fund returned 15.2% annually as investors raced to buy utilities stocks with reliable dividends. Skip Aylesworth, the Hennessy portfolio manager, cautions investors not to expect huge returns in the future. "With a utilities fund, you should be pleased to get annual returns in the range of 6% to 8%," he says.