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Resist Temptation With Shale Gas Stocks

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Be patient until there are market conditions that promise stable profits.

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Investors are always logically tempted to pour money into fast-growing, innovative economic sectors – like railroads in the 19th century and the Internet in the late 20th century. As these examples show, the temptation should often be resisted. Too many companies charge into the new perceived Klondike, and a few decades need to pass before market conditions that promise stable profit to the survivors gel.

The game is afoot again in a smaller way these days with shale gas, which everyone from President Obama to ExxonMobil Corp. (NYSE:XOM) is promising us will transform America's economic future for the better.

US natural gas prices have doubled since the epic low they hit a year ago, and they have been rising more or less steadily since October. Shares of companies drilling for shale have lately followed suit. Chesapeake Energy Corp. (NYSE:CHK) has jumped 28% since the start of 2013. Cheniere Energy (NYSEAMEX:LNG), the only company so far approved to export gas in liquid form, is up 23%. Southwestern Energy (NYSE:SWN) and Pioneer Natural Resources (NYSE:PXD), two stalwarts of the first big shale discoveries in Texas and Louisiana, have gained 13% and 19%, respectively.

Should investors jump on the shale train as it gathers momentum? Probably not. These stocks are priced for ferocious growth. Chesapeake sports a trailing price-earnings ratio of 44, Pioneer's is 35, and Southwestern Energy's is 27. That compares to an average of around 8 for Big Oil equities. Cheniere lost money last year, so it has no earnings to measure against its stock price.

The natural gas sector is running out of the growth needed to support these multiples, at least in the short term. US gas production did indeed spurt over the past two years, increasing by 7.4% in in 2011 and another 5.2% in 2012, according to the government's Energy Information Agency (EIA). The result was a catastrophic price crash. The Henry Hub benchmark fell below $1.90 per million British Thermal Units (MMBTU) last April, down from $4.80 18 months earlier.

Henry Hub prices are back up around $3.60 now, but the means have been slamming the breaks on production. US gas output will creep up just 0.7% this year and flatline in 2014, the EIA projects. The Barnett gas shale in Texas has already passed one cycle from boomtown to ghost town: It had 200 working rigs in 2008, and has just two dozen now. Production at the Marcellus Shale that stretches across Pennsylvania, West Virginia, Ohio and New York continues to grow because of its access to dense Northeastern markets. But that economically lucky location also brings political controversy.

US natural gas consumption will also plateau over the next few years, EIA predicts, leaving the market in a state of structural glut. The gas price where it makes sense to bring extra production back on line is around $4.00, says Lou Gagliardi, an economist writing on industry blog Energy Trends Insider. That means if the price creeps that high, idle wells at Barnett and elsewhere will start pumping again, and knock it back down.

The industry's yellow brick road out of this dark forest is export. More than a dozen competitors are waiting in line behind Cheniere for federal government approval to build liquefied natural gas ports and ship US shale across the globe. The trade seems irresistible on its face. Current gas prices in Europe are above $10 per MMBTU. In Japan and Korea, that figure is about $15.

But the outlook for LNG export is cloudy both politically and economically. Gas-consuming industries like utilities and chemicals are marching on Washington, arguing (probably speciously) that captive cheap gas is necessary to spur a US "manufacturing renaissance." Ron Wyden, the Oregon Democrat who chairs the Senate Energy Committee, lent them a sympathetic ear at a hearing last month, calling a pro-export study commissioned by the Department of Energy "flawed."

Even if natural gas exports proceed unchecked, the economics look shaky. The rest of the world, from Algeria to China, is ramping up its own shale gas exploration, which will inevitably increase supply and slash the intercontinental price differential. And building LNG facilities is a dauntingly expensive enterprise, demanding assured payback for decades afterwards.

The chief executive of Norway's Statoil (NYSE:STO), a person who knows something about world gas markets, said he would have to be assured of a $4-$5 per MMBTU US price advantage for the next 20-30 years before investing in gas export from America. The Energy Department Study, commissioned from New York-based NERA Economic Consulting, also poured cold water on the economics of foreign LNG sales. "NERA found that the US would only be able to market LNG successfully with higher global demand or lower US costs of production than [currently assumed]," the report states.

President Obama recently proclaimed that reserves of shale gas would last our country for 100 years. At some point during that period, producers will probably start making reliable money off the fuel. For now, it is best to avoid their growing pains.
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No positions in stocks mentioned.

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