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Citigroup Finds a Hitch in the Shale Trade

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Few expected that a shale drilling boom could push natural gas prices to near decade lows at $2 per million BTUs. But even fewer anticipated its quick 50%-plus rise from 2012 lows and investors now need to prepare for an impact on industrials and agricultural stocks, according to a Monday note from Citigroup.

Rising natural gas prices above $3.25 on the heels of a near 20% jump in the commodity's prices in September may provide a dent to the fourth quarter earnings of agricultural and industrials giants like CF Industries (NYSE:CF), Eastman Chemical (NYSE:EMN), Dow Chemicals (NYSE:DOW), LyondellBasell (NYSE:LYB), and Agrium (NYSE:AGU), according to Citigroup.

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The sudden surge in commodity prices may signal an end to decade low natural gas prices hit in early 2012 on a glut of supply from the explosion of shale drilling -- cutting at the margins of producers who use gas as a key input -- and denting fourth quarter earnings by between roughly 5% and 10%, Citigroup calculates.

Current natural prices at $3.35 are roughly 25% above Citigroup's year-end forecast for the commodity and in-line with 2013 estimates, causing analyst P.J. Juvekar to reduce fourth quarter earnings estimates and forecast that the tailwind on operating margins may be closer to an end than some expect.

"A sustained increase in natural gas prices could be a risk to earnings in 4Q, and possibly beyond," writes Juvekar, in a Monday note to clients. "The companies most impacted in our universe are nitrogen fertilizer and commodity chemical companies, in particular CF, EMN, DOW, and LYB," he adds, in a note cutting the fourth quarter EPS estimates of nitrogen producers like CF Industries and Agrium by 11% and by 5% on ethylene producers like Dow Chemical and LyondellBasell.

In spite of the recent commodity price rise, many notable industrials investors continue to preach the positive earnings impact of low gas prices and vast US shale supplies.

Earlier in October, hedge fund giant Jana Partners said it is counting sustained low natural gas prices and the benefits of a shale drilling boom to be a key piece of its $500 million-plus investment in Calgary-based Agrium, and its push for agricultural conglomerate to unlock share value by splitting its retail business from a much larger wholesale business.

Jana Partners calculates that the benefits of low natural gas prices and a breakup of Agrium could unlock a $50 per share upside in the company.

Doubling down on an investment thesis laid out in August, Jana chief executive Barry Rosenstein said on Oct. 1 he will continue to push for a wholesale and retail unit split, noting that a shale drilling boom has significantly lowered the input costs for Agrium's nitrogen and fertilizer businesses on the wholesale side of the operations.

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The hedge fund investor said Agrium's retail business could be worth $15 to $20 per share independently and that, in total, Agrium may be undervalued by $50 per share as a result of its conglomerate structure.

Still, while Jukevar of Citigroup is shooting off an early fourth quarter warning on the earnings of key gas users, the analyst isn't ready to call the end to the benefits of low gas prices or a shale drilling boom on top agricultural and chemical producers.

"Taking a step back, nitrogen producers are in a far better position today despite this very recent rally in natural gas thanks to the 'shale supremacy'... If higher gas costs are sustained, there could be some modest margin pressure starting in 4Q, but this does not alter our positive view on nitrogen ahead of another ~95mm acre corn planting in the US in 2013," writes Juvekar.

In spite of the fourth quarter EPS revision, Citigroup remains a buyer of Dow Chemicals and LyondellBasell, and highlights Agrium as a top pick in the agricultural sector as a result of the farm-related income the company earns from its retail business.

Citigroup's Monday analysis on the impact of a sudden rise in natural gas dents the expected impact of a shale boom as an earnings tailwind, but it isn't enough yet to cut against the thesis of hedge funds like Jana Partners or the optimism that investors have on the industrials sector, generally.

Nevertheless, investors should continue to watch natural gas prices as a read-through on industrial earnings and not just on the share prices of oil and gas producers like Chesapeake Energy (NYSE:CHK), who need rising prices to help fill waning finances.

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