Mr. Market is about to heal America’s collective amnesia.

Investors will once again remember why they were selling stocks last March, and they will also remember why they used to invest in natural gas.

Share prices have gained a lot of ground during the last few months, even though the economy has not. The major averages have rallied about 40%, but many stocks are up a whole lot more than that. Seventeen of the thirty-three stocks I have recommended to the subscribers have gained more than 50% since those March lows. Eight are up more than 100% and one is up more than 200%.

Robust rallies like these are not uncommon, even in the worst of markets. By now, you’ve probably read about how the stock market rallied 41% in early 1930 after the crash of 1929. Yet that rally fizzled and the stock market tumbled to even lower lows, and had years of hard slogging ahead of it.

I’m not saying this is 1930, but I would caution against overconfidence. Investors should be looking to hedge their bets after this recent rally… and should be looking for a margin of safety. I believe natural gas might be a great place to hide.

Natural gas is, simply put, super cheap. As most other commodities – including oil – have rallied, natural gas has remained stuck in the mud. In fact, the ratio of the price of crude oil to the price of natural gas topped 18-to-1 recently, which is a ratio we have not seen since 1990.

The spike in this ratio is due to two very simple facts: oil prices are rising, gas prices are not. The prices of these two energy sources tend to loosely track one another. But as the chart below illustrates, the prices of oil and natural gas have diverged dramatically during the last six months.

This trend has not been pleasant for natural gas producers, nor for the folks who have been investing in natural gas stocks. In this market, where nearly everything is rallying, the shares of most natural gas companies have been conspicuously sluggish. But the past is not necessarily prologue. I have not seen a better opportunity in many years to buy natural gas stocks.

Let me lay it all out for you before you click “delete” on this e-mail.

There are two reasons why natural gas prices are likely to rise from their current depressed level:

1. Natural gas exploration efforts are dropping rapidly, which will lead to a drop in supply.
2. Government initiatives will create significant new demand for natural gas.

Let’s begin by acknowledging that the price of natural gas fell because there was too much of it. We are in a recession, after all. Industrial demand for natural gas has fallen through the floor and into the basement. But the best cure for low prices is low prices.

Producers are cutting back, thereby reducing supplies. The rig count has collapsed. It has fallen much faster than in the 1981/82 collapse, the worst drop since the Great Depression, and one that still makes old-time natural gas men cringe to this day. Meanwhile, the decline rates on shale gas plays (which helped contribute so much gas to supply during the last few years) are 60-75% – meaning that the flow of gas from these wells will drop by this percentage in the first year.

Another point: The marginal cost to produce natural gas for the vast majority of natural gas companies is somewhere around $6-8 per thousand cubic feet (mcf).

Production costs are an important guide to natural gas prices, as the nearby chart illustrates. The natural gas price usually bounces off the “cash cost” of production. No producer makes money below cash costs. So supply drops. Conversely, when gas prices gravitate toward the marginal cost of production, supplies increase, thereby putting pressure on prices.

Right now, the spot price of natural gas is under $4 – sitting right on the industry’s cash costs, but well below marginal costs. In short, natural gas supply is going to start to dry up here really soon.

Meanwhile, the war on so-called greenhouse gases is officially under way. As this war progresses, clean fuels like natural gas will attract growing demand. Each passing month brings us closer to capping, taxing or cutting the gases thought to cause global warming.

I don’t think investors appreciate how far-reaching such efforts could be. And there will be definite winners and losers as a result. Some of these are far from obvious and some are in plain sight.

The first obvious big loser is American coal, from which we get half about of our electricity needs. Already, you see companies reacting to this news. Consol Energy, a big coal company, said it halted two big mines in Appalachia because of uncertainty over the costs of pending new regulations. If you own a U.S. coal miner, I’d fold the hand, so to speak.

Coal-fired power plants look like big losers, too. And the utility AEP, the biggest user of coal in North America, is looking to shutter some of its coal plants. It is also looking at how high rates would have to go to comply with possible rule changes. In some places, rates could rise as high as 50%. It is no sure thing that AEP could get such rate increases. Natural gas-fired plants, by contrast, may be one winner relative to coal. Natural gas, in general, looks to be a winner.

Beat the rush; buy your natural gas stocks now.

Source: To Do: Buy Natural Gas

We don’t have to like the changes underway, but we do have to respond to them intelligently if we hope to preserve and increase our wealth. The time has come for us “free market” aficionados to dry our tears and try to figure out what to do next.

The federal government’s attempts to reshape the U.S. economy will provide numerous profit opportunities. Take, for instance, the inevitable move toward taxing carbon emissions. Attaching a price to carbon dioxide would, obviously, increase utility bills (and the price of anything made with electricity). As a result, consumers of energy would try to avoid this taxation by utilizing cleaner sources of energy.

Right now, many natural gas-fired power plants are brought online only at times of peak demand, while coal is considered a “base load” fuel since it’s cheaper. But a carbon tax would raise the price of coal (and the extra carbon it emits) closer to the price of natural gas. So it’s seems likely that carbon taxes or any other “climate change” legislation that comes from the Obama Administration will favor natural gas-fired electricity at the expense of coal.

Assuming the political popularity of natural gas will keep growing, and that solar and wind power production cannot increase fast enough to be meaningful (even with heavy subsidies), it makes sense that natural gas-focused exploration and production (E&P) companies and their critical suppliers like National-Oilwell Varco (NYSE: NOV) will enjoy years of attractive growth opportunities. NOV has an attractive business selling brand-new, highly efficient rigs built for shale gas drilling.

At the moment, a glut of natural gas has produced a drop in number of drilling rigs operating in the U.S. This drop was already discounted by the crash in the oil service stocks last fall. But the faster the rig count falls, the faster the gas glut will dissipate as 2009 wears on. If demand for natural gas rebounds later in 2009, while supply is falling, then prices could move much higher in a short period of time. I’m going to keep monitoring the supply situation closely because I think it will yield several good trading opportunities this year. And the best way to get a handle on supply is to follow where and how the smartest companies are investing.

I recently tuned in to several Webcast presentations made at the BMO Capital Markets North American Unconventional Gas Conference. The larger presenters included Talisman Energy, Comstock Resources, Southwestern Energy, Ultra Petroleum, and Range Resources — several of the visionary early movers into shale gas drilling.

These companies employ cutting-edge technology in the natural gas industry. As a group, they delivered much of the production growth the U.S. has enjoyed in recent years. We can’t do without this shale growth. Keep in mind that virtually all new electric power plants brought online in recent years have been gas-fired plants.

Most of the premier shale gas plays (Barnett, Marcellus, Fayetteville, Haynesville, etc.) can be booked into reserves and brought online at cash costs between $2-4 per million cubic feet of gas. With natural gas prices currently at $5.50, the economics of adding to shale gas reserves and production makes sense. Even if they don’t immediately hook up newly drilled wells to gathering pipelines, most of these exploration-and-production companies will still want to drill at a fairly rapid clip to book new proved reserves in 2009.

The E&P industry, like most others, contains the “haves” and “have-nots.” The haves tend to be public companies with premium valuations that reflect their huge inventories of low-cost drilling opportunities. The have-nots tend to be private highly leveraged companies that hit the accelerator on any resource that looked economic in the high-price environment. Many of them are releasing low-end rigs and will not survive this downturn.

Ultra Petroleum is certainly at the top of the “haves” list. It controls tons of acreage in the obscenely profitable Jonah and Pinedale fields in Wyoming. Because its acreage is so cheap to develop, it can keep expending production very quickly, and incremental returns on invested capital are enormous.

The same goes for Range Resources. Range is a first mover and considered an expert in developing the Marcellus Shale. It looks to have locked up most of the highest-quality acreage in the Marcellus. The Marcellus is definitely promising, but it has different characteristics across its wide geography. Range has the most profitable gas wells because it has the most experience, expertise, and proprietary seismic data. At the BMO conference, Range estimated that its Marcellus wells have the potential to earn 20% internal rates of return at $4 natural gas.

The good news if you’re exposed to E&P or service stocks exposed to shale gas: The stocks have already crashed in anticipation of an ugly environment for natural gas pricing, production, and drilling in 2009 and 2010. If conditions stabilize, rather than continue collapsing, many of the stocks exposed to growth in shale gas drilling — including NOV — should regain plenty of lost ground.

The big concern with NOV recently was J.P. Morgan’s downgrade. I read J.P. Morgan’s report and agree with many of its points. But I disagree with its method of getting to a $31 price target for NOV (I think $31 is much too conservative). It gets to $31 through a discounted cash flow model in which it assumes 2009-2011 returns on invested capital will average 8%. This is down dramatically from the 2005-2008 average of 16% and equal to the 2002-2004 average of 8%. I have two issues with this:

1) Hardly any company was investing in rig equipment during 2002-2004. The upturn in day rates didn’t really gain traction until 2004. On the next up cycle, most of the world’s drilling fleet will be approaching 30 years of age. So many of the oldest rigs will be scrapped and there could be a shortage of newer, more productive rigs that NOV helps create.

2) J.P. Morgan gives no consideration to NOV’s greatly strengthened negotiating position relative to its customers, since it scooped up several competitors. It is a one-stop shop for equipment and consumables for every E&P and drilling company worldwide. It can afford to take advantage of this down cycle with more cheap acquisitions. Such moves won’t dilute shareholder value — thanks to its strong balance sheet and cash flow.

3) J.P. Morgan gives no credit to NOV for its excellent integration of Grant Prideco — a company with very attractive growth prospects (considering that its product lines are levered to the strongest trends in oil and gas production, including stronger drill bits and better drill pipe).

So J.P. Morgan reflects the bear case on NOV, yet it still gets to a $31 price target.

J.P. Morgan’s target implies that NOV should trade at 3 times its estimated 2009 EBITDA, in line with the offshore drillers. In my view, NOV deserves to trade at more than twice the EBITDA multiple of the drillers, since it’s a far less capital-intensive business model. NOV will not be generating losses during this downturn, nor will it be forced to spend a lot on maintenance capital expenditures (as drillers must, depending on the age and shape of their fleet).

I expect the market to come around to this view when NOV reports earnings in early February. Sure, the segments of NOV’s business that are the most sensitive to the rig count will slow in 2009, but the stock market excessively discounted this slowdown when it hammered the NOV share price from its crash from $92 last July to $18 in November.

At the current quote of $25.62, NOV is a very cheap stock that could easily rebound to the mid-$30s in the coming months. I think the trend for NOV will be up over the next month or two as the market anticipates that 2009 and 2010 earnings will not be as bad as previously expected.

Source: Investing for Comrades, 101