This bear market has pushed the price of many good stocks to bargain-basement levels. In my view, the stock prices of many oil and natural gas exploration and production (E&P) companies are irrationally low. Many are valued like they are depleting assets (like energy trusts or master limited partnerships), when, in fact, they are growth companies.

Many of them have been expanding gas production too quickly until recently, because they were accessing outside capital in the form of debt. But ever since natural gas prices tanked, most have announced that they will “spend within cash flow,” or limit drilling activity to reinvesting the cash flow that they generate.

I’ve spent a lot of time in recent weeks reviewing E&P capital spending plans, and I think the market is underestimating just how quickly U.S. natural gas inventories could contract, given the recent collapse in drilling activity.

The Jan. 23 natural gas inventory report from the EIA revealed a 176 billion cubic foot inventory draw despite severely depressed industrial demand.

E&P companies were financing new drilling projects with debt in 2007 and early 2008, but it did not lead to an inventory glut. This reflects just how intensely the industry needs to drill to meet demand. Now that debt-financed projects are a thing of the past, we can expect to see a significant negative supply response.

For the most part, the E&P industry in the U.S. is very disciplined — perhaps more so than OPEC. E&P companies are responding to the lower natural gas price by slashing drilling and well completion activity in this depressed gas price environment. At $4.50 per thousand cubic feet, the spot price of gas is below marginal cost for most producing fields.

At today’s low prices, it makes economic sense for E&P companies to defer new projects. The U.S. natural gas supply originates from thousands of wells scattered all over the country.

Decline rates of these wells are very steep. Consider that most new production comes from shale plays — where production can decline 70% in the first year after well completion.

So low natural gas production should balance the market later in 2009 — prompting a rebound in natural gas prices. E&P stocks should rebound even faster than gas prices, since they are already discounting years of unattractive prices.

Regards,
Dan Amoss

January 30, 2009

Dan Amoss

Dan Amoss, CFA, joined Agora Financial from Investment Counselors of Maryland, investment adviser for one of the top small-cap value mutual funds over the past 15 years. As a buy-side analyst, Dan refined his value investing approach by meeting with corporate executives and sell-side analysts and writing proprietary research for the fund’s management team. Dan is the editor of Strategic Short Report.

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