Natural Gas Suppliers to Benefit from Rising Prices?

I was worried about rising natural gas prices for companies that make products trying to unseat oil’s dominant position, but the flip side of that is the benefit to the suppliers. One of the great things about investing is that a problem in one place can mean opportunity in another. The companies could only go for the easiest, aka cheapest, gas available. If the natural gas price trend continues upward it can finally lead some companies much higher.

The extended environment of low prices has meant that these companies have had to operate lean. Squeezing out savings in costs whenever possible. When prices increase the companies see an amplified benefit. Natural gas companies have to be far more judicious in their spending, and that experience could work to their benefit in a better price environment.

Hard luck giant

I have a tendency to like down and out companies the best. Even ones that are pretty far gone get my attention. I like to look at them, though I do not uniformly see the good in them. The potential is enticing. Chesapeake Energy (NYSE: CHK) has a new CEO, and one really terrible quarter in 2012 that makes the numbers look worse than they are. Considering the issues surrounding the previous CEO and his departing the company, there might be some concern that the new CEO is not from outside the company. However, the bright side is that the new CEO, being the former COO, understands the operations of the company.

Natural gas production accounts for 70% of the company’s total production. The other 30% is called liquids production and consists of oil, two-thirds, and natural gas liquids, one third. Natural gas liquids are components that are absorbed into the gas like propane, butane, etc. It is economic to extract those and sell them. Despite, liquids being 30% of the overall production it is 62% of the revenue for 4Q2012.

Rising prices should re-balance those numbers, but by just increasing one side not by redistributing the revenue. The balance is likely to improve as natural gas brings in more money to the company. Also, once the price gets high enough Chesapeake can increase production, which means the company can make more money per unit and produce more units of gas by extracting more expensive gas.

A lot of the profit from the previous quarter came due to oil. Oil is still going to be the key product for the company in 2013 as the price of natural gas is not expected to rise too much. However, there are a lot of forces over the next 2-3 years that could put upward pressures on natural gas, and these will continue as natural gas becomes increasingly important. A lot of factories producing LNG and CNG are expected to come online by 2015, and there are potential developments on the political front as well.

This overarching factors will work in Chesapeake’s favor, and oil will keep the company growing in 2013. Oil is likely to be responsible for 51% of revenue for 2013 according to the company. A patient investor has the chance to invest in the long game that is natural gas, and you can collect a very modest 1.7% dividend yield in the mean time.

Unraveling the fear

Linn Energy (Nasdaq: LINE) has mostly recovered from its fall down to $36 and is now in the mid-$38s. However, it is lower than when I first started looking at it where it was above $40. There were some murmurs of accounting problems a few months ago that brought the stock down. It was not a huge decline considering the high dividend and the lack of substantive evidence. Now that the stock has recovered it seems poised to continue growing.

The company managed to increase its distributions and expand its operations in a deteriorating price environment. It seems like sound logic that increase in natural gas prices will eventually work in the company’s favor. Its hedging strategy might push back gains from fast rising prices, but eventually it will benefit.

Linn also seems to be beefing up its oil reserves. Its acquisition of Berry Petroleum gives it primarily reserves in oil. That diversity should help it get through the near-term, and should allow the company to keep paying its great 7.6% dividend.

Linn Energy is a master limited partnership with all the tax issues that brings. Linn Co, LLC (Nasdaq: LNCO) is a company that is designed to avoid that annoying K-1 filing for Linn Energy. Instead the dividends are passed through to the Linn Co and taxes are paid at that level, then distributed to shareholders with the standard 1099-DIV simplifying things a bit. Linn Co does have a lower yield of 7.3%, and trades separately from Linn Energy with the potential for a premium or a discount. Consult a tax lawyer or accountant to handle these issues if you are unfamiliar with them.

Conclusion

Chesapeake is the capital gains investment here. Oil is an important part of the company’s business, but out of necessity and due to success. It is a natural gas producer, but has had a hard time due to the price of natural gas. Oil is likely to remain important for the next year or two, but over the next 2-3 years a lot of production will be activated with even more coming after that. Things like refueling stations, CNG factories, LNG factories, and a whole slew of potential political initiatives for clean natural gas or local energy sources. Linn Energy is the dividend investment, and if it continues to play it smart it can keep distributions and even increase them. It has done well with natural gas even in a terrible price environment. When things improve it should have an easier go of it, and in the mean time it is adding more oil to its business.