Gas Investing Dilemma (CKHpd, CHK-D, PDE)

Investors in natural gas are on the horns of a dilemma -- will global demand really continue apace, with LNG investment around the world bearing fruit while prices remain at historic highs (above $6), or is the huge inventory glut we're now seeing just the beginning of a return to the historically low (sub-$4) NG prices that led to its popularity in the US?

There are good arguments on both sides -- the Washington Post had a good article this morning on the glut, implying that investors right now are really assuming a hot summer, cold winter, and active hurricane season. It looks to me like that's the investors in futures they're talking about, since Chesapeake
(CHK) and most of the other energy producers I'm familiar with have hedged a lot of their NG production at prices significantly higher than today's spot rate. The most important part of this article for those who invest in NG companies, in my opinion, is the reminder that the expiration of contracts is one of the most critical moments -- if hedges or contracts are due for renewal when prices are high, no harm done ... but if prices have bottomed thanks to this current supply glut, companies may be forced to sign supply contracts at much lower rates.

But in the longer term, as Bernanke said the other day in what seemed to be his thousandth speech of the year, it seems foolish to assume that energy demand will dry up or that supply will materially increase. With energy companies routinely being too conservative -- as we saw in 2004 when Exxon and all the big oils were priced as if oil would return to $20 a barrel -- I'm inclined to believe Bernanke's assessment that use of fossil fuels will continue to climb as the world industrializes, with at least several years before improving efficiencies can overcome increased overall demand to reduce the usage rate.

The safe bet, in my opinion, is to stay out of any short term (less than a year) gambles on the price of natural gas -- that's just a bet on weather -- and take advantage of any weakness in the natural gas spot rate to pick up shares in profitable energy companies with good long term potential, and plan to hold them for at least a couple years. For me, that's drillers SeaDrill and possibly Pride International, and natural gas developer Chesapeake through their preferred stock.

This worked well for me in the oil runup of 2004 and 2005 with low-priced oil companies like Petrobras, Statoil and PetroChina as company and analyst expectations continued to underplay the increase in demand while oil climbed from $30 to $70, and while I don't expect that kind of dramatic change in natural gas I do think we're underestimating demand and letting solid, profitable companies like Chesapeake trade too low. Your mileage may vary.

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Energy Oooff (SDRL, CHK-D, PDE)

I posted a few days ago that I had bought shares in Chesapeake Preferred (CHK-D, CHKpd) -- those are holding up fine and are, as expected, acting less wildly than the shares of Chesapeake common (CHK). All fine and dandy, and working out like I planned so far.

But the universe of my energy holdings and the energy companies I've considered, which at this point includes only SeaDrill (SDRL.OL) and fellow driller Pride International (PDE), is certainly not looking too healthy. Even if you throw in my solar energy play, which consists of MEMC Electronic Materials (WFR) and some call options on Cypress Semiconductor, the whole shebang is going to heck in a handbasket.

The worst performer, and one of my larger holdings, is SeaDrill. I am keeping a steady hand on this and have averaged down once (way too early, it turns out) ... and if I was willing to overcommit to this volatile company I'd be tempted to buy up more. But the combination of easing oil futures (depending on what day you check), an IEA report on easing oil demand, and the unpleasant Kroner: USD exchange rate has really clobbered the shares, as it has virtually everything on the Oslo Bourse. My holdings are down more than 25%, a state in which they'll find plenty of company in this market but one that I still find unpleasant. I simply must remind myself to focus on the out years -- SDRL is really a 2008-2009 play because of their huge order book of deepwater rigs, and I hope that I'm correct in believing that those who are in at these prices, before earnings pick up, have bought a bargain in the long term.

While SeaDrill is really a long term growth investment, and an investment in the acumen of John Fredriksen, Pride International (which I hold a few short term call options in but nothing else yet) is a possible value play. Pride has long lagged the drilling group in performance, with worse margins and some ineffective management. I theorized that Pride might be a takeover tarket for Fredriksen's SeaDrill a few weeks ago, but even if that's a bit unlikely I am still starting to like the idea of picking up a few Pride shares as a bet on their potential turnaround.

Pride is trading right now at a very, very low forward PE of about 7 -- it's not unusual in that, since all the drillers are trading at low PEs, but they're lower than the others. Since I think this discount is likely to be removed, and the uncertainty about their future business erased as the industry remains flush with business, I like PDE as a turnaround play to pick up its evaluation. The two catalysts seem to be that they are likely to either get a takeover bid or sell off their land-based drilling and services segments, and that I expect the current scandal investigation will eventually dissipate and cease to materially impact the shares. That's just a guess, mind you, but I'm not that worried (financially -- morally I'm not crazy about it) about an oil company bribing foreign officials and don't expect that Pride is any different in this activity than their competitors. I could be wildly wrong, and they could be criminals, which is just one small point of uncertainty that has kept me from buying shares.

The other thing that has kept me from buying shares is the downturn ... I'm hoping that they fall more, and if they do I'll revisit this argument again and perhaps pick some up. Woe is the investor in this market who doesn't have enough cash (me) to pick up shares in all the companies that he thinks are becoming bargains.

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