Now, five years later, with prices at a paltry $3.62/Mcf, Pendill is, again, taking a contrarian view. It may take a few years, he says, but the price of natural gas will rise.

Despite Pendill’s optimism, many investors think the price of gas will stay low for a long time, so they’ve abandoned it for higher-priced oil. That’s made natural gas—the commodity and the companies—the black sheep of the energy sector. And that’s a good thing. “The natural gas industry is a value play,” says Pendill. “Near-term, natural gas producers will lag their oil-based peers, but down the road the market will balance itself.” The natural gas industry is also going through some major changes, which presents numerous undervalued opportunities for investors. Find the right stocks today, and you’ll likely be rewarded later.

Natural gas prices have a long history of dramatic rises and falls, but the last time they dropped, in 2008, it was because of a revolutionary change in the industry. Advances in drilling technology made it possible to extract gas from solid rock formations such as shale, vastly increasing the size of the reserves that could be economically recovered. Eric Nuttall, manager of Toronto’s Sprott Asset Management’s Energy Fund, says that eight years ago the average natural gas well would initially produce 250,000 cubic feet of gas per day. That number is over a million cubic feet today. The go-big-or-go-home economics of shale gas mean North American supply is far outstripping demand, even though that is increasing, too, as users switch from more expensive (oil), more polluting (coal) or more dangerous (nuclear) energy sources.

But while North America faces a glut, Asia faces a shortage. China’s natural gas imports have climbed 27% in the first half of 2011, and Indian demand for gas is expected to double by 2015. Currently, North American companies can’t tap into that demand; there’s currently no way to transport gas produced domestically overseas. So, while a Canadian utility might pay $3.62/Mcf for gas, Chinese customers are coughing up $11/Mcf. To move gas from Canada to China, it needs to be liquefied and shipped over the ocean. Scott Vali, a vice-president and portfolio manager with Toronto’s Signature Global Advisors, says North America has been slow to adopt the technology needed to convert natural gas to liquefied natural gas (LNG). With so much supply here, though, companies are now working hard to build LNG conversion plants. Canadian companies should be ready to begin shipping gas to Asia by 2015, says Vali. When that happens, North American operations with export contracts will start earning a higher price for gas, while domestic supplies may finally get drawn down.

To get into this market, investors could buy an exchange-traded fund, but Steffen Torres, a portfolio manager with Kalmar Investments, based in Wilmington, Del., advises against it. Some gas ETFs hold futures contacts that are purchased at a certain price. When it comes time to sell, if the contract is lower than the purchase price, the ETF’s value drops. With gas prices so low, Torres thinks there’s potential to lose a lot of money. If you invested US$10,000 in the United States Natural Gas Fund ETF in March 2007, for example, you’d have about $900 today. ETFs that hold an undifferentiated basket of stocks are likewise inadvisable since some of the companies will have a cost of production above current prices.

It’s a better idea, says Torres, to buy company stock directly. With gas prices so low, though, investors have to look hard for the best buys. The first thing to consider, from a stock valuation perspective, is how much it costs a company to produce gas. The lower the cost, the better. The current price of a basket of natural gas companies, says Torres, assumes gas can be produced at $4.50/Mcf. With gas likely to bounce around between the $3.75 and $5 range, he wants to buy companies where the stock assumes that gas could be produced for $3.50/Mcf or less.

Investors should also look at companies that drill “liquid-rich gas,” which contains some dry gas (methane) and several other liquid forms such as ethane, propane, butane and condensate. “All those different products have a different sales price,” says Nuttall. Companies that can sell all these wet gases often make more than operations that only produce methane. Calgary-based Painted Pony Petroleum, for example, makes 62% more in revenues with those gases than if it only produced dry gas, Nuttall explains.

It’s also important to look at reserve potential and proven reserves. Vali wants to know if a resource base can be grown. “Based on what we know today, how can that resource be developed?” he asks. “What is the value you can assume for that resource base?” It’s risky to place a bet on something unknown, which is why companies on unproven reserves are often cheaper, but if an investor concludes that there is potential, and that pays off, the returns could be huge. Pendill likes to look at proven reserves—reserves that people know will yield gas, but the land hasn’t yet been drilled. The price of proven reserves is based on today’s economics with today’s technology. If technology improves, or gas prices rise, the economics will be that much better.

Looking at the usual metrics, like price-to-earnings, doesn’t work with natural gas companies, but investors still want to see healthy free cash flow and nearly no debt. Look for under one times debt to cash flow, says Nuttall. If prices fall further and a company does have to cut back on growth, a large debt load could force it into bankruptcy. Also look for dividend-paying companies. “You’re basically getting paid to wait for the recovery in the gas markets,” says Pendill.

It may still take years before the benefits of investing in the sector appear, but don’t wait until stock prices rise to get into the market. Pendill was correct when he warned investors in 2007 that the price was too high, and he may be right again that prices are too low. “It will turn,” he says now. “When we get those export facilities, things could really change.”

Our picks

Encana (TSX: ECA) Lanny Pendill, an Edward Jones portfolio manager, can’t say enough good things about Calgary-based EnCana. It’s a low-cost producer, it’s in four of the five most attractive natural gas basins in North America and it pays a 3.56% yield. He also says the company is sitting on a lot of acreage in emerging gas fields, and its investment-grade credit rating of BBB+ means it’s a low-risk play.

Range Resources (NYSE: RRC) Range Resources, based in Fort Worth, Texas, is a big player in the Marcellus Formation, a large area in New York, Pennsylvania and other neighbouring states that’s expected to produce vast amounts of liquid-rich gas. Scott Vali, a portfolio manager with Signature Global Advisors, says the company owns a lot of land, and because it’s so close to a consuming market—the northeastern U.S.—it doesn’t have to pay heavy tolls to ship it to its final destination.

Painted Pony Petroleum (TSXV: PPY.A) Calgary’s Painted Pony Petroleum, a junior oil and gas company, has been a “huge winner,” says Sprott fund manager Eric Nuttall. It recently flowed the highest volume of natural gas ever from a well in the Montney shale formation in B.C. and Alberta. “It’s extremely prolific,” he says. It’s also producing natural gas liquids, which means it makes more money than it would if it just mined methane. It trades at $12, but Nuttall thinks it could soon reach $18 to $20 a share.

Magnum Hunter Resources (NYSE: MHR) Houston-based Magnum Hunter has three operations in “the United States’ most enviable formations,” says Steffen Torres, a portfolio manager with Kalmar Investments, including five “strong” wells in the Marcellus Formation. It’s trading at about US$4, but Torres thinks it’ll rise to $7. Its capital expenditures have outpaced cash flow, but the company has the ability to grow production by 80% over the next few years, he says.

Chicago Bridge & Iron Co. (NYSE: CBI) It’s not a gas producer, but buying this Amsterdam-based engineering and construction company is another way to play the natural gas market. CB&I has designed numerous liquefied natural gas plants around the world, and with demand for LNG conversion facilities rising in North America, Torres thinks it’s poised to make huge profits. “Their backlog is increasing,” he says. It seems others agree with Torres; the firm’s stock price has risen by 10% year-to-date.

Appeared in Canadian Business magazine’s November 2, 2011 issue.

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Paul Ehrlichman can’t wait to see Greece finally default. “The country’s a fraud,” he says. “There is no hope.” With a one-year government bond yielding more than 100%, it’s as if the country has already defaulted, explains the head of global equity for Delaware-based Global Currents Investment Management. The sooner it goes under, the sooner Europe can start healing. But until the region works out its myriad problems— there’s also Italy, which was recently downgraded by S&P from A to A–, not to mention Spain and Portugal—people will continue to run from Europe’s markets.

Ehrlichman, though, isn’t going anywhere. There are plenty of opportunities, he says. People just need to make sure they’re investing in the right countries, instead of the region as a whole. “We used to look at the world as one big happy place,” he says. “But now we’re starting to talk about countries again because not everyone is getting access to capital at the same price.”

Because of the worries around sovereign debt, all of Europe, from Finland to Poland, has never been cheaper. Parus Shah, a London- based portfolio manager with Fidelity Investments, says that, in general, companies are trading at a 20% discount from the depths of the recession. Yet, having cleaned up their balance sheets since 2008, businesses are in better shape. Compared to the S&P 500, which is trading at about 14 times earnings, Germany’s DAX Index is trading at 9.9 times earnings; France’s CAC is trading at 8.5; most of the eurozone is trading at 10 times or below. Shah thinks people are overreacting to Europe’s economic woes. “There are so many global funds not invested in a single European company,” he says. “That’s strange.” The longer people stay away, though, the better stocks look to value investors.

The rule of thumb is to buy blue-chip, dividend-paying multinationals that sell to fast-growing emerging markets. That way, you aren’t exposed to country risk and don’t have to worry as much about slowdowns in consumer spending. But with the gap between healthy and weak European countries widening, investors can’t simply ignore where a company is based anymore. A weak country could raise corporate taxes as a way to increase revenues and pay down debt, says Shah. It could levy fees on utilities or telecoms. While higher taxes won’t kill a strong business, a 5% tax increase could destroy some of a company’s value.

Shah also warns that companies in weaker countries may also find borrowing more expensive. The longer the turmoil continues, the more investors will want a premium from corporate bonds. If a business has to pay a 6% yield instead of 3%, it could eat into profits or make it difficult to pay the higher coupon back.

Germany tops most people’s list of places to invest because its debt-to-GDP ratio is low, at least compared to other eurozone countries, at 83%. It’s also competitive, explains Ed Devlin, an executive vice-president at Pacific Investment Management, with the price of products increasing more than wages. It’s got a skilled workforce, and exports are still strong. Its main risk, says Devlin, is that it, along with France, has put its balance sheet at risk by propping up struggling countries.

Opinion is mixed on France, because its banks have more sovereign debt exposure than Italy. But, says Ehrlichman, Italian banks are in worse shape than French ones, and the French are more productive, so GDP is likely to grow faster. France’s government also directly or indirectly employs about 35% of the workforce, says Shah. As long as the country’s finances stay stable, these people aren’t going to lose their jobs. Investors should consider telecoms, infrastructure companies and, though they’re riskier, banks.

If investors want to buy companies in the weaker countries, such as Spain and Portugal, it would be wise to stick to more international operations as it’s likely the domestic market will continue to face downward pressure. Shah says that governments may be less likely to tax multinationals since they can move their head office if there’s a threat to their profits. However, Ehrlichman says there are a lot of good opportunities in Ireland. That country has already faced the worst of its problems and, he says, is beginning to heal. Two years ago Irish bonds were yielding about 20%; today rates are closer to 9%. “The credit markets have been telling an accurate story,” he says. Besides buying bonds which, Ehrlichman says, “looks like money,” a basket of contrarian and quality stocks—including Bank of Ireland for the former and airline Ryanair for the latter—is the way to go.

Countries outside the eurozone, like the U.K., Switzerland, the Scandinavian countries and some Baltic states, are also worth a look. Their banks don’t have the same sovereign debt exposure as Germany and France and, since they have their own currencies, they have more options to deal with financial crises.

After deciding which countries to focus on, you’ll want to find companies with low debt, especially in the weaker countries. If a business is too leveraged, and interest costs rise, then there will a massive drop in earning power, Shah explains. Also make sure that more than half of revenues come from international sources.

Price-to-earnings and price-to-book ratios don’t matter as much in Europe because everything looks cheap. Dividends, though, are important as they speak to a company’s health. Don Reed, president and CEO of Franklin Templeton Investments, likes companies that can grow earnings and pay dividends higher than 3.5%, which is what the MSCI EAFE Index, a benchmark that tracks Europe, Australasia and the Far East, pays.

Ehrlichman wants companies that have lowered their earnings expectations for 2012 and 2013. He says a lot of businesses, especially in the industrial sector, haven’t yet adjusted their projections to the global economic slowdown. “We know the forecast will be wrong,” he says. “And would you rather be on the side of a positive surprise or a negative one?”

Ultimately, investors need to be patient. Valuations could still drop as the region works out its economic issues, and there are still uncertainties around who will be using the euro in the future. But hold on for the long term and you won’t go wrong. “What will happen in Europe over the next 10 years?” asks Shah. “I think the next 10 years will be a lot better than the last 10.”

Our picks

BNP Paribas SA (EPA: BNP)
While many investors still consider Europe’s financial sector risky, fund manager Paul Ehrlichman is happy to take a chance on Paris-based BNP Paribas. The European Central Bank has demonstrated that it won’t let large banks fail, “so there won’t be a Lehman-like event,” he says. And, with a strong consumer banking business, a near-7% yield and a price of about five times earnings, it’s got a lot of upside.

Marks & Spencer Group PLC (LON: MKS)
Despite living in what Ehrlichman says is “the worst consumer environment since 1870,” Britain’s retail stores are doing surprisingly well. In May, Marks & Spencer, which has more than 700 stores across the U.K., reported a 13% increase in profits over the year before. Its shares jumped 7% in September after it announced it was revamping its stores. Private equity investors are reportedly interested in buying the company. Its price-to-earnings is 8.6 and it pays a 5.1% dividend yield.

Novartis AG (NYSE: NVS)
Switzerland-based Novartis is a favourite of Don Reed, CEO of Franklin Templeton Investments. He likes the pharmaceutical giant because it’s a global company in a non-cyclical sector. The company produces some of the world’s leading drugs, including Excedrin and Ritalin. Because a large portion of its business is outside of Europe, it has less exposure to the region’s economic risks. It’s not as cheap as some other companies—it trades at about 13 times earnings—but it does pay a 4.2% yield.

Bank of Ireland (NYSE: IRE)
Dublin’s Bank of Ireland is a contrarian play, says Ehrlichman. Most investors still think it could fail, but with Ireland’s fortunes improving—it’s already implemented its austerity measures— he thinks the bank’s shares should start climbing soon. In a sign of confidence, the bank has raised US$3.9 billion of term debt since June, despite not being able to access the public debt market. Another private bond sale worth $1.6 billion is reportedly on the horizon.

Telefonica SA (NYSE: TEF)
Reed likes this Madrid-based telecom company because of its high dividend—about 9%—and its international exposure. The company’s stock is down 15% year-to-date because of fears over Spain’s public debt load, but only onethird of its business is done in its home country. A big piece of its business comes from Latin America, where GDP growth is still robust. Its P/E is about eight times.

Appeared in Canadian Business’ October 5, 2011 issue.

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