Two energy stocks to invest in now

Natural gas is the world’s fastest-growing major energy resource. The US Department of Energy forecasts that global demand for it will double over the next two decades. So which energy stocks will let you cash in on this growth? On Target's Martin Spring takes a look at two - including one extremely controversial option...

Natural gas is the world's fastest-growing major energy resource. The US Department of Energy forecasts that global demand for it will double over the next two decades, compared to growth of just 20 per cent in demand for oil.

Yet gas prices are very low relative to those for oil. The current ratio of 13.4 in the US (which means you can buy 13.4 units of natural gas for the price of one unit of oil) compares to a five-year average of 6.9, says UBS Wealth Management. It reflects above-average stocks, and demand depressed by mild weather.

But such low relative prices must be encouraging substitution of gas for oil. And any supply shock, such as a hurricane that cuts production in the Gulf of Mexico, would produce another price explosion - as we saw a year ago in the wake of Katrina.

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Invest in energy stocks: natural gas

Although most reports are currently bearish about prospects for natural gas, "sentiment is always most bearish at the bottom," says Fullermoney. "Since the outlook for oil is bullish, coupled with the fact that natural gas is near 12-month lows, gas has enormous potential to appreciate."

The Canadian analyst Kurt Wulff agrees. In terms of energy content, gas has been trading at prices equivalent to $40 a barrel of oil, compared to futures prices for crude almost twice as high. "The price for delivery over the next six years looks like a bargain."

However, natural gas isn't easy to invest in. There are no specialist funds, and although all major oil companies have substantial gas interests, only a handful of listed firms are gas specialists operating on a global scale.

Invest in energy stocks: why you should consider Gazprom

The most interesting and controversial of these in Gazprom, the Russian giant whose shares or depositary receipts are listed in Moscow, New York, London and Frankfurt (OGZD in London, OGZPY in New York).

Since the Russian government lifted restrictions last year on foreign ownership of up to half its shares (the other half remain in state hands), Gazprom has become the world's third largest energy company by market capitalization, after ExxonMobil and BP.

But in natural gas, it is THE giant. Its position is extraordinary:

- It owns one-third of the world's proven and probable reserves and accounts for a fifth of global production.

- It provides nearly a third of all the gas used in Europe, and plans to increase that share to 40 per cent within five years. It is building a $12 billion pipeline under the Baltic to feed gas to Germany, its most important European market. And it's mulling a takeover bid for Centrica, the UK's biggest gas distributor.

- It is about to announce choice of foreign partners for its $20 billion project to exploit the enormous Shtokman deposit in the Arctic, the world's third largest. The gas will be liquefied for shipment to the US and other foreign markets.

- It controls the pipeline network connecting Russian and Central Asian fields to domestic and European markets and has monopoly control over exports of Russian gas.

With resources and prospects like that and a share price valuing proven reserves at the oil equivalent of only about $3 a barrel (in America, ConocoPhillips has just paid $18/barrel for Burlington Resources'), Gazprom looks like a no-brainer for long-term investment in energy stocks.

Invest in energy stocks: reasons to be cautious of Gazprom

However, there are several reasons for caution.

The company is clearly viewed by President Vladimir Putin's government as a political instrument, so the interests of foreign shareholders aren't likely to have priority.

Russia seems to be wanting to use its supply of scarce resources to re-establish the global influence it lost when the Soviet empire collapsed. Gazprom has, "with the possible exception of nuclear weapons become Russia's most powerful foreign-policy tool," one commentator has suggested.

On the other hand, Moscow knows well enough that it must be reasonable in its dealings with foreign investors if it is to secure the knowhow and international market access it needs to exploit its enormous natural resources.

Domestically, Gazprom is required to provide a huge subsidy to the economy by selling gas at less than a third of the price it commands when exported to Europe. If Gazprom achieves bigger profits, that takes pressure off the politicians to raise tariffs in the domestic market, so there is a perverse incentive not to worry too much about cutting costs and thereby raising profits. Last year's operating cashflow did not cover capex.

Another reason for caution is that the company currently has no spare productive capacity and has a poor record of developing additional capacity.

It can only expand its revenues by importing more gas from Central Asia to sell on to Europe, secure higher prices (especially for domestic sales), or enter into joint ventures with foreign majors in new projects such as Shtokman.

Invest in energy stocks: Gazprom is the natural gas giant

Here are some reasons to buy

Despite those negatives, Gazprom looks as if it's going to be too important to fail to attract support for its shares.

It's already the biggest stock by far in the emerging markets. The relevant Morgan Stanley index, which most emerging markets tracker funds use as their benchmark, has increased Gazprom's weighting and will raise it further, to 4.8 per cent of the index, next month. This will force index trackers to buy more shares.

The investment bank reckons the company, already worth around $230 billion, should go to more than $330 billion. Gazprom's own target is to achieve a market value of $1 trillion by 2010-15, which would almost certainly make it the world's biggest company by far.

In March Citigroup Research took this view: "We believe that Gazprom is unfairly undervalued on a reserve basis relative to its earnings power when compared to developed and emerging market peers.

"Over the long term the valuations of Gazprom's reserves and those of global peers will converge as the reserves of the developed markets become depleted, unlocking the true value of Gazprom's reserves especially considering that there are fewer alternative supply sources for gas than for oil."

Wulff says: "There is more than normal potential for present value to increase as the company's selling price for natural gas moves to the world level and its reserves expand with new development."

If you can buy the depositary receipts in London at current prices (below $39), they should prove to be a good core investment in the energy sector.

Invest in energy stocks: coal-bed methane

However, with natural gas, as with oil, the advanced economies are becoming increasingly dependent on imports - including those from Gazprom - and worried about that dependence. Especially as it seems future supplies will increasingly have to be drawn from politically unreliable sources (more than half the world's proved reserves of natural gas are in just three countries Russia, Iran and Qatar).

Part of the solution is going to be gas recovered from coal, which is an energy resource that most advanced economies have in abundance.

The gas found in coal deposits consists almost entirely of methane, which is the principal constituent of natural gas and therefore an excellent substitute for it.

Throughout history methane known as fire-damp has been the curse of coal mining, causing the explosions that bring death to those who work down the pits. Some coal deposits are so rich in the gas that they have been too dangerous to mine, so have been left unexploited.

But within the last quarter-century the gas has been recognized as a potential asset that can be recovered from virgin or abandoned coalfields by drilling wells to tap it, just as you would with oil.

In the US, coal-bed methane (CBM) already accounts for almost 10 per cent of gas production and its share is increasing as the nation's natural gas reserves are depleted.

Invest in energy stocks: a pioneer of CBM

A pure play on gas in Europe

In Europe, where CBM is in its infancy, one of the pioneers is a small Australian company, European Gas.

It has tied up the rights to exploit the methane resources of 8,000 square kilometres of coalfields in France and Italy.

Its first project is to tap the "very gassy" coals of Lorraine, in Eastern France, where the 35-metre-thick seams of its licensed St Avold sector are estimated to contain more than 400 billion cubic feet of gas (equivalent to 18 million barrels of oil).

This month it starts drilling its first wells using an experienced American contractor, with a planned roll-out next year of 30 wells in the first phase, expanding eventually to 200.

The company's MD, Anthony McClure, who is also a director of the American CBM developer/producer Planet Gas, said at a presentation I attended in London recently that each producing well will cost about €2 million. At a gas price of €5 per unit, each well should earn an average of about €1.8 million a year gross, €1.4 million after expenses.

Invest in energy stocks: reasons to consider European Gas

Positive features of the project include:

- Strong support from the French government as a producer of "terrestrial gas in the heart of Europe" will be considered "a strategic asset." France has to import almost all its natural gas requirements. Tax incentives will be equivalent to a 30 per cent capital subsidy. And government support should overcome environmental objections.

- Availability of extensive data on the resource because of past mining and exploratory work.

- The Lorraine area resource alone is large by global CBM standards -- proved reserves of nearly 7 trillion cu.ft. of gas. At American usage rates, that would be enough to supply the gas needs of 7 million homes for 15 years.

- No transportation problems, as the gas will be fed straight into the European pipeline system that crosses the coalfields. There is similar convenient pipeline access from all the company's other permit areas.

- Use of proven drilling, exploitation and processing technology from America and Australia.

European Gas is listed in Sydney (ASX code EPG). It plans to list also on AIM in London, and is considering listing in Euronext in Paris, possibly next year.

This is a company worth watching.

If the above two stocks are too speculative for you, some alternatives to consider are London-listed BG, a pure gas play with worldwide interests and excellent management; the big Australian independent Woodside Petroleum, a gas-focused group with major expansion plans in offshore gas; and several North American middleweights that are primarily gas producers Encana, EOG Resources and XTO Energy.

By Martin Spring in On Target, a private newsletter on global strategy