Natural Gas Bulls Love This Strange Weather Event

By: David Sterman of Street Authority

It started snowing early in Siberia.

According to Rutgers University's Global Snow Lab, there is already more than 10 inches of snow on the ground in the massive tundra north of Moscow. That's the first time 10 inches had already fallen by the end of October since 2002. Roughly 900,000 square miles are covered in snow right now, much higher than the 50-year average of 573,000 square miles.

Why should you care? Because the Siberian snowpack provides an uncanny correlation with our winter weather. Scientists call it the negative phase of arctic oscillation. As the National Snow and Ice Data Center notes, "A strongly negative phase of the arctic oscillation brings warm weather to high latitudes, and cold, stormy weather to the more temperate regions where people live."

These climatologists add that in 2009, the arctic oscillation phase was the most negative on record. What was the impact? The U.S. and Europe had brutally cold winters in 2009 and 2010. According to the National Oceanic and Atmospheric Administration, nine of the 10 coldest Januarys in New York City since 1950 have coincided with negative arctic oscillations.

Meanwhile, natural gas traders don't appear to be paying attention to this unusual weather anomaly. The spot price has recently trended between $3.50 and $3.80 per thousand cubic feet (MCF), and even the futures markets don't price in a move above $3.75 this winter. Yet right now, natural gas inventories are below their five-year average, and a deep cold snap is threatening to work off those inventories even faster.

That makes this a good time to start focusing on stocks that have a high degree of exposure to natural gas prices. Wall Street analysts call these firms "gassy," as they are more squarely focused on natural gas production and not on oil production. Here's a quick look at some of these gassy plays.

1. Cabot Oil Gas (NYSE: COG)

This company, which focuses on the Marcellus Shale region, is really hitting its stride. Its gas output rose 61% in the third quarter, from a year ago, and equally important, the company is nearing completion of a heavy spending program, which sets the stage for rising cash flow in coming quarters.

Yet the big spending push was money well spent, as analysts at Morningstar (Nasdaq: MORN) note: "During the past few years, Cabot Oil Gas has leveraged its early-mover position in the Pennsylvania Marcellus shale to transform itself into one of the lowest-cost natural gas producers in the industry. The firm now boasts a huge inventory of some of the best acreage in North America and is guided by one of the more conservative management teams in exploration and production."

Management assumes that gas prices will remain flat in coming quarters, and still believes that Cabot is capable of producing prodigious cash flow. Analysts at Goldman Sachs (NYSE: GS), who rate shares a "buy" with a $48 price target, predict that pre-tax profits will spike from $515 million this year to $800 million in 2014. If the Eastern U.S. is in for a colder-than-normal winter and gas prices rise, then those cash flow forecasts would start to look too conservative.

2. Southwestern Energy (NYSE: SWN)

This company appears especially well positioned for any spike in gas prices. Earlier this year, Southwestern decided to hike its 2013 capital spending plan by $240 million to $2.25 billion, which should lead to a 15% spike in output in 2013, according to analysts at UBS (NYSE: UBS). "SWN is able to distinguish itself among the gassy resource plays given its sector leading low cost structure and exposure to the Marcellus and Fayetteville, which offer the most attractive returns amongst gas plays," they note, underscoring their $45 price target.

Goldman Sachs is also a fan for the same reasons it likes Cabot Resources (strong Marcellus exposure, rising cash flow) and sees 25% upside for Southwestern to its $51 price target.

3. Range Resources (NYSE: RRC)

This gas driller is also ramping up production at a fast clip. Third-quarter output rose 21% form a year ago. And as is the case with Cabot Oil Gas, the bulk of drilling spending is now completed, and cash flow is begin to build quickly.

On a just completed conference call, Range's management noted that Range can boost output by another 50% by 2015, which would prove to be quite fortuitous if gas prices move above $4. Even at current prices, Range is one of the industry's most profitable gas drillers, thanks in part to the fact that its Marcellus Shale acreage sits at the nexus of six major gas pipelines, leading to low transportation costs.

Analysts at Canaccord Genuity peg fair value at $94 a share, noting that a combination of steady output growth and a 14% decline in annual drilling costs from a year ago should set the stage for robust growth in earnings before interest, taxes, depreciation and amortization (EBITDA). They see that metric rising from $1.1 billion this year to $1.6 billion in 2014 and $2.1 billion in 2015.

Risks to Consider: Firming gas prices often leads to increased production, so any gas price rally is likely to be capped in the $4.50 to $5 range.

Action To Take -- Gas drillers appear to have adjusted to sharp pricing drops seen over the past three or four years, and companies like Cabot, Southwestern and Range Resources appear poised to deliver solid cash flow, even if gas prices don't rise from here. However, if the Siberian snowpack leads to a colder-than-normal winter, then these shares have even more upside than analysts currently envision.

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