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Bet on Clean Energy

Consider these natural-gas stocks for the long term.

Last June, the Colorado School of Mines issued an earth-shaking report about a development that could have a major impact on the economy, the environment, national security and your own portfolio. Researchers found that between 2004 and 2008, the potential supply of natural gas in the U.S. -- which had been flat for 20 years -- shot up 64%. A short time later, Tony Hayward, chief executive of London-based BP, the largest oil-and-gas producer in the U.S., estimated that America "now has 50 to 100 years' supply of natural gas."

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Technology breakthrough. Suddenly, natural gas -- a fossil fuel used for generating electricity, heating homes, running factories, and powering trucks and buses -- has become all the rage in the energy business. The main reason is a technology called hydraulic fracturing, or fracking, which blows water and sand down into rock at high pressure to create cracks that liberate gas, especially from heavy, dense black rock called shale.

In less than 20 years, such "unconventional gas" -- that is, gas gathered using means other than plain old drilling -- has risen from 10% to 40% of U.S. production, with gas extracted from shale formations through fracking by far the largest part. But the big jump has come only recently.

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The new abundance has set off the gaseous equivalent of a gold rush. In December, ExxonMobil (symbol XOM) struck a deal to buy XTO Energy (XTO), a leader in drawing natural gas from shale, for $41 billion. In January, France's Total (TOT), the fifth-largest energy company in the world, bought a 25% interest in the holdings of Chesapeake Energy (CHK) in the Barnett Shale, a 5,000-square-mile area that covers Fort Worth and at least 17 counties in Texas.

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The advantages of natural gas are clear. It's relatively clean, cheap and doesn't have to be imported. When it's burned for energy, it produces two-thirds of the carbon that oil emits and about half that of coal.

But for an investor in natural-gas stocks, the growing supply would seem more likely to be a detriment than a benefit. After all, when the supply of something rises, the price falls. That's certainly been the case with natural gas, which in mid February sold for about $5.50 per million Btu after peaking at more than twice that level in the summer of 2008. Part of the decline in price is simply a result of the global recession, but much of it can be attributed to the increased supply.

Low prices -- for both gas and the shares of gas producers -- were what attracted major energy companies such as ExxonMobil and Total. After trading for as much as $74 a share in 2008, XTO had dropped to about $41 by the time ExxonMobil made its offer. Devon Energy (DVN) , the Barnett Shale pioneer, traded at $127 in 2008; the stock fell to one-third of that price last year before bouncing back -- but it was still only $67 in mid February, even though Devon is rumored to be a takeover candidate.

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The question for investors, then, centers not on supply but demand. Will the U.S. significantly increase its use of natural gas in the years ahead? With the obvious attractions of natural gas, logic says yes. But in the highly politicized world of energy, logic doesn't always win. For natural gas to succeed in the short term, it may need a boost from federal and local governments.

Recently I had breakfast in Dallas with energy-industry legend T. Boone Pickens, whose "Pickens Plan" calls for government to encourage heavy-duty vehicles to shift to compressed or liquefied natural gas. (Pickens is the chairman of Clean Energy Fuels [CLNE], a publicly traded company that builds fueling stations and supplies natural gas for 320 customers, including trash haulers, that collectively operate 15,000 vehicles.)

Currently, 8.5 million large trucks and buses travel U.S. roads, and nearly all are powered by diesel fuel. Pickens says that if only 3.2% of these vehicles transitioned to natural gas by 2015, demand would rise by 600 billion cubic feet a year and dependence on oil imports would decrease by 18%. Yet, in his State of the Union message the day before my breakfast with Pickens, President Obama did not mention natural gas at all. Rather, he emphasized the importance of nuclear and solar power -- and coal. Coal? Yes, it's a critical product in many key electoral states.

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Natural gas may be forced to succeed on its own merits, which are considerable. Currently, gas accounts for 24% of all U.S. energy use, compared with 37% for oil, 23% for coal, 9% for nuclear, and less than 1% for wind, solar and geothermal combined. We import nearly three-fourths of our oil; the other energy sources are almost entirely homegrown.

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Pickens is right that the key to energy security -- and economic growth -- is transportation, which accounts for 28% of U.S. energy use. But putting compressed natural gas into your fuel tank is not the only way to use gas to power vehicles. Natural gas also offers advantages in electricity generation, and with the right infrastructure, electricity may eventually become the primary means of powering cars.

Companies to buy. So a bet on natural-gas stocks is a bet on two events: an economic recovery and an energy policy built on economic and environmental rationality. Let's assume we get some of both. What are the best companies to buy? Among the gas exploration-and-production companies, one standout is Devon, for its expertise in fracking, its presence in the Barnett Shale and its takeover potential. "We expect further consolidation in the shale gas market, and I expect it to be led by the well-financed international oil companies," says Chris Sheehan, of IHS Herold, an energy-research firm in Norwalk, Conn. It will take a buyer with deep pockets to acquire Devon. Its market capitalization is $30 billion, but it still trades at just five times estimated 2010 cash flow. (Price to cash flow -- earnings plus depreciation and other noncash charges -- is the preferred measure of value among energy-production companies.)

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John Freeman and John Fitzgerald, highly regarded energy analysts at Raymond James, praise Chesapeake. They say that the deal with Total in the Barnett Shale could lead to similar joint ventures in other areas. Chesapeake also has major holdings in the Marcellus Shale, a vast area of Pennsylvania, New York, West Virginia and Ohio that could have even greater potential than Barnett. Chesapeake's stock trades at four times Raymond James's estimate of cash flow per share for 2010.

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Royal Dutch Shell and other major oil companies want to expand their Marcellus drilling, and a possible takeover candidate is Range Resources (RRC) , which has leased 1.4 million acres in the area. Standard & Poor's lists one natural-gas stock, EOG Resources (EOG) , which is expanding its drilling in the Barnett Shale, among the 15 stocks in its "high-quality capital appreciation portfolio." And consider Natural Gas Services (NGS) and BJ Services (BJS) , which provide drilling services to natural-gas explorers. Both are trading far below their record-high share prices.

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The easiest way to invest in the sector is through Fidelity Select Natural Gas (FSNGX) , an actively managed mutual fund that holds 86 stocks. It's top-heavy, with the ten largest holdings -- led by one of my favorites, Anadarko Petroleum (APC) -- representing more than half of assets. The fund, which carries an expense ratio of 0.85%, returned 11.8% annualized over the past ten years as of February 15. An exchange-traded fund that focuses on this group is First Trust ISE-Revere Natural Gas (FCG) . Launched in 2007, the ETF charges 0.60% a year.

Gas is a game changer, but politicians have a lot to say about how we use energy, so the game probably won't change overnight. An investment in natural gas based on rising demand will likely require a long-term commitment, but that's what stocks are for.

James K. Glassman is executive director of the George W. Bush Institute in Dallas. His next investing book appears later this year.

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