Skip to Content
Stock Strategist

Low-Cost Gas Producers for Your Radar Screen

These narrow-moat companies are worth watching.

Mentioned: , , , , , , , , ,

In North America, we use natural gas to heat our buildings, fire our electricity plants, and fuel our industries. Gas production is truly a commodity industry--my furnace doesn't care if it's burning gas produced by  EOG Resources (EOG) in the Barnett Shale in Texas or  Compton Petroleum (CMZ) in Alberta, and I certainly wouldn't pay more for gas from a particular company.

If you're familiar with Morningstar's ideas on economic moats (if not, click here), it might surprise you to learn that we award many gas producers we cover our narrow economic moat rating. The first crucial part of these firms' economic moats is the stranded nature of the gas resource. Because it's gaseous at room temperature, gas must be transported by pipeline or in super-cooled liquid form on special tankers. This means that it's not easy for extremely low-cost gas from the Middle East to enter our markets, and North American gas producers are therefore somewhat protected from cheap imports. But that's not enough. We wouldn't think a gas producer had an economic moat if its production costs were high enough to outweigh the transportation cost disadvantage of Middle Eastern gas. Therefore, the second critical part of gas producers' economic moats is low costs. Generally speaking, if a gas producer has low enough operating costs that it can still generate returns on invested capital exceeding its cost of capital, then we award that firm our narrow moat rating.

What does this mean for stock investors? We should keep our eyes open for companies that can produce gas efficiently, then wait for these stocks to trade at sufficient discounts to our fair value estimates. This article will highlight some low-cost gas producers and describe how they're able to keep capital and operating costs down. We leave it up to you to check up on these firms' star ratings to find out when they're trading below our Consider Buying price.

Ultra Profitable
It would be impossible to talk about low-cost gas producers without mentioning  Ultra Petroleum (UPL). Due to its impressive position in the Pinedale Anticline in southwest Wyoming--a geological formation with substantial gas resources trapped in tight sands--Ultra has posted the lowest firmwide per-unit costs of any of the independent North American gas producers we've covered. This has translated into mouth-watering margins and returns on invested capital. Further, Ultra has a massive amount of undeveloped acreage in the area, giving it the potential opportunity to continue drilling low-cost wells for decades to come.  Questar (STR) also has an attractive position in the Pinedale Anticline and enjoys the same benefits from this low-cost resource.

Cheap Land
Some gas producers are able to acquire land leases cheaply enough that their total overall costs for finding, developing, and producing gas are kept quite low. For example, EOG Resources,  Newfield Exploration (NFX),  Southwestern Energy (SWN),  Quicksilver Resources (KWK), and  Devon Energy (DVN) were each on the early side in finding gas embedded in shale formations in the U.S. midcontinental region. Given this early-mover advantage, each quickly and quietly secured enough low-cost land to support several years of drilling before too many competitors caught wind of the prospects and bid up land prices. Combined with technical advances and operating efficiencies that should lower operating costs, this low-cost acreage should translate into promising economics in these shale formations. Another example is Compton Petroleum, which has a substantial Canadian asset base with below-average costs because of its methodical accumulation of a million acres across the deep basin fairway in southern and central Alberta. Compton used its infrastructure assets to get access to the best properties in the area.

Technology Advances
Many firms are able to lower costs by using new technologies or methods that allow them to drill wells more cheaply or coax gas out of the ground more efficiently. For example, EOG Resources was able to halve the time it takes to drill a well in the Barnett Shale by using automated rigs--a skill honed in its Canadian operations. Also, in the Piceance Basin in Colorado,  EnCana (ECA) has increased gas recovery rates and reduced costs by applying microseismic technology, which analyzes microfractures within the gas deposit so companies can orient their wells to optimize gas flows. This is but a small example of EnCana's endeavors to manage costs through techniques and technology.

Savvy Shoppers
Gas properties can change hands quite often, and producers have the opportunity to add significant shareholder value if they can acquire assets for less than the total discounted free cash flows the properties will generate. Some firms can find assets on the cheap--that is, less than what they would be worth to any potential acquirer. Other firms juice this equation by maximizing the free cash-flow side of the transaction; they have the unique ability to increase free cash flows so the acquired property is actually worth more to them.

Probably the best examples of savvy shoppers are  Apache Corporation (APA) and  XTO Energy (XTO). Apache has a knack for buying unloved properties and remodeling them. Focus and discipline, as well as large positions in a number of key gas-producing regions, are what set XTO Energy apart. XTO acquires and develops onshore properties, typically in regions with an established production record. XTO boosts investment in these properties, leading to higher production. Much of XTO's strategy hinges on its ability to produce more from these properties than previous owners or other bidders anticipated.  Range Resources' (RRC) strategy also includes buying legacy-producing properties on the cheap and boosting production rapidly. Finally,  St. Mary Land & Exploration Company's (SM) decentralized business model--coupled with a net profits interest bonus plan that serves to attract, motivate, and retain skilled employees--allows the company to develop extensive regional expertise. With this strong local presence, St. Mary is able to evaluate promising acquisition candidates in a negotiated setting, which has resulted in some promising transactions.

This brief overview is by no means inclusive of all of the low-cost, narrow-moat natural-gas producers we cover. It's simply an attempt to introduce you to some more-salient examples of low-cost producers. Please be sure to read our Analyst Reports to discover if there are other stocks you'd like to keep on your radar screen.

Elizabeth Collins does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.