With a weather-related supply disruption or a cold winter the only foreseeable events likely to drain gas supply and normalize the price, oil-weighted and balanced companies continue to be favored by analysts, according to John P. Herrlin, an E&P analyst with Merrill Lynch in New York. He recently upgraded Nexen Inc. to Buy from Neutral and increased his price targets for Chevron Corp. 15% and Hess Corp. 26%, bringing his universe to 10 Buy-rated stocks out of 29, up from six just five months ago. All three recently upgraded companies have an above-average leverage to oil, he notes. "For well over a year-almost two-we've espoused an investment thesis which has emphasized oil leverage-U.S. integrateds or select independents-or balanced companies-a more even mix of oil and natural gas production-free cash flow, solid management teams, visible production growth and good balance sheets," Herrlin says. "Historically, we've liked the insularity of North American natural gas, but viewed the current inventories and industry activity to be problematic for operating-margin contraction. We've been 'whiney bears' on natural gas since third-quarter 2005, and remain sidelined." In July, there was 413 billion cubic feet more gas in storage than a year earlier and, despite a drop in gas prices, an active rig count was continuing. Total U.S. inventory was 2.7 trillion cubic feet. August natural gas was trading at around $6 and oil was at some $77. "So, with the oil/gas price relationship 12.5:1, one must ask if the latest oil price escalation will finally be the tide to lift the North American natural gas boat," he says. "We don't think so, and note that most E&P stocks went down as natural gas went up (in mid-July), and that many of the integrateds appreciated or went down less versus the E&Ps or the overall market." Herrlin recommends investors stay with oil-leveraged and balanced companies, particularly large-caps. "In times of uncertainty, we want less small- or midcap exposure when there is potential weakness, such as with North American gas," he says. "At this stage, we need to see signs of industrial demand recovery or a reduction in the large price contango in forward months for natural gas."
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