Chris Mayer: Welcome to the first edition of Crisis Recovery Report. My name is Chris Mayer, and I am the managing editor of Agora Financial and editor of Capital & Crisis and Mayer’s Special Situations. I have here as our guest Dan Amoss, who edits Strategic Short Report.

We’re going to talk about what we think are good places to be in today’s scary market and weak-kneed economy. Our focus is going to be on natural gas. Now, don’t give up on us just yet. We are fully aware how the market hates natural gas right now, and we are going to talk about all of that and look into a few specific ideas as well.

So I guess we’ll start off with kind of the bigger-picture reasons here. Dan, we both know that the market definitely hates natural gas. And we can see that in a lot of the valuations in natural gas stocks. But maybe you want to talk a little bit about why you think natural gas is a good spot to consider now.

Dan Amoss: For starters, I saw just today that the bullish sentiment figure for natural gas is only 22 on a scale of 100. Last summer, when natural gas was priced in the teens, this same percentage was up in the high 80s. So that alone gives you the opportunity to enter attractive long-term investments at low prices, because everybody hates the sector.

Certainly, the demand scenario for natural gas is weak and supply is still fairly abundant, but there are lots of micro trends that can reverse those bearish supply-and-demand factors over the next few years.

Chris Mayer: Agreed. Now, you and I both talk a lot about trying to get ahold of what the consensus is. Whatever kind of investment idea we have, we like to get a sense for what the consensus is and why our view is different from that. And I think most of the time that’s hard to do. It’s easy to talk about consensus, but to really figure it out is messy and uncertain in most cases. But with natural gas, like you point out here, I think it’s pretty clear where the consensus is.

And that consensus is that we’re just going to swim in natural gas forever. Maybe you want to talk a little bit about the actual mechanism of why that argument might not be the right one. Basically, give us some of those micro factors you mentioned.

Dan Amoss: I think there are a lot of moving parts in the supply side. One thing that’s always been hanging over us is the prospect for lots of liquefied natural gas coming into the U.S. — in particular from Qatar. Exxon Mobil has heavily invested with Qatar’s government, and there are a lot of giant LNG projects coming online in the next few years. So that leads to speculation at the moment about where that gas is going to go.

Ultimately, a lot of it will go to Europe to offset its dependence on Russia, which weakens the potential for Russia to use gas as a political weapon. Also, it’s becoming clear that Russia has been underinvesting in its legacy gas fields. Over time, Europe’s demand for LNG will grow to offset declines in Russian gas production and exports.

Then the other area seeing growth in demand for LNG imports I think will be Asia. India and China in particular will look to clear up the skies around cities by supplanting coal-fired electricity with gas-fired electricity wherever they can.

Looking at the U.S., we saw when the gas rig count was up to 1,500 last summer a lot of capital was flooding into the sector, and most of it was financed by banks. That inflow has now dried up, and banks are leery about lending to finance drilling projects.

There were a lot of mom and pop companies that started up, so you had this massive wave of investment into drilling and well completion. Then the rig count collapsed last fall, but there’s still a backlog of wells left to be completed and connected to the pipeline network. And that’s temporarily kept supply up.

But there’ll be a six–12-month lag after this collapse in the rig count when we’ll see U.S. land production fall pretty dramatically. On June 30, the EIA-914 report came out and showed the second straight month of declining U.S. natural gas production. That trend may last through the end of the year.

Chris Mayer: The government also plays a role in all this. There’s been a lot of talk recently about cap and trade and carbon emissions and that sort of thing. So maybe you want to give us a little bit of an idea of what you think the global warming regulations will look like and how they will affect natural gas. I think we both have the same opinion here, that we’ll see a lot of switching at the margin to natural gas, and ultimately, that will create a lot more demand for natural gas.

Dan Amoss: The Waxman-Markey bill, which recently passed the House of Representatives, incorporated a cap-and-trade program where the government will initially put a cap on the amount of carbon emissions that power plants, refineries and so forth can omit, and that cap will decline over time, the idea being to make the cost of carbon emissions rise. So this will prompt electric utilities to shift capital spending plans from coal to natural gas because gas-fired electricity omits roughly 30–50% less carbon per megawatt compared with coal. And also these gas plants are less capital-intensive, easier to permit than coal plants and easier to switch on and off to serve as backup generation for wind and solar — for when the wind is not blowing and the sun is not out.

Chris Mayer: The other thing to consider here is when we talk about some of the effects of low natural gas prices and why they make it interesting to buy now is the marginal cost to produce gas.

This is the matter of debate, but I don’t think it’s controversial to say that the marginal cost is somewhere between $6–8, and natural gas is trading around $3 and change. So when you’re thinking about commodity investing, some of the best times to buy in commodities are when most of the industry can’t make money at the current price.

So I’ve argued that if you can find the low-cost ways to invest in this idea — in which you can sort of wait out the nuclear freeze here — then you’ve got a good idea on the other side.

Give us some of your thoughts on that and what the marginal cost are, and how that dynamic plays in.

Dan Amoss: Yeah, I think just like in the stock market, you can find companies that tend to be shrewd investors with regard to their capital budgets. A lot of the larger E&P companies didn’t expand too aggressively near the peak last year, and instead, they’ve slowly accumulated acreage and kept free cash flow levels fairly high, and now we’ve seen just in recent months a lot of these well-capitalized E&P companies strike very favorable joint venture deals with acreage-rich, but cash-poor small-cap companies. For example, just recently, BG Group, also known as British Gas, paid about a billion dollars for a stake in the shale acreage controlled by EXCO Resources.

EXCO was one of the more aggressive small-cap companies that took on a lot of debt and grew really fast, executing a land grab strategy for Haynesville acreage. Now BG has the opportunity to invest in EXCO’s acreage position at a low-cost basis that’ll result in better full-cycle economics than the companies that stretched their balance sheets to overpay for acreage last year during the boom. Chesapeake Energy is an example of another company that got too aggressive in spending on acreage acquisitions and drilling. So Chesapeake struck joint venture deals with Statoil and also BP to split future capital spending and profits on its own acreage.

So based on these types of deals, I think we’ll see the companies that are now investing in shale plays at bargain prices will generate good returns for their shareholders, and certainly technology will tend to lower the marginal cost of producing gas over time. But there are so many differences between which area of the country you are drilling and the existence of pipeline infrastructure that we’re going to find out later this year that the marginal cost remains stubbornly high, and as that happens, the market will push gas prices back up.

Chris Mayer: I think also that a lot of these producers still have attractive hedges on from last year. So I think their numbers look a little better, but as we get on in the year and those hedges roll off, it will be interesting to see what happens with some of the leveraged players.

Some companies are in a much better position than others. Readers know that one of my favorite natural gas producers is Contango Oil & Gas. The symbol is MCF.

Contango is completely debt free and profitable even at these low prices for natural gas. So you would think that could be a potential target for somebody. Certainly, some of the bigger players you mentioned still have a lot of room to make deals. And with prices where they are, now would be the time to gobble up some quality reserves.

What kind of conclusions would you draw from some of these deals that you’ve been talking about?

Dan Amoss: I think, on the E&P side, you want to focus on companies like Contango — those with healthy balance sheets and attractive properties that result in low production costs. And then you can shop for a lot of service and equipment companies that are on the right side of a lot of technology trends. One in particular: The economics on these shale gas wells work best when you have a very efficient new rig that can drill multiple horizontal wells from one site and drill very far out in a horizontal fashion to enable multistage fracturing; with this technology, your initial production from shale gas wells is very high and you get your investment back out of the well more quickly.

One company in particular that in Strategic Short Report we bought calls on near the market low is a company called National Oilwell Varco — ticker symbol NOV. NOV is really the only remaining integrated drilling rig manufacturer in the U.S. It’s essentially a combination of all the companies that didn’t survive the last drilling rig construction boom, which was in the late ’70s and early ’80s.

In particular, for the land rig market, the company has a product called the Rapid Rig, and you can watch a video animation of its efficiency on NOV’s Web site. This rig automates and improves the safety and productivity of all the rig hands, and it reduces the industry’s need for skilled labor, which tends to be scarce in this sector. NOV also has the advantage of a great management team. Management has a good track record with acquisitions, has produced a great balance sheet and now has attractive acquisition opportunities, with smaller competitors trading at discounts to intrinsic value. So NOV is a stock that I think if you buy in the low 30s will be a good investment for patient investors.

Chris Mayer: Agree. Some of the price action on these things gets scary, of course, and they can be very volatile. But if you’re an investor and you take advantage of some of those dips, you can do very well.

One of my longtime favorites is Nabors Industries, which is the largest of the land drillers. The ticker is NBR. It has a good balance sheet. It’s got a fleet of new rigs, as it has spent a lot of money in the last few years upgrading that fleet. And finally, CEO Eugene Isenberg is sitting on $1 billion in cash. So he’s got some room to make some deals and do some things.

The stock price — and the high and low of some of these things have been incredible — has been all over the place. We first picked up Nabors at about $29, and it’s been as high as $50 and as low as eight bucks within the last nine months.

I know I pounded the table when it got down to $10, but I think now it’s around $16 or $17, still a good buy, because when that rig count snaps back, a company like Nabors is going to gush cash. So that would be another one I would throw out there.

Dan Amoss: Yeah just from a big-picture perspective, one thing I’ve been thinking about a lot lately relates to the sectors to invest in as the economy bounces back from this crisis. You definitely want to focus on the sectors operating near their capacity. So many sectors became so overbuilt — real estate, housing, banking — that it’s going to take years for those sectors to get back to earning their typical profit margins. Whereas in a sector like the oil and natural gas sector, every year, production capacity naturally falls, and it requires hundreds of billions just to keep capacity constant.

And right now, we’re underinvesting in oil and gas capital spending and will probably continue to do so for the rest of this year. But within six–12 months, I think the market will discover that production capacity in oil and gas is much tighter than widely perceived. This will result in surprising rallies in energy prices. I think in the meantime, you’re not paying much for these stocks. If you own the ones with attractive assets and good balance sheets, you can just sit and wait for the market to recognize the value.

Chris Mayer: I think that’s one of the things that are so appealing about it. If you can wait it out, you know it’s going to rebound at some point. You look at the history of, say, natural gas, and you can see that it runs up and down. You know natural gas is not going to go away, and as you say, there was a long period of underinvestment.

We’re not talking about underinvestment for just the last five or 10 years — we’re talking about two decades in oil and gas when a lot of the needed investments haven’t been made.

Instead, the country had its boom markets in first tech stocks and media and telecom and then we rolled into the giant real estate bubble. I know you listen to a lot of industry people, as do I, and they always talk about the shortage of skilled people. Then there is the equipment itself. Matt Simmons always likes to say how rust never sleeps, and I always think that’s a good point too.

We talked about how when it comes to natural gas and rigs, for example, we’ve kind of wondered between ourselves how much of those would be scrapped, and it’ll be interesting to see what happens on that front. It’ll be interesting to see how much equipment gets kind of wiped out with this blowout. It’ll set the stage for the next rally.

Dan Amoss: If you look at the capital spending plans of the mid-size and major oil and gas companies, it certainly indicates that the demand for the late-’70s vintage rigs will not bounce back strongly. I think roughly half of the land rigs in the U.S. were built in the late ’70s and early ’80s, which is a very important fact that the market rarely recognizes. A lot of these ancient rigs are only capable of drilling vertical wells, which are not much in demand at this point, and especially in the future, the demand for those will evaporate. They are also more labor-intensive and dangerous for the rig crews to operate.

Since the kind of returns drilling companies can get from refurbishing those rigs and committing scarce skilled labor to them will not be worthwhile, I think the drilling companies will wind up scrapping most of them. This will act to tighten capacity utilization in the drilling business and boost day rates and profit margins in the next up cycle. This will first become apparent in the next increase in the rig count, which we’ll probably see by the end of 2009.

Chris Mayer: So that’s our look at why we think natural gas is a good place to be now as we await this recovery, and again, the three names we talked about that we think are pretty attractive right now are Contango Oil & Gas, ticker MCF. We have Natural Oilwell Varco, which Dan talked about; the ticker is NOV. And Nabors Industries, ticker NBR. We think all of them will benefit from a rebound in natural gas demand, which we think is on the not-too-distant horizon.

I want kick it back to Dan here, because he writes an excellent report, Strategic Short Report, which focuses mostly on things that are going to or about to blow up. Dan shows readers how they can make a lot of money as a result.

Dan, in a bigger-picture sense, where do you see good short opportunities right now?

Dan Amoss: On the short side, I like to look for ideas where you see the opposite characteristics of what we were talking about with oil and gas. In particular, we saw too much investment in financial companies and in businesses like casual dining during the bubble years. Over the next year or two, the stock market will continue to recognize that much of this capital was wasted, and future returns will be ugly. Recently, I recommended put options on two restaurant chains that grew astronomically between 2000–2007, especially in the areas most inflicted with housing weakness. Future profits at the corporate level of these restaurant chains will look nothing like the past, yet the stock market is not recognizing this.

So these are the kind of ideas we look to sell short, and I think a lot of the excesses that built up during the boom years are going to be corrected. A lot of the stocks that rallied since March are low-quality stocks, and selling them short is a good risk/reward proposition.

Chris Mayer: Yeah, I agree, and I think you’ll probably have a very rich environment for those ideas here as this credit-based economy unwinds.

So we will end it right there with our first Crisis Recovery Report.