With the oil-and-gas price link weaker than it's been in over a decade and with natural gas too dependent on a fierce winter to fuel demand and drive pricing up, CRT Capital Group Senior VP Duane Grubert likes oil better than gas. Consistent with that stance, he also prefers producers that are leaning more toward oil than gas.

In the gas arena, he tells The Energy Report in this exclusive interview, he's sticking with players who are diversifying and tends to choose those that are involved in exploration as well as production. While he favors better-capitalized companies for their proven ability to endure, he also likes at least one small-cap firm in the field—Energy XXI—in part for its "material volume upsides through exploring."

The Energy Report: Basically, Duane, we'd appreciate a top-down overview of where you see natural gas and oil going in the short run and then long term, and where you see the markets both domestically and internationally.

Duane Grubert: I'm primarily focused on North American markets, and the link between oil and gas has been falling apart over the last year or so, which is one of the very investable themes out there right now. Let's start with the natural gas side. We've really had this revolution; in the last five or seven years producers have discovered that they could produce gas out of really terrible rock—the gas shales. In the last year, with really high prices in 2008 as an incentive, the sector has been very creative in increasing the productivity of these wells in effectively bad rock to the point where there really is a sea change.

Gas is now abundant; very credible producers are saying they have tremendous volumes of project backlogs. So we're in a situation where gas prices are really going back to gas-on-gas competition and the clearing price of gas being set by the sector's cost structure.

TER: And the oil side?

DG: It's a lot different on the oil side. Time and time again, we've seen politics, macro factors, infrastructure constraints, etc. It's much less researchable to talk about where oil prices are going relative to gas prices (again, for North America), because effectively you have this island market for natural gas and dominantly a domestic supply.

We certainly pay attention to cost structure on the oil side and we certainly pay attention to things like social budgets of some of the Middle East nations. But in terms of a number, which ultimately everybody wants, we start with the first question: What will investors be willing to assume as a long-run normalized price? I'm very comfortable thinking that gas markets will reflect a clearing price of something like $6 per MMBTU, which is miserable relative to where oil is trading currently.

Right now the stock and bond markets are reflecting something like $60 oil, even though the current prices are a lot closer to $80. So in terms of an outlook for price, I am comfortable telling people to think about a normalized $6 gas price for the medium and long term, but I am a lot less certain on the oil side. Because of cost structures and so forth, we're kind of a $60-plus shop in terms of an outlook. We recently bumped up our view of what securities will reflect to $65 oil in our target setting, but left gas alone at $6.

TER: So the opportunity appears to be in natural gas because you're looking at a 50% upside from the current price?

DG: The situation has really changed quickly. We had a period in the shoulder season when people didn't use either air conditioners or heaters, between summer and winter, where the spot price of gas dipped below $3, but we very quickly recovered from that. In mid-October, November gas was priced at over $5, with the strip for next year very close to that clearing price I've been talking about—around $6.

So it was correct early in the year to say gas prices must go up. They did go up, and they've gone up toward this clearing price. If you're a bull on gas, you're really making a weather call from this point forward into 2010, and there are some moving parts. We have had far less drilling, we may have some economic recovery, but at the end of the day, the weather call is very dominant as a driver of whether gas prices will improve much from here.

TER: What is it typically costing to produce gas out of some of the shale plays you mentioned?

DG: People often confuse the notion of an ongoing cash cost versus an all-in invested cost. In terms of cash cost, most producers now are able to get gas out of the ground from existing wells for about a dollar per MCF. On the capital side, very credible producers—for example, Chesapeake Energy Corp. (NYSE:CHK)—are showing numbers that indicate they can have, say, a 10% pre-tax return with on the order of $4 for the gas in the most competitive shales, such as the Haynesville and the Marcellus.

It quickly erodes when we look at a broader universe of types and qualities of wells. The best projects that can tolerate a fully loaded $4 are very material, but very many producers are doing a lot of work on what they perceive to be best-in-class type projects within their own portfolios. They need more like $5–$5.50 fully loaded.

TER: As you said, you need a higher price before it makes sense to get the gas out of the ground.

DG: Yes, and so we've seen a very rational response by the sector laying down drilling rigs. While they're producing and making positive returns on a cash basis, on a project basis prices simply haven't been high enough to justify activity. We've dropped down from about 1,600 rigs drilling for gas mid-to-late last year to about 700 rigs now.

TER: Haven't we seen some uptick since the bottom?

DG: Very small. The last few weeks we've seen a little bit here and there, partly driven by the ability of producers with those perceived best projects to hedge. In the last couple of months, we've had very low spot and near-month NYMEX prices, but very big spreads moving into next year such that producers could have sold forward at $6 or even $7 per MCF for 2010. So we're beginning to see a little bit of an uptick in activity related to hedging and also to some of the producers needing to drill to retain their acreage.

TER: What are some of the natural gas stocks you're telling your clients they should be buying?

DG: We're actually running out of upside to our targets. The names we like best are the better-capitalized names—Chesapeake and EOG Resources, Inc. (NYSE:EOG), for example. Generally, we're sticking with the better-capitalized names because they would be able to endure, as they had to do earlier with this year's weaker markets.

For the next quarter or two, where gas prices will be and how stocks will behave is very much a call on weather, but we do still see some upside in a few names independent of weather. That would be going toward valuations reflecting the long-term $6. If we have a wicked cold winter season, though, we will see bigger upsides and don't want to miss out on those.

We stay generally away from some of the smaller go-go names, and right now names that are very cheap are pretty scarce. An exception is Forest Oil Corporation (NYSE:FST). It's been in the doghouse with investors for a while, having used up liquidity for some acquisitions last year and having taken a slow growth year in 2009. But with Forest Oil, you've got a deep value opportunity and not too much risk on natural gas relative to where the stock is trading.

TER: Any other names of interesting gas plays you'd like to share with us?

DG: Energy XXI (NASDAQ:EXXI) is one of the more interesting names in the space, inasmuch as there is so much uncertainty about gas prices. We're always on the lookout for names that have material volume upsides through exploring, and Energy XXI is effectively a company that acquired properties from firms such as Pogo Producing Company, which was bought out a couple of years ago. The Energy XXI business model is to improve properties that they acquire, and they've proven quite capable of doing that.

But their second line of business is they're partnered with McMoRan Exploration Co. (NYSE:MMR), which is another name we like. McMoRan is involved with some ultra-deep drilling near shore. Effectively their idea is that certain sands will still be of good quality at great depth and the associated great pressures at great depth will make them producible at high rates. McMoRan has had some good luck with that in some shallower projects, but a couple of very large projects—one known as Blackbeard and one known as Davy Jones—may be very material to the industry and certainly to both McMoRan and Energy XXI.

So our view on Energy XXI is that its core business of keeping production relatively flat and therefore cash flow flat has been good, and we've been very positive on the bonds for Energy XXI. But for the equity call, the progress being made on McMoRan and the extent of Energy XXI's participation in those programs is the material driver. In fact, we find this relatively small and really still fairly unknown name one of the more exciting stories in the sector.

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