3 Undervalued Natural Gas Stocks To Buy

David is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

The conventional wisdom in energy is being directly refuted by a recovery in natural gas prices. Futures rose to their highest price in a year--a second weekly gain. I encourage diversifying across a mixture of cheap producers on a P/CF basis and those with leading growth potential in underestimated plays. Below, I review three stocks in oil & gas that I am bullish about.

Several Catalysts To Drive Apache (NYSE: APA)

With the stock trading just under book value, Apache is an ideal buy right now. It has fallen 32.4% from its 52-week high and now, at $75.30 per share, is valued substantially below the $112.32 price target. Moreover, it was just June when UBS issued a $127 price target on the firm--a month before that Barclays was calling it a $132 stock. Investors are rightfully concerned about the company's volatile free cash flow, but the company is making the right investments.

How so? 53% of production goes towards liquids, which allow for better market flexibility. Domestic natural gas prices have risen 60% from their lows, and yet the stock is down significantly. And one third of the company's gas production comes abroad where price realizations were 20% above domestic average realizations. Management has also delivered record rig counts in the Permian and Central regions. An extensive drilling program at the same has delivered strong production--an average of 771,000 boe/d in the most recent quarters. And to be specific, if you look at a play that Exxon recently traded (Canadian gas acreage), Apache has 300,000 acres in that same region and 6.5 million altogether in Canada--management has become more optimistic about resource potential in liquids there. 

At less than 4x operating cash flow, you are paying very little for all of these catalysts. I encourage backing the company now to capitalize on their under-recognized potential. Performance may have been below expectations in the last three quarters, but EPS growth of 5.7%, when combined with depressed multiples, is enough to keep the stock from materially dipping in the next few years.

EOG Resources (NYSE: EOG), Chesapeake Energy (NYSE: CHK) Maintain Leverage In Undervalued Plays

In contrast to Apache's hit and miss performance, EOG Resources has generated consistently strong returns. EPS has been above consensus if 4 of the last 5 quarter (in 1Q12, it was in-line) with an average beat of 28.1%. While the stock's 19.7x forward earnings multiples is above the historical average past earnings multiple (excluding outliers, it ranged in the 13x-18x range), analysts are still bullish on the stock. In fact, just a few days ago, Baird upgraded the stock to "outperform" and increased the price target from $126 to $142. Canaccord Genuity was even more bullish and upped the price target from $158 to $162. The stock currently trades at $116.67.

With 2012 production increased for next year and Bakken secondary recovery performance to look forward to, investors should anticipate strong cash flow ahead. And with independent reports indicating that Marcellus natural gas reserves are both larger than originally expected and cheaper to develop. Even Chesapeake (NYSE: CHK), which has decided to substantially lower drilling in the Marcellus and is in need of asset sales to boost liquidity, has taken every action within its power to maintain Marcellus acreage. The contrasting report by the Energy Information Administration reducing Marcellus reserves by a staggering 70% is thus being dismissed by the largest producers.

I think the ideal strategy then is to diversify across Chesapeake, EOG, and Apache. The diversification across various plays is nicely timed for a continued recovery in natural gas prices. While Chesapeake trades 28% below book value, EOG is forecasted for leading annual EPS growth of 14.8% over the next 5 years. The combination of cheapness and high-growth is, in my view, a winning investment strategy.

TakeoverAnalyst has no positions in the stocks mentioned above. The Motley Fool owns shares of Apache and has the following options: long JAN 2013 $16.00 calls on Chesapeake Energy, long JAN 2013 $16.00 calls on Chesapeake Energy, long JAN 2013 $25.00 calls on Chesapeake Energy, long JAN 2014 $20.00 calls on Chesapeake Energy, long JAN 2014 $20.00 calls on Chesapeake Energy, long JAN 2014 $30.00 calls on Chesapeake Energy, long JAN 2014 $30.00 calls on Chesapeake Energy, and short JAN 2014 $15.00 puts on Chesapeake Energy. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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