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Wholesale Changes

By Peter Staas on Aug. 14, 2014

In last week’s Energy in Pictures, we examined how robust US natural-gas production has led to record injections this summer, reducing the gap between working gas in storage and the five-year seasonal average.

As we forecast at the beginning of the year, this supply response has crushed naïve expectations of a sustained recovery in natural-gas prices. Unsophisticated pundits who mistook last winter’s weather-related rally for a durable uptrend talked up producers in the Marcellus Shale as the best way to gain exposure to climbing gas prices.

At face value, this recommendation makes sense. Companies such as Antero Resources (NYSE: AR), Cabot Oil & Gas (NYSE: COG) and Range Resources Corp (NYSE: RRC) own some of the best acreage in this prolific gas-producing basin and boast some of the lowest production costs in North America.

There’s also no disputing the long-term appeal of these names, which own long-lived resource bases and can ramp up production significantly as midstream operators address takeaway constraints and new demand outlets emerge.

The problem is valuation. At this stage in the shale oil and gas revolution, the market has a firm understanding of these names and their growth stories–and their valuations reflect this knowledge.

Investors looking to play the seasonal recovery in natural-gas prices would have been better off adding exposure to beaten-down utilities that have significant exposure to wholesale electricity markets.

Depressed natural-gas prices have weighed heavily on prices and economics in this market; any uptick in the price of this thermal fuel can produce a dramatic rebound in these stocks.

This phenomenon partially explains Exelon Corp (NYSE: EXC) and Calpine Corp (NYSE: CPC) have outperformed the shares of popular producers that operate primarily in the Marcellus Shale.

Although utilities with outsized exposure to wholesale electricity prices have pulled back in recent trading sessions, the market has overlooked some companies’ progress in reducing their exposure to persistently weak natural-gas prices.

NRG Energy (NYSE: NRG), for example, grew its second-quarter cash flow by 15 percent year over year, despite a difficult quarter for its wholesale operations. Nevertheless, the market continues to overlook the utility’s efforts to diversify and its access to low-cost capital by dropping down assets to the wildly popular NRG Yield (NYSE: NYLD).

Meanwhile, Exelon’s proposed acquisition of Pepco Holdings (NYSE: POM) will ensure that the utility’s regulated operations cover the dividend and put the company in a position to raise its payout. (See Exelon Corp Peps Up.)

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